johnhuber

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Berkshire Meeting Notes – Daily Improvement, Business Evolution, and Investment Strategy

Last week I headed to Omaha to attend Berkshire Hathaway’s annual meeting. Nowadays, there is less of a reason to attend the meeting in person because it is available to watch online, but I love attending the event for all of the peripheral meetings that occur. It was a great weekend, and I got to connect with a few Saber Capital clients, as well as some good friends that I don’t see very often.

No matter how long you’ve been following Buffett and Munger, there are almost always some valuable learnings to be had at this event, and they usually touch on a topic or two that provokes me to think more deeply about a particular subject.

Here are a few main highlights from the meeting that I thought were worth mentioning:

On Learning and Getting Better

I’ve talked before about the process of continually getting better as an investor. I think investing is in some ways similar to other performance-based disciplines such as athletics or music. Top performers work on getting better each day, and while there isn’t usually a noticeable difference on any given day, stringing together a bunch of days where you are getting incrementally better by even a very small margin leads to a collectively significant improvement over time. As Buffett has pointed out many times, knowledge builds on previous foundations and grows over time, just like compound interest.

Munger has often said that your goal as an investor should be to go to bed a little bit smarter than when you woke up. Along with the idea of focusing on “the work that’s on your desk” (i.e. not looking too far ahead and just keeping focused on the task at hand), I think this goal of daily improvement is one of the most useful and practical lessons that Munger has ever taught us. I’ve tried to build Saber Capital’s business around this idea, keeping a clear schedule each morning to ensure that this objective stays at the top of my priority list.

Over the weekend, this topic of self-improvement came up, as it often does. Munger talked about his most important learning lesson, which he thought was See’s Candies.

I want to go into a brief tangent on some thoughts I have relating to this discussion. I occasionally think about what Buffett and Munger might be investing in if they were starting today. I think it would look a lot different than it did then.

First off, Munger said See’s was his most important learning lesson because it taught Munger and Buffett about the value of owning a great business, specifically one that can produce ever growing levels of cash flow with very little incremental capital requirements. See’s was a cash cow that didn’t need to be fed. And it produced more and more milk each year, still without requiring any “food” (i.e. little to no cash needed to be invested back into the business to grow).

See’s produced $4 million of pretax earnings the year they bought it. They paid $25 million, or somewhere around 12 times earnings after tax. Since that time, the company has sent around $2 billion of pretax cash flow to Berkshire, using just $40 million or so of incremental capital investments. As Buffett said in the 2014 shareholder letter:

“See’s has thus been able to distribute huge sums that have helped Berkshire buy other businesses that, in turn, have themselves produced large distributable profits. (Envision rabbits breeding.) Additionally, through watching See’s in action, I gained a business education about the value of powerful brands that opened my eyes to many other profitable investments.”

What If Buffett Knew What He Knows Now?

Everyone knows by now that See’s was a great business to buy. But the tangent I wanted to briefly take is to consider how the See’s experience likely would have impacted the decisions Buffett previously made. In other words, would it have changed some of his investments, or would it have changed his investing approach had he been able to go back in time, knowing in the 50’s and 60’s what he learned in the 70’s from the See’s investment?

I think the answer to that is undoubtedly yes. And while I’ve always thought that there is somewhat of a misunderstanding* about Buffett’s early investment strategy, it is true that he bought some cigar butts (seemingly cheap stocks of poor businesses). I think the learning experience they had with See’s would have significantly changed some of their major early investments. Buffett almost certainly wouldn’t have started buying Dempster Mill in the 1950’s—a capital intensive windmill and farm equipment company with sub-par returns on equity. Nor would he likely have purchased Hochschild Kohn (the Baltimore department store) in the 1960’s.

*(Note, when I say misunderstanding about Buffett’s early investment style, I mean the following: yes, he bought some cigar butts of mediocre businesses, but even very early on he grasped the power and value of owning a good business—he bought GEICO in 1951, putting 65% of his then-small net worth into the stock as a 21-year old. Also, two of his biggest and most meaningful contributors to his results in the 1960’s, American Express and Disney, were stocks purchased while still running his partnership. Even the incredibly cheap stocks that he bought in the early years of his fund, like Commonwealth Bank or Western Insurance, were still pretty decent businesses with stable earning power and good balance sheets. He certainly bought some laggards like Dempster Mill and even Berkshire Hathaway itself, but those were usually when he felt like he could gain control of the business eventually and reallocate the cash. Even early on, he made most of his money in the stocks of better businesses).

So the point is: I don’t think Buffett and Munger would be buying cigar butts in today’s world if they were starting from scratch, given the knowledge they gained in the 70’s and 80’s from investing in both good and bad businesses.

If they could start over with their current knowledge base, I think Buffett and Munger would be buying small and large cap stocks (and everything in between). I think they’d be turning over rocks just as they did in the early days, but I think they’d place a much greater emphasis on the earning power and longer-term viability of the business.

This Time is Different

This also gets me into a broader point on today’s markets: Things would look a lot different if Buffett and Munger were starting today. Buffett said recently that if he had started a partnership in 2004, he would have been 100% invested in South Korean stocks. Munger said at the Daily Journal Meeting that he’d be focused on looking for opportunities in China if he were starting out today.

Neither of these ideas are recommendations, it just means that they’d be approaching things differently based on the skillsets they’ve developed over the years and the knowledge they’ve accumulated. They would use that experience to capitalize on the most obvious and best available opportunities that are offered in today’s business world.

Capital Light Businesses

Along these lines, Buffett talked about how different businesses are now. He mentioned that business moguls like Carnegie, Mellon, and Rockefeller would be absolutely shocked if they knew how quickly companies could grow today and how little capital would be required to support that growth.

He pointed out that the five largest companies in the market are:

Apple

Google

Microsoft

Amazon

Facebook

With the exception of maybe Amazon, those companies require virtually no capital to grow, and even Amazon, despite spending billions of dollars building out its foundation for growth, has a number of major business lines like its third party seller marketplace and its cloud business that produce extremely high returns on incremental capital investments. Facebook, which was founded just over a decade ago, did $27 billion of revenue that had 45% operating margins last year. In just the last twelve months, the company grew its pretax earnings by $6.2 billion on just $3.7 billion of additional capital investments, including acquisitions (good for a healthy 170% incremental ROIC).

In fact, the business probably would be growing even without that additional capital, and the nature of Facebook, Microsoft, and Google’s main businesses are that they produce huge returns on capital, significant cash flow, and require little to no capex.

All of these businesses got to scale much more quickly than Carnegie’s steel plants, Rockefeller’s oil refineries, or Mellon’s banks. It took decades of toil and significant sums of capital to go around the country and cobble together a network of refineries in the late 19th and early 20th century. It took Zuckerberg just eight years to build a business from scratch that reached a $100 billion valuation, and four more to reach $300 billion. In 2010, Facebook had $1.9 billion in revenue. Last year it did over $12.5 billion in pretax profits. These are businesses that Carnegie and Rockefeller could only have dreamed about.

I’d also add that the great companies of a century ago were confined primarily to their industries. Rockefeller was an oil man. He wouldn’t have even thought about getting into retail, or banking. But companies like Alibaba or Amazon start in retail, and then use their foundations and user bases to expand into businesses such as banking, payments, storage, and even investment management.

Given the value these companies provide and the size of the markets they might enter, these businesses can likely become much larger than the relative size of even the greatest monopolistic giants of last century.

I’m simply using the large-cap tech stocks as an example to illustrate my point (I’m not suggesting that buying mega-caps is solely what Buffett would be doing). I don’t pretend to know what stocks Buffett and Munger would be buying today if they were starting over, but what I do think is relevant to take home is that Buffett and Munger were both very independent-minded in the 1960’s. They did things their own way. They capitalized on the opportunities they had at that time, and I think they’d be doing the same today.

I think the foundation of value—getting more future cash flow for the price paid—will always be the philosophy that works. I also think that investors should use Buffett’s blueprint to form their own independent thoughts about opportunities—both big and small—in today’s business world. There are lots of incredible opportunities, and the one thing that will always stay the same is human nature—Mr. Market will always be moody.

Consumer Shift

Buffett also mentioned Apple, and how his main thesis was observing consumers’ perception of the brand and the stickiness of the software ecosystem. This leads to predictable demand for the iPhone, and other related Apple hardware products.

But he also said that consumer behavior is more difficult to judge than it used to be. I think that this is in part because people aren’t as beholden to consumer brands as much as they used to be. Or, put differently, I think many companies that we think had a brand really just had a distribution advantage that came from being a big incumbent with the largest market share for many years. The high gross margins led to bigger advertising budgets, which further entrenched these market leaders. Kraft used to own its place in the center of the grocery isle. This advantage is eroding, as distribution costs have plummeted. The internet and social media have lowered the cost of getting products to market and reduced the time required to get to scale. They’ve cut out the middleman in many cases, allowing small upstart companies to sell directly to consumers and avoid the typical retail markup.

Is the Product Undervalued?

As I mentioned in my 2016 year-end investor letter, one of the things I try to consider when analyzing a potential investment is whether the company’s product or service is a good deal for customers. If a business has attractive economics but is extracting value from (rather than adding value to) its customers, then I think there are some inherent risks in that model that will eventually come home to roost. This parasitic relationship might lead to above average profitability in the near term, but it also leads to customers who feel exploited, and when a competitor comes in that offers more value to customers (in the form of better products and/or lower prices), these alienated customers will be much more quick to leave.

For example, Costar owns a commercial real estate website called Loopnet, which had enormous embedded pricing power when Costar bought the site. The company understood that the site was essential to commercial real estate brokers, and began raising prices very rapidly. Some brokers I’ve talked to have seen their Loopnet subscription costs rise multiples from where they were just a couple years ago. Just about everyone in that business that I’ve talked to feels that they aren’t getting good value, but they continue to pay because of the monopoly-like position of the website (it’s basically the commercial real estate MLS, and brokers must have access to it to do business in most cases).

This type of position is often viewed as an attractive asset, a moat. But as a business owner, I’d be worried that my customers would quickly jump ship if a competitor came up with an alternative. Contrast that with the experience customers feel at Amazon Prime, which continues to provide more and more value to customers through wider selection, greater convenience, and prices that more often than not can’t be beat. This extreme customer value makes it more and more difficult for a competitor take customers away from Amazon’s platform.

The Most Important Moat

I gave a talk last weekend in Omaha called “The Most Important Moat”, which basically outlined this idea that the best way to build an enduring competitive advantage is to focus on ensuring that the customer feels like the product or service that you’re selling is a good deal.

If not, you will no longer be able to rest on the laurels of barriers to entry, high distribution costs, incumbent advantages like shelf space, bigger advertising budgets, switching costs, or just about any other advantage that you used to enjoy in years past. It’s much easier to start a business, sell directly to consumers and build a product brand using social media. This allows you (and other small like-minded upstart companies) to collectively compete against much larger brands, despite having much lower advertising or distribution resources.

I think the advantages that used to be relied on by big incumbents like Gillette, Kraft, or Kellogg are eroding. Consumers have more options to choose from, better information on products, and receive more value for the price paid.

High margins and consumer brands are still very valuable, but I think the key is determining whether a company’s perceived brand comes from its market share, distribution, or advertising budget, or whether it comes from providing customers with great value. I think the former category will see their brands lose value. The latter category will still face plenty of competition, but I think it’s much harder to dislodge a company with the best value proposition to the end customer.

Bezos said the following:

“The balance of power is shifting toward consumers and away from companies. The right way to respond to this if you are a company is to put the vast majority of your energy, attention and dollars into building a great product or service and put a smaller amount into shouting about it, marketing it.”

So I think some things to keep in mind regarding Buffett’s comments about the greater difficulty in predicting consumer behavior are the following:

Brands are generally less powerful than they used to be

Distribution and advertising costs are no longer insurmountable barriers to entry (companies can sell directly to consumers on a shoestring ad budget)

Products can scale much faster

Large market share and well-known products don’t necessarily equal a moat

Key questions:

Does the company have a true brand that offers a valuable product?

Or is it a highly profitable incumbent whose high margins are due to an overpriced product and an eroding “shelf space” distribution advantage?

Is the customer getting a good deal when they buy the company’s products or services? I think spending time trying to think about and answer this question will go a long way in helping understand consumer behavior and also help value the business in question.

That wraps up some of my main notes/thoughts on this year’s meeting. I enjoyed meeting some of you in Omaha, both readers and clients of Saber Capital, and hope to see you there next year!

Disclosure: John Huber and Saber Capital Management clients owns shares of AAPL.

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

To read more of John’s writings or to get on Saber Capital’s email distribution list, please visit the Letters and Commentary page on Saber’s website. John can be reached at john@sabercapitalmgt.com.

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Charlie Munger’s Most Important Concept (Takeaways from the DJCO Meeting)

A couple weeks ago, I flew to Los Angeles to listen to Charlie Munger at the Daily Journal annual meeting. These days, you can read the transcript of these events or even watch it on YouTube, so there is less of a practical reason to attend the actual event. But the main reason I enjoy these events is to meet with people. I have as much fun at the peripheral gatherings as I do at the main event. It’s nice getting to see friends of mine in the investment business who I don’t often see. It’s also great to meet up with clients who might live in the area of these events. That said, I have no doubt you can get more out of attending the event than you would watching it on YouTube. Hearing it straight from the horse’s mouth is good; but when the horse is in the same room as you, even better.

As usual, Charlie was full of Mungerisms, and while everything he said has probably been uttered by him previously, there were still a number of things I found relevant and worth highlighting. Nothing most investors haven’t heard, but it was very clear to me that these general principles were a very important part of the foundation that Charlie Munger used to help build his investment record over the last half-century.

Here two of my main takeaways/thought provoking topics that he discussed:

Takeaway #1: Patience—The Importance of Focusing on Your Best Ideas

As Charlie has said many times (including in my favorite talk he ever gave—The Art of Stock Picking), the ability to patiently wait for only the exceptional opportunities (and the ability to capitalize on them when they come along) has been a big edge for him over time.

At the meeting, Charlie talked about how his grandfather built a fortune in the Midwest by focusing on just one or two really good ideas. I believe Munger said he owned banks, and then at a few key times, opportunistically bought farms during recessions. The concept of doing nothing for years and then capitalizing on opportunity makes a lot of sense in most areas of business, but rarely is practiced in the stock market. Munger is probably the closest I’ve seen to someone actually implementing this concept.

Charlie made a comment about when he was starting out in his original investment partnership, he sat in his office at the law firm and sketched out a few basic ideas about portfolio management:

He said he figured he hold the average stock in his portfolio 3 or 4 years

He figured he might have 40 years or so to invest

Given the above two assumptions, he wouldn’t need more than 4 stocks in his portfolio to be adequately diversified

I think what he’s basically implying here is that if he has a 4 stock portfolio and he does this for 40 years, he’ll make 40 or 50 investments over the life of the partnership (assuming a 3 or 4 year hold time).

He said numerous times throughout the afternoon (as he’s said all his life) that:

You won’t get that many great ideas

You don’t need that many great ideas

Again, this is all stuff that has been repeated ad nauseam, but it is a very valuable idea to keep in mind��and given the contents of most portfolios I look at from other investors, it’s advice that’s very rarely followed.

In Saber Capital’s 2016 Investor Letter, I outlined some of the reasons for why I think this “do as I say, not as I do” dynamic exists in professional money management.

Takeaway #2: “Things Are Harder Now” (Or Different Now?)

The typical NBA offense used to be much more centered around the big 7 footer. You needed a star big man if you expected to be a title contender. But the game has changed. To be successful, you need to spread the floor with sharp shooters and your offense relies much more on the three-point shot. It’s not harder to win a championship than it was 30 years ago, but it would be if you were forced to implement the same game plan now that you used back then.

I’ve heard a lot of larger, well-known successful investors repeat the general idea that “investing is harder than it used to be”. Klarman said it in a recent letter, and I’ve heard probably three or four well-known top-tier investors repeat something similar in recent years. Munger repeated this same idea at the meeting. Basically, their feeling is that due to much greater competition, it’s harder to find the really low-hanging fruit and thus harder to beat the market.

However, I think that this view is influenced to a much greater degree by the size of the portfolios that these guys manage than it is by the actual competitiveness of the market. Of course it’s going to be hard for Klarman to do what he did in the 1980’s—he’s got somewhere around $25 billion or so to allocate now.

This is not to say that investing isn’t competitive—it’s one of the most competitive fields out there, as competition tends to be commensurate with financial rewards, and the rewards are almost unlimited in this particular field. I also don’t want to imply that beating the market is easy. It’s extremely hard to do over long periods of time, as evidenced by the staggering long-term win/loss record of the S&P 500 vs portfolio managers.

I also agree with Munger that the style of investing that he and Buffett used to trounce the market in the early years of their careers (mostly buying and selling really cheap stocks of decent businesses that nobody was following) is also much harder. There are no Western Insurance’s at 1 P/E anymore. Those stones have been turned over long ago.

But where I might cautiously disagree with Munger is on this point: the edge they had in the 50’s no longer works as well, but that doesn’t mean that there aren’t edges to be had in the stock market. As I’ve talked about a few times in recent posts, I think there are three general potential advantages that can be gained in the markets:

Informational edge

Analytical edge

Time-horizon edge

Most people only really consider the first advantage. I think Munger—when he talks about things being harder today—is simply saying that the informational advantage that he and Buffett gained by simply looking through Moody’s manuals—is obviously no longer there. The availability of information and the quantity of people analyzing it has largely arbitraged this general advantage away. This concept has really solidified for me over the past year or two. It’s still worth turning over stones, and certainly there are more inefficiencies with smaller securities, but I completely agree with Munger that the low-hanging fruit is gone.

But I think the reasons why this advantage has been mitigated in recent decades has also helped create a different edge—long-term thinking. Better technology and easier available information has made it impossible to locate a solid business like Western Insurance trading at 1 times earnings—that opportunity would have been “arbitraged” long before it got to such a crazy valuation. But the speed and pace of information flow combined with the short-term demands of the owners of capital (or their proxies) has helped widen the “arbitrage” opportunity for those who don’t have to play that game. Stocks were held over 10 years on average when Buffett and Munger were plucking the low hanging fruit—today the average stock is held for just a period of months. These buying and selling decisions are largely made for reasons other than the intrinsic value of the security in question, and thus create volatility in stock prices that don’t always correspond to volatility in business operations.

Basically, time arbitrage is an advantage that I think is much stronger than it was in Buffett and Munger’s day. It’s a different game, and this edge probably isn’t quite as large as the information edge of yesteryear, but I think it’s still quite significant.

So I think that when great investors made fortunes using a particularly technique and that technique is no longer working, they feel the game is much harder to win. Their big 7 foot center isn’t as dominant as he was in previous decades. But I think that just like competitive advantages in business evolve, or general strategies in sports evolve, the strategies that are successful in beating the market have also evolved over time.

I know of numerous small professional money managers that are beating the market over a decade plus, and I personally know a few people who are trouncing it, and have been for years. They are using the same principles that Munger used, but their tactics are different. Time will tell if these people have been better lucky than good, but I would bet on their record continuing until the point that they become whales. I would also bet heavily that if Munger, Klarman, or any other of the greats who long for the good-old-days were given a clean slate with a smaller sum of money, they’d too be able to once again trounce the market.

Buffett himself has talked at length about his size becoming too high a hurdle for great performance, but he recently said that if had started a new investment partnership in 2004, he would have been 100% invested in Korean stocks. At the DJCO meeting, Munger mentioned China as a place he would be actively looking for opportunities today.

So advantages evolve over time in business and investing, as do tactics and areas of focus. Were these great investors to start from scratch today, they might have to focus more on the metaphorical three point shot as opposed to their bigs, but I bet they’d bring home a few championships.

Wishing for the Good-Old-Days is Nothing New

One last point on this concept that “It’s harder now than it used to be”: I’ve not just heard this point recently, I’ve read about great investors who have said this point at various times throughout history.

In the mid 1970’s, Graham began to feel that the investing field had become too competitive and that his method of rigorous security analysis would no longer work as well. At this same time that Graham had felt the time in the sun had passed for the stock picker, Buffett was just getting his Berkshire snowball rolling.

In the late 90’s, famed stock picker Julian Robertson closed the doors of his enormously successful hedge funds, citing that the market had “changed”, and that the strategies he used for decades were no longer working. At this same time, a new class of small stock pickers like Dan Loeb and David Einhorn were busy stacking up 30% annual returns in their early years when their funds were still small. I think it wasn’t that Robertson’s strategies didn’t work or that the market had changed, it was just that he was too big.

Today Loeb and Einhorn are big, and both have hinted that things are different now. I think two takeaways from this section are that:

Size makes things harder

Sometimes tactics that were once successful don’t work as well. This doesn’t mean investing success is no longer possible, but it might mean that different tactics have to be utilized.

Takeaway #3: Great Ideas Are Obvious

Munger is incredibly sharp for being in his early 90’s, and while he sat for a couple hours in front of hundreds, he also took questions in front of a smaller group afterward. I wasn’t at this gathering, but the videos can be found here.

In the video I linked to above, he mentions that he has read Barron’s for 50 years and got one idea from it that made him $80 million. He gave that $80 million to Li Lu who has turned it into $400 million. Munger jokes that most people wouldn’t have the patience to read Barron’s for 50 years and only come away with one idea. But his point had nothing to do with Barron’s—it had to do with the concept of patience, and the idea that there won’t be that many great ideas out there.

The stock he bought was a cigar butt (as he categorized it)—some auto parts supplier that he bought for $1 per share and then sold it a couple years later for $15. Munger said it took him an hour and a half to decide to buy it. This tells me a couple things.

Munger thought it was an obvious idea and didn’t need long to realize that.

Although he spent 90 minutes on this idea, there was an immeasurable amount of preparation time led up to that decision, so that when the opportunity came, he was prepared to quickly evaluate it and capitalize on it.

Munger talked about how for his entire life, he has read four newspapers each and every morning and that he always has had two or three books going at once. This is how he has approached his life and his investment process. He enjoys doing this work, and he has used that strategy of compounding knowledge over time with an extreme amount of discretion and patience to build a great investment record.

All of these concepts are widely acknowledged, but it always helps to sear them in deeper every so often.

Have a great week.

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

To read more of John’s writings or to get on Saber Capital’s email distribution list, please visit the Letters and Commentary page on Saber’s website. John can be reached at john@sabercapitalmgt.com.

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Importance of Knowing Your Investment Boundaries (Sears Mini-Case Study)

A few months ago we had an interesting post/discussion on the site where Matt Brice and I share some of our research and investment ideas. The topic was Munger’s ability to quickly discard an investment opportunity if it was something he didn’t understand or a business he didn’t like. The comment that Munger made regarding the business of cattle ranching was one of the key takeaways that stayed with me from the 2016 Berkshire Annual Meeting—in short, the discipline that Munger has when it comes to his “too hard pile”.

A week ago I read an article in Business Insider that referenced a Q&A from 2005 where Buffett was talking to a group of students from the University of Kansas and he was asked about the chances of success of the Sears/Kmart merger (which had just recently occurred at that time).

Buffett’s answer—as so often is the case—was quite simple-minded and succinct, yet very logical and packed full of good advice to consider. What really struck me was the same thing that struck me in Munger’s reply to the cattle rancher: Buffett’s ability to quickly discard an investment opportunity that belongs in his too hard pile. He wastes very little time and energy considering these types of ideas.

Here is the question from the student:

“What is your opinion of the prospects for the Kmart/Sears merger? How will Eddie Lampert do at bringing Kmart and Sears together?”

Buffett’s reply is simple and brief, but contains some really valuable gems on the circle of competence concept, the too hard pile, and more specifically, the dangers and difficulty of the retail business:

“Nobody knows. Eddie is a very smart guy but putting Kmart and Sears together is a tough hand. Turning around a retailer that has been slipping for a long time would be very difficult. Can you think of an example of a retailer that was successfully turned around? Broadcasting is easy; retailing is the other extreme. If you had a network television station 50 years ago, you didn’t really have to be a good salesman. The network paid you, car dealers paid you, and you made money.

“But in retail you have to be smarter than Wal-Mart. Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day.

“Retailing is like shooting at a moving target. In the past, people didn’t like to go excessive distances from the street cars to buy things. People would flock to those retailers that were nearby. In 1966, we bought the Hochschild Kohn department store in Baltimore. We learned quickly that it wasn’t going to be a winner, long-term, in a very short period of time. We had an antiquated distribution system. We did everything else right. We put in escalators. We gave people more credit. We had a great guy running it, and we still couldn’t win. So we sold it around 1970. That store isn’t there anymore. It isn’t good enough that there were smart people running it.

“It will be interesting to see how Kmart and Sears play out. They already have a lot of real estate, and have let go of a bunch of Sears’ management (500 people). They’ve captured some savings already.

“We would rather look for easier things to do. The Buffett grocery stores started in Omaha in 1869 and lasted for 100 years. There were two competitors. In 1950, one competitor went out of business. In 1960 the other closed. We had the whole town to ourselves and still didn’t make any money.

“How many retailers have really sunk, and then come back? Not many. I can’t think of any. Don’t bet against the best. Costco is working on a 10-11% gross margin that is better than Wal-Mart’s and Sam’s. In comparison, department stores have 35% gross margins. It’s tough to compete against the best deal for customers. Department stores will keep their old customers that have a habit of shopping there, but they won’t pick up new ones. Wal-Mart is also a tough competitor because others can’t compete at their margins. It’s very efficient.

“If Eddie sees it as impossible, he won’t watch it evaporate. Maybe he can combine certain things and increase efficiencies, but he won’t be able to compete against Costco’s margins.”

Circle of Competence and the Too Hard Pile

There are a few really valuable comments in this reply, but probably most significantly to me was the ease with which he passed on the investment idea. Buffett didn’t necessarily say he knew Sears would fail or that he was shorting Sears, or anything certain. He definitely expressed doubt about the company’s prospects, but he simply said it was too difficult of a business for him to want to own. There were too many things that needed to go right for Sears to work out as an investment, and Buffett just felt the odds were against him.

Everyone talks about circles of competence, but one of the greatest skills Buffett and Munger have is their ability to say “no” to ideas that are too difficult. Their ability to successfully stay within their boundaries (most of the time) comes from their unique combination of incredible brain power and unusual humility. Most people who are smart and ultra-driven (character traits of most successful people) have a hard time saying “no” to challenging new ideas. They tend to believe that their will power can overcome most obstacles. These are attractive character traits in many business fields—but they can, at times, become a liability when it comes to the field of investing.

Retail is Difficult

The more specific takeaway from Buffett’s comments is that retail investing is difficult. Buffett makes a few really valuable points. The first point is that he couldn’t find any evidence or cite even one example of a retailer that turned around after suffering a major decline in business. Customer tastes change often, and once a retailer loses a step with customers, it is extremely difficult to gain those customers back. Buffett mentions department stores “will keep their old customers that have a habit of shopping there, but they won’t pick up new ones”.

The second point he made is that retail is not just competitive, but that you often don’t have control over how you run your business because you are constantly required to keep up with both the whims of customer tastes and also match whatever your competitors are doing. Buffett has said before that his Baltimore department store would see the competitor across the street offer some special promotion for the weekend, forcing Buffett’s store to offer the same discount or else lose business. It’s a game that forces you to react in ways that you might not want to, but have to.

The third point is that even a high-quality manager can’t save a retail business that has lost its way. Buffett learned this first-hand with not just Hochschild-Kohn, but also with Associated Cotton. The latter was a business run by a manager that Buffett praised as an outstanding operator numerous times in his early Berkshire Hathaway annual letters, but despite the high-quality, cost-conscious manager, the business ended up liquidating for pennies on the dollar a decade or so later.

Be Careful With Sum-of-the-Parts Analysis

One other interesting note is that the key pillar of the Sears’ investment thesis (the sum-of-the-parts real estate value) is one that has been around long before the time that Eddie Lampert entered the picture. Two years ago I wrote a post that references a 1988 article that was written in a Chicago Business Newspaper titled “Sears: Why the Last Big Store Must Transform Itself, Or Die”. This article is a really great read from a case study perspective, but one quote really stood out:

“Certainly, the profit potential of a Sears bust-up is tempting. Despite hidden assets, especially a coveted real estate portfolio valued as high as $11 billion, Sears’ shares are selling at about $36.50 each–slightly above book value and a whopping 160% less than Sears’ estimated break-up value.”

Investors were talking about the value of Sears’ real estate as far back as 1988, almost 20 years before Lampert merged the company with Kmart and began discussing plans to monetize those assets. At the time the 1988 article was written, Sears had a market value of $14 billion. But this value largely lied in the insurance and financial services businesses that Sears owned (All-State and Dean Witter) and not in the retail businesses that generated most of the revenue at that time. Today, the market value of Sears Holdings is under $1 billion. In the last 10 years alone, Sears Holdings (SHLD) has lost over 90% of its value. Even after accounting for the various spinoffs and asset sales, the last decade hasn’t been a good one for the retailer.

While hindsight is always 20/20, Buffett saw the difficulty Sears/Kmart was facing in 2005 because he experienced the same headwinds in his own travails in the retail business. Investing is largely a game of pattern recognition, and Buffett saw this pattern before.

“Don’t Bet Against the Best”

Finally, Buffett touches on the economics of the retail business, and how important scale can be, given that retail is an ultra-competitive industry. Buffett mentions Costco’s “10-11% gross margin that is better than Wal-Mart’s and Sam’s.” He goes on to mention that the typical department store has a gross margin of 35%, meaning that customers at Costco are getting a significantly better deal (in the form of lower markups from cost) than customers of department stores. Yet the department store’s fixed operating costs are too high to be able to lower prices to a level that would allow them to be competitive with the discount chains.

I checked out the current gross margins for a number of retailers, and the same dynamic that Buffett referenced twelve years ago is almost exactly the same today. Costco beats Wal-Mart and its prices are much lower (relative to its cost) than the department stores:

Almost all the department stores are right in that 35% gross margin area that Buffett referenced, with the coincidental exception of Sears, which is an example of what happens to a department store’s overall profit margins when it tries to lower its markups:

Sears, like most other department stores, has fixed operating expenses that are too high to support lower gross margins. These types of retailers have a tough choice:

Sell merchandise at higher margins (and thus higher prices to customers)

Price merchandise at lower markups (making it difficult to cover operating expenses)

The first option allows for the retailer to make a profit in the near-term but takes the existential risk of losing customers who leave to buy the same products at lower prices elsewhere. The second option makes an attempt to stave off customer defections, but then might result in significant losses as the lower gross margins aren’t sufficient to cover the company’s fixed costs.

The problem is that lower margins might be too little, too late. Sears seems to be pricing its products at consistently lower markups each year, but sales have gone from $53 billion to $23 billion in the last 10 years. They’re losing customers even while trying to appease them with lower prices. It’s kind of the opposite of having your cake and eating it too.

Amazon

One company conspicuously absent from Buffett’s comments of course is Amazon, and while Amazon’s gross margins are higher relative to other retailers, this is in part due to the extremely high-margin business of Amazon Web Services (AWS). If not for AWS and if we just focused on the company’s core retail business, we’d likely find Amazon’s margins to be razor thin relative to its competition. When combined with its massive buying power, the result is extremely low prices (like Costco). It’s clear that Amazon’s price and selection is impossible for most retailers to match, and when the customer-value proposition of convenience is added, the result is the following:

(source: visualcapitalist.com)

So retail is a competitive space that rewards vast economies of scale that allow for large quantities of products available at very low markups (i.e. low prices for customers). There are a few businesses like Costco and Amazon that have succeeded, and Buffett wisely says not to bet against the best. Unlike some industries where second or third-rate businesses can thrive, retail is an uphill battle that makes success very difficult.

To Sum It Up—The Takeaway

Perhaps the biggest takeaway from Buffett’s comments on retail is that when a retailer loses the favor of its customers, it is likely a situation that will not be reversed. But the broader investment takeaway is that understanding the boundaries of your circle of competence and having the discipline to avoid crossing those boundaries is one of the most important attributes for an investor.

___________________

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

[johnhuber]

Saber Capital Investor Note – Thoughts on the Election

Note: This is a reprint of a letter I sent to my investors two weeks ago with my comments on the US presidential election. A link to the letter can be found here, but below is the full letter reprinted. Please contact me with any questions or comments at john@sabercapitalmgt.com. 

Dear Investment Partner:

This is probably the first and the last time that I’ll go into general political and so-called “macro” concepts in an investor note, but since the election is on everyone’s mind, and since some clients have asked for my (inconsequential) opinion, I thought I’d share some general thoughts. Think of this not as a view on the election, but a view on America: the greatest “business” in the world—one that I am very bullish on and one that I believe will compound intrinsic value over many decades to come.

However, my views have nothing to do (nor were they impacted whatsoever) by the election. My overarching view of this country would be no different if Hillary Clinton had won, and my view remains the same under a President-elect Trump as it has been the past eight years under President Obama. I certainly believe that some candidates and certain policies are better than others, but my general view on America—especially when viewed through the lens of an equity investor—does not change much based on who moves into the White House.

America Needs to “Zoom Out”

Steve Jobs used to talk about "zooming out" when faced with a difficult problem or when thinking about a complicated issue. I think it would behoove the American electorate to occasionally zoom out when discussing the implications of presidential election outcomes, which seem so life-altering in the heat of the present moment.

In 1901, Theodore Roosevelt (a Republican) was sworn into office after the assassination of President William McKinley. As Roosevelt was making his routine daily rides on his horse from Pennsylvania Avenue to Potomac Park, America’s gross domestic product was around $21 billion.  

Let’s fast forward a few decades to Franklin D. Roosevelt (a Democrat who governed much differently than Teddy, despite sharing the same last name). FDR was famous for bigger government and the stimulative projects and entitlement laws that collectively became known as the New Deal.

The time period from the beginning of the Republican Roosevelt’s term to the end of the Democrat Roosevelt’s time in office included a variety of economic adversities including:

Eight economic recessions

A lesser known, but still severe Depression in 1920-21 that included the worst bout of deflationary conditions since 1790, with wholesale prices dropping 37%

An epic financial panic in 1907 that included a 50% crash in stock prices and a run on the banks that nearly collapsed the US banking system, leading to J.P. Morgan himself pledging his own capital to shore up the banks (“The Panic of 1907” in large part led to the establishment of the nation’s central bank—The Federal Reserve—in 1913)

The Great Depression, a time when unemployment rose to 25% and stock prices dropped 90%

Two long, brutal World Wars that exacted a toll on America’s psyche and challenged its resolve

However, despite these massive headwinds, America’s GDP grew from $21 billion in 1901 when the first Roosevelt took office to around $228 billion by the time the second Roosevelt died in office in 1945—a remarkable 11-fold increase in 44 years. During this time from the turn of the 20th century through the end of the second World War, Republicans held the White House for 24 years, Democrats the other 20. America forged ahead, whether being led by the “red” or the “blue”.

Postwar to the Present Time

The postwar era has seen a similar balance, as the political pendulum continues to swing back and forth, but all the while the economy marches on. Since 1945 through the end of 2016—a 72 year period—Republicans have held the presidency for 36 of those years—exactly the same amount of time as Democrats. Not only was the time in office divided right down the middle between the two parties at 36 years apiece, but also the individual presidencies—there have been 12 presidents since FDR: 6 Republicans and 6 Democrats.  

Remarkably, during each of those 12 presidential terms (including the shortened terms of JFK and Nixon), GDP was higher when each president left office than it was when he entered. Through 72 years of Republicans and Democrats, the nominal GDP has grown from $0.2 trillion to $18.6 trillion, a 93 fold increase and a 6.4% compound annual growth rate.

A better measure would involve adjusting these numbers for inflation, which produces numbers that are equally astounding. Real GDP per capita was around $13,000 (in today’s dollars) in the mid-1940’s. The real GDP per capita today is around $56,000, more than a 4-fold increase in purchasing power and standard of living in just two and a half generations.

Of course, moving the needle on an $18 trillion economy is much more difficult, and the economy will not grow nearly as fast as it did in previous decades, but as Buffett has pointed out in his recent letter, even 2% growth in real GDP will produce much greater standards of living just one generation from now:

“America’s population is growing about .8% per year... Thus 2% of overall growth produces about 1.2% of per capita growth. That may not sound impressive. But in a single generation of, say, 25 years, that rate of growth leads to a gain of 34.4% in real GDP per capita… In turn, that 34.4% gain will produce a staggering $19,000 increase in real GDP per capita for the next generation. Were that to be distributed equally, the gain would be $76,000 annually for a family of four.”

America Is a Great Pond to Fish In

America has an incredible two-fold advantage. The first is geographical. The US has benefited from a vast amount of land, including over 300 million acres of fertile farmland, 400 million acres of pasture, and nearly 100 million acres of woodlands. The country also has significant amounts of fresh water, as well as natural borders on both the eastern and western sides of the country that have served to both protect and to be ports of commerce. And the energy resources of this country are immense, including an abundance of coal, oil, and natural gas.

But a big part of the country’s success has been combining the benefits of its vast natural resources with a system of government that has allowed its citizens the freedom to work hard, pursue great new ideas, and risk capital in pursuit of financial gain.

The system we have in place here in America has resulted in a level of prosperity that surely would have been unimaginable when the founding fathers were meeting down in Independence Hall to lay the groundwork and the principles on which the United States of America was founded.  

Throughout our history, we’ve had volatile periods. The country has been involved in wars, social injustice, poverty, depressions, financial panics and instability at times. The country has seen great leaders and ineffective leaders, productive lawmakers and political gridlock. But the great thing about our country is the genius behind the framework that was assembled during the decade that culminated in that epic summer of 1787 when the Constitution was ratified and the three branches of government were formed, giving power to lawmakers, executive leaders, and judges—but balancing their power in a manner that has proven to be remarkably resilient over time, especially when viewed through the lens of world history.

My 5th grade teacher taught me a long time ago that the founding fathers designed the Constitution in such a way that no one person would have too much power and control over the government. This balance of power is such a simple concept. Like many great businesses, the concept could have been etched on the back of a napkin. But that simple concept has been stitched into the fabric of our freedom, and it is still just as true today as it was at the beginning.

To be sure, there have been growing pains that at times have been felt inequitably by certain communities or certain portions of the labor market.

Dock workers fought tooth and nail against the mass adoption of the container ships, which eventually eliminated their jobs at the ports in LA, New York, and elsewhere. But the simple invention of the box metal container led to drastically lower shipping costs and allowed manufacturers to reduce their working capital requirements, speed up their asset turnover, make their supply chains more nimble, and eventually allowed them to increase the breadth of products that they could make and eventually sell to the end-user—all at a significantly lower cost to the individual consumer.

The dock workers were hurting temporarily, but the collective long-term benefit to the overall consumer (in the form of better selection of merchandise at lower prices) outweighed the temporary plight on the docks.  

As Buffett pointed out in a recent letter, in 1900 there were about 90 million acres of farmland devoted to corn, with a yield of around 30 bushels of corn per acre. It took around 11 million farm workers to harvest this land. Today, there are around 85 million acres of farmland for corn, but the yield has gone from 30 bushels per acre to around 150 bushels per acre. This significant 5-fold increase in output has been accomplished with just 3 million farm workers (around 25% of the total workforce that it took to farm the land a century ago).

This 20-fold increase in farm worker productivity meant that 8 million farmers had to go find new lines of work. But collectively, just like the dock workers, the farmers and their families (and society as a whole) have benefited in a big way over time.

America will continue to come up with new ideas and will continue to create and build some of the world’s best companies—ones that provide necessary services or innovative products to its customers, which will lead to greater revenue and earning power for those companies. Owners (shareholders) of those companies will see their wealth increase along the way.

This economic progress will happen when Republicans hold control in Washington, just as it will when Democrats do.

Political Disagreements Are Nothing To Fear

“What has been will be again, what has been done will be done again; there is nothing new under the sun.” – Ecclesiastes 1:9

Political disagreements have always been a part of this country. The freedom to exchange ideas, to speak freely, and to voice opinions is one of the foundations of our nation’s Constitution. But again, it helps to “zoom out” to gain some perspective. No one election poses an existential threat to our existence, which is what you might think if you read the opinion columns or heaven forbid, glance at Facebook or Twitter.

We often view history with a nostalgic filter. For example, we remember our founding fathers for all the great things they did (and they were truly great). But we generally don’t focus on the fact that many of them owned slaves and the architects of the Constitution “compromised” by counting slaves as 3/5th the value of a free person when it came to determining the population.  

Another example is the collection of laws in FDR’s New Deal, out of which came Social Security—something that is now considered a “right”. But in the 1930’s, (like the ACA today) Social Security was heavily debated with enormous amounts of heated and opinionated rhetoric being thrown from both sides. Glance at any newspaper archives from the 1930’s and you’ll see language and opinions that look very similar to disagreements we face today. But Social Security is now widely considered untouchable.

I mentioned the Panic of 1907 earlier. There are many similarities to this financial crisis and the one that occurred almost exactly 101 years later in 2008. Like many panics, there was effectively a run on the banking system, panicked depositors, crashing stock prices, shrinking liquidity and eventually a bailout. One key interesting difference: in 1907, a small group of individuals (as opposed to the government) led by J.P. Morgan himself pledged to put up his own capital and convinced other Wall Street bankers to do the same (shoring up the banking system in the process). While these two panics a century apart had very different causes, they unfolded with similar symptoms (greed followed by fear and herd behavior) and were resolved using similar remedies (an injection of liquidity from reputable individuals/institutions). Both crises left people angry, led to heated debates, and eventually to government regulations.

The Constitution itself was hotly (and even bitterly) debated, and in the end only secured 39 votes from the 55 delegates, barely enough to ensure support from all the represented states at the Convention. So political disagreements are nothing new, and are nothing to fear.

Last Thing on Politics

If you don’t like who won, just wait a few years. Just when all hope seems lost for a particular side, the political pendulum swings the other direction. In 1974, Richard Nixon resigned the presidency in disgrace, and political pundits everywhere were talking about the destruction and end of the Republican Party. Six years later Ronald Reagan defeated the incumbent Jimmy Carter, and four years after that, Reagan won 49 of 50 states in the biggest landslide in modern political history, getting nearly 60% of the popular vote. Eight short years after this 1984 blowout, Bill Clinton took back the White House for Democrats.

The political pendulum is very predictable—like clockwork. In fact, since FDR, Democrats have not held the White House for more than two terms in a row, and Republicans have done that only once (Reagan and Bush held office from 1981-1993).

America’s system of government transcends the power of whoever sits in the White House. The fabric of this nation and the foundation of our system are much stronger and much more inevitable than any one man or woman, or any particular body of lawmakers. The country’s checks and balances will continue to work, and the pendulum that has swung back and forth between the subsets of ideas that exist on both sides of the aisle will continue to swing.

Throughout the inevitable fights, gridlock, ineffective leadership, and bad policies that have (and will surely continue to) come out of Washington, the American economy marches on and the best American businesses flourish. This has always been the case, and for the foreseeable future, this will continue.

Owning a piece of this great system is a sure-fire way to succeed. It’s a lottery ticket that is certain to pay off over time. And the best way to own a piece of America is to own a collection of great businesses that take advantage of this great system. As stockholders of some excellent companies, that is what we are attempting to achieve as investors here at Saber.

So if you like Trump, then bask in the sun for the next four years. If you don’t like Trump, then know that your time is just around the corner. But either way, regardless of how good or bad you think Washington is doing, America will collectively be more valuable in 4 years and in 8 years than it is now, just as it is more valuable now than it was 4 years and 8 years ago.

As a quick reminder, I’ve started writing what I’ll call “investor notes” periodically between the two semi-annual investor letters. In the next few weeks, I’ll send another investor note that will get back to basics and resume discussing things that are much more relevant to our portfolio, including a new investment we made recently.

I feel lucky and fortunate to be able to do the work that I do, and I want to thank you for trusting me with the management of your capital. Feel free to reach me anytime.

Your Partner,

John Huber

Managing Member

Saber Capital Management, LLC

john@sabercapitalmgt.com

[johnhuber]

Buffett’s Comments on Why Airlines Are Bad Businesses

“A truly great business must have an enduring “moat” that protects excellent returns on invested capital.”

        – Warren Buffett, 2007 Shareholder Letter

Berkshire Hathaway’s latest 13-F filings show new investments in all of the major airlines ($AAL, $DAL, and $UAL, and Buffett mentioned in an interview that they also bought Southwest Airlines ($LUV) after the end of the quarter, which won’t show up until next quarter’s regulatory filings). This is very interesting because Buffett’s 2007 Shareholder Letter has some pointed language toward why he doesn’t (or didn’t) like airlines. Of course, it is widely presumed that these investments were made by Todd Combs or Ted Weschler, the two portfolio managers that Buffett hired a few years back. But regardless, it’s interesting that airlines are now part of Berkshire’s equity portfolio. 

The 2007 Shareholder Letter also discusses a topic that we’ve discussed quite a bit: the concept of return on capital, why it’s important, and how to think about it.

For those interested, you could review all the previous posts on the concept of ROIC here.

Basically, I just thought I’d make a few brief comments on Buffett’s ideas here, but largely just clip a few portions of the letter, since I think this is a really useful topic to think about.

In this 2007 letter, Buffett groups businesses into three general categories based on their ROIC profile, and explains the differences between those three categories.

Category #1—High ROIC Businesses with Low Capital Requirements

“Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

“Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.

“At See’s, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.”

Buffett then talks about the return on incremental capital and how he thinks about ROIC:

“We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.

“Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to “be fruitful and multiply” is one we take seriously at Berkshire.)”

I used this general back of the envelope math when thinking about return on capital (see this post for details on how I think about calculating incremental ROIC). It’s helpful to know roughly how much capital a business requires, how much of its earnings it can retain and reinvest, and what the returns from those investments will look like going forward.

So See’s invested an incremental $32 million over the life of the business which produced an additional $1.35 billion of aggregate profits over that time, an astronomically high return on capital. Obviously, See’s is a “capital light business” and the ROIC is high because the denominator is low. See’s couldn’t reinvest that cash flow at high rates of return, so it had to ship the cash to Omaha for Buffett to reinvest elsewhere.

Category #2—Businesses that Require Capital to Grow; Produce Adequate Returns on that Capital

Companies like See’s produce huge returns on the small amount of capital that it previously invested. These are rare businesses that can grow their earning power without capital investment. In See’s case, this was largely done through pricing power. But See’s is a rare business, and as Buffett points out, companies that can reinvest capital at high rates of return are still attractive businesses to own:

“There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.

“A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.

“One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure.

“Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.) Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See’s-like, return on our incremental investment of $509 million.

“Consequently, if measured only by economic returns, FlightSafety is an excellent but not extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it.”

Category #3—Businesses that Require Capital but Generates Low Returns

Here he uses the often-cited airline business as one that requires a lot of capital but can’t generate a decent return on that capital:

“Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.

“The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice.”

He sums it up by using a savings account analogy:

“To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.”

What’s interesting is that Buffett talks about See’s as the most attractive type of business in this example, and certainly a business that produces steadily rising cash flow on a very low capital base is a great business. But a business that has the ability to retain and reinvest a large portion of its cash flow at high rates of return is also a great business in my view.

See’s is great because it produces cash flow without the need for capital investments, and it can still grow its earnings through pricing power. So this is truly an exceptional business. Moody’s might be a similar business—the ability to grow without new capital, which in essence means an infinitely high return on capital.

But those companies are incredibly rare birds. The next best business (and depending on the rate of return maybe even a better business) is one that can reinvest lots of capital at very high rates. This is where the compounding machine kicks into gear.

I used the example of CMG in the previous post mentioned above. The company had incredible attractive restaurant-level economics: it could set up a new location for around $800,000 and in the first year that restaurant would generate over $2 million in sales and $600,000 in cash flow, or a 75% return on capital.

Combine these high returns, with a long runway to put lots of capital to work (it was able to maintain these returns while growing from 500 stores to over 2000), and you have a formula for a compounding machine of great proportions.

CMG invested $1.25 billion during the decade between 2006-2015, an investment that led to $435 million of incremental earnings, an outstanding 35% return on incremental capital:

These high returns on capital led to steadily rising intrinsic value for the business over that time. In these types of businesses, requiring a lot of capital is a good thing (or at least certainly not a bad thing if it can be reinvested at 75% cash on cash returns).

Another example is Markel, an insurance business that is obviously much more capital intensive than See’s Candy, but yet has been an incredible compounding machine over the years thanks to its ability to retain its earnings and reinvest them back into the business at high rates of returns. The result of these high returns on incremental capital has been a steadily rising intrinsic value per share (and stock price):

Buffett himself described this type of business in an earlier letter (1992) when he said:

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”

So we might think two categories of great businesses:

Those that can retain and reinvest most/all of its earnings at high rates of returns

Those that don’t have any reinvestment ability within the business but can still grow earning power with little to no incremental capital

In a durable business with predictable cash flows, the latter category leads to a compounding effect that sees earning power per share impacted by the absolute growth of earnings as well as the steadily shrinking share count.

Both types of businesses are rare birds, but I would say the second category (the See’s or Moody’s type businesses that can produce sizable free cash flow using very little capital and can grow its earnings through pricing power) is exceedingly rare, but probably the most valuable.

A Few Other Posts on the topic of ROIC:

Calculating the Incremental ROIC

Importance of ROIC: Compounding and Reinvestment

Reinvestment Moats vs. Legacy Moats

Capital Light Compounders

I also wrote a piece (Good Businesses Tend to Stay Good) on our new research site where Matt Brice and I discuss our investment ideas, share our research notes on the companies we follow, and discuss various investing topics with readers. That post discusses some research that (somewhat surprisingly) points to how high returns on capital are more sustainable than one might think, given the nature of capitalism.

Thanks for reading!

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

[johnhuber]

Practicing a “Punch Card” Approach to Investing

John Hempton, who runs a hedge fund and writes the blog called Bronte Capital, wrote a really interesting post over the weekend on investment philosophy. He basically calls out the majority of the professional money management community for cloning Buffett in word, but not in deed. His main point: many Buffett followers talk about the “punch card” approach to investing, but very few people actually implement this approach.

Here is Buffett explaining the Punch Card philosophy:

“I always tell students in business school they’d be better off when they got out of business school to have a punch card with 20 punches on it. And every time they made an investment decision, they used up one of their punches, because they aren’t going to get 20 great ideas in their lifetime. They’re going to get five or three or seven, and you can get rich off five or three or seven. But what you can’t get rich doing is trying to get one every day.”

It’s hard to describe how important and valuable this simple concept is. It’s one that I try to focus on, and try to get better at implementing each year.

But Hempton brings up a good point: lots of people talk about it, but very few people actually act this way. His reasoning for why people don’t follow such a sound approach is that it is hard to sell to clients. If you bought one stock every year or two, and you have a portfolio of say 7 or 8 stocks at a time, it may appear to clients (who see hardly any activity in their portfolios for months, sometimes years at a time) that you might not be working all that hard.

Trading activity has a way of making clients think that work is actually getting done. However, trading activity is almost always inversely correlated with investment performance. The client would be better off with the manager who charged his or her fee for selecting the punch card investments and then just sitting and waiting.

Bias Toward Activity

But human nature is difficult to overcome, and this type of an approach is difficult to implement. There are a few: Norbert Lou (who fittingly runs a fund named Punch Card) has built an outstanding track record of beating the market handily while making very few investments (his current portfolio consists of just three stocks and he makes very few new investments).

Hempton mentions that even Buffett’s two portfolio managers (Todd Combs and Ted Weschler) don’t follow a true punch card approach. I don’t know about Combs, but Hempton is wrong on Weschler I think, who is known for owning very concentrated positions in very few stocks and holding them for years (he compounded money at around 25% annually for 12 years in his fund before closing it to go work for Buffett, and the majority of his returns came from just a few positions that he held the entire life of the fund).

In fact, the majority of Weschler’s performance can be traced to two large investments that he owned throughout the life of his fund: DaVita and WR Grace. You could argue that those two investments were in large part responsible for his landing of a position at Berkshire. According to this article, he still holds a large personal stake in WR Grace (and what must be a massive personal deferred tax liability of something close to $100 million—he bought the stock for $2 in the early 2000’s).

So there are a few out there who walk the walk. But largely, I think Hempton is exactly right that most managers are biased toward activity. I also think many managers might not even consciously realize this bias. They intuitively want to convey to their clients that they are working hard, and one of the only ways to measure work progress (from the perspective of the client) is by looking at activity within the portfolio.

Some investment managers fear their clients think like this:

Lots of activity: the manager must be busy looking at lots of ideas

No change in the portfolio since last quarter: what has this guy been doing for three months? And why am I paying him?

Also, during a period of underwhelming performance, it can be difficult to stick with this approach. As Hempton says, these times can be extremely productive from a learning point of view:

But mostly I would have been just idle. So in the midst of underperformance a client might ask me what I did last year and I would say something like

a) I read 57 books

b) I read about 200 sets of financial accounts

c) I talked to about 70 management teams and

d) I visited Italy, the UK, Germany, France, Japan, the USA and Canada

This is such a great point. That type of workload will produce measurable results at some point in the future, but it won’t show up in this quarter’s statement that clients receive.

Just because there isn’t a lot (or any) activity in the portfolio doesn’t mean there isn’t a lot of activity going on in the research/learning department. I try and focus on getting better each day, regardless of whether I’m buying or selling anything. And in fact, the days I feel I’ve improved the most as an investor are usually the days where I am away from my computer screen deep in thought, reading something useful, or having productive conversations with someone that knows more about a particular business than I do.

Fortunately, I happen to have great clients who don’t expect activity from me, so I don’t feel any pressure to “come up with new ideas”. Instead, I can conduct my research efforts each and every day, and wait for opportunities. That said, I can improve on focusing more on my best ideas, and I try each year to get better at this.

The Concept Matters

Let me say that the concept is what is important here, not the actual number of punches. Buffett selected 20 as an example. Obviously, Buffett has made hundreds of investments over the years. He once said at an annual meeting that his partnership (from 1956-1969) made somewhere around 400 investments in various stocks. But he also said that the vast majority of those investments were small investments that didn’t have a significant net benefit to his returns. The vast majority of the money he made in his partnership was made from a handful of well-selected investments that he made a large portion of his portfolio (the famous example of course being American Express in the early 60’s, when he put 40% of his assets into that stock).

The key for Buffett was not his batting average, but his slugging percentage. He hit a lot of home runs in the stocks that he took big positions in. And even in the 70’s and 80’s when he was running a much larger portfolio, his best ideas made up a sizable portion of his portfolio. A quick glance at the equity portfolio from 1977 shows 24% of the assets in GEICO and another 18% in Washington Post. 2/3rds of his portfolio was concentrated in five stocks. By that point in his career, he was fully implementing the punch card approach, probably in large part because of his review of his partnership where he realized only a few big ideas were responsible for the entire performance record.

But again, there is no magic number that should be focused on. I think the concept is what is the key: there aren’t that many great investment ideas, and it’s crazy to think that you can find great ideas every day, week, month, or even year. Great ideas are rare, should be patiently waited on, and should be capitalized on when they come.

Easy to say, hard to do—especially when there is a built-in bias toward activity.

To Sum It Up

I really liked Hempton’s introspective review of his own investment philosophy, along with his honest observations. The strange thing is that he seems to imply that the punch card approach is the most sound, but yet he himself doesn’t practice it. This confounds me a bit. Either he hasn’t been able to shake the same bias he talks about (in his view it’s a very tough sell to clients), or maybe he thinks he can build a bigger business (more AUM) if he implements a more conventional long/short hedge fund strategy. I’m just completely guessing at his reasoning. Maybe I’m wrong and he doesn’t think the punch card approach is best.

But I think recognizing the “over-activity” bias is most of the battle—if you understand that you, as an investment manager, are going to be prone to activity and over-trading in an effort to justify your existence, then you at least have a chance to guard against it. It’s those who “don’t know that they don’t know” are the ones who don’t have a chance. Hempton clearly isn’t in the latter camp. He knows that he (like most humans) might be prone to this bias, so you’d think he would choose to guard against it and implement the better approach.

Either way, it was an interesting commentary, and one that I really agree with. Practicing a portfolio management strategy that involves very few (and very large) investments in high-quality companies at very infrequent junctures is a great approach, but one that can be viewed as unconventional, and thus difficult to practice in real life. I hope and plan to keep improving on this, one day at a time.

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

[johnhuber]

Weekend Reading

I thought I’d put up a quick post with a couple articles I’m reading this weekend. But first, I wanted to mention to readers that I’ll be speaking at the MicroCap Conference in Philadelphia on October 24th. It should be a fun event with both investing strategy discussions as well as opportunities to talk with management teams of small companies about their businesses. Check out their site for more details or to register for the event. If anyone is attending and would like to meet up, feel free to contact me.

Weekend Reading

I often get asked what I read on a regular basis. At some point, I’ll put together a list, but for now, this list covers lots of ground, and overlaps with a good amount of what I read as well. This list was put together by my friend Connor Leonard, who manages the equity portfolio for IMC, a holding company that owns stocks and wholly-owned businesses. Connor also has written a couple excellent guest posts here on BHI. This is an AP-style ranking of Connor’s top reading material:

The Economist ranks number 18 on his list, just behind Women’s Wear Daily (which to date remains unranked on my Top 25). I tend to read the Economist on the weekend, as it usually contains a number of articles and news I find interesting, but these articles often get pushed to the back burner during the week.

Here are a few that I thought were worth reading this weekend from the Economist:

Still Ringing Bells–Slowing Growth and Less Innovation Do Not Spell the End of an Era

According to one research shop’s estimates, the global smartphone market will be about a $350 billion market this year. It is maturing, especially in developed countries, which was a primary reason for Apple’s stagnating stock price earlier this year. However, I agree with the author’s main point in this piece. The smartphone generally, and Apple in particular, have a very bright future (despite the saturation level).

My thought that I’ll add is that while innovation and technological shifts will keep occurring, Apple will continue to be a primary conduit from which that technology finds its way to the consumer. Apple sells hardware and software, but it is first and foremost a brand. Regardless of what widget it produces going forward, the brand remains one of the most valuable in the world. (And while other widgets will become popular, the iPhone isn’t going anywhere).

The REIT Stuff–Explaining the Boom in Property-based Investment Trusts

I think the residential housing market in the US is very strong, and with low inventories, low interest rates, still below average new builds, and the largest generation in history (the millenials) still largely preferring to rent (this will change as they get married, get dogs, get kids, get minivans, etc…), there are some tailwinds to that asset class.

I don’t feel as good about some of the commercial property sectors, as capital has been flowing into that asset class at a very high rate over the past few years:

“This year their market capitalisation passed $1 trillion, or 4% of the American total, close to the size of the utilities sector. They have been performing well, beating the market in 2014, 2015 and so far this year, when they have generated a return of 18.1%, and are trading at an average multiple of 23 times earnings, compared with 17 times for the S&P 500 index as a whole. In a mark of their new prominence, this month S&P and MSCI, another index provider, classified real estate as a distinct sector.”

Retail investors love these stocks for their dividends, and the sponsors love to issue those retail investors new shares, as their incentives often are aligned with “assets under management” (the more debt and equity capital they issue, the more they get paid). All REITs shouldn’t be painted with this brush, but the demand for dividend income from mom and pop investors who can’t find comparable interest rates for their savings have driven a large amount of demand for these securities. Those capital flows mean more demand for the underlying real estate, which has driven cap rates (a property’s cash flow divided by its purchase price) toward all-time lows. This, along with the high management fees, should be heavily considered when considering investing in these stocks, which own cyclical assets.

Prison Breakthrough

An interesting piece about the Nash Equilibrium, a theory which is best illustrated by the famous “prisoner’s dilemma” (which is described in the piece). Nash was a mathematical genius whose life was the subject of the movieA Beautiful Mind, and his contributions to mathematics and the subject of game theory won him a Nobel Prize. The Nash Equilibrium has practical implications for the business world:

“From auctions to labour markets, the Nash equilibrium gave the dismal science a way to make real-world predictions based on information about each person’s incentives…

“…Nash’s idea had antecedents. In 1838 August Cournot, a French economist, theorised that in a market with only two competing companies, each would see the disadvantages of pursuing market share by boosting output, in the form of lower prices and thinner profit margins. Unwittingly, Cournot had stumbled across an example of a Nash equilibrium. It made sense for each firm to set production levels based on the strategy of its competitor; consumers, however, would end up with less stuff and higher prices than if full-blooded competition had prevailed.”

Charlie Munger once mentioned how perplexed he was at how one industry (such as cereal makers) would all coexist with sizable profit margins while another industry (such as airlines) relentlessly pursue market share, eroding profitability in the process. It seems that airlines pursue their own interests to the detriment of the entire industry, whereas cereal makers (at least at one time) for some reason found a Nash equilibrium.

A Few Other Articles from Other Publications:

As iPhone 7 Hits Stores, Apple Devotees Click Buy

FDIC Quarterly Banking Profile

How Wells Fargo’s High-Pressure Sales Culture Spiraled Out of Control

As Amazon Arrives, the Campus Bookstore Is a Books Store No More

Have a great weekend!

Disclosure: John Huber owns shares of Apple and Saber Capital Management, LLC manages accounts that own shares of Apple.

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

[johnhuber]

Two Key Checklist Items

I am not a big fan of going through specific “checklist” items one by one when evaluating an investment idea. I know this idea has gained enormous popularity in recent years, partly due to the good book The Checklist Manifesto, and partly popularized in value investing circles by Mohnish Pabrai.

I respect Mohnish a lot, and I think his idea of evaluating previous investment mistakes (both his own mistakes and especially the mistakes of other great investors) is an excellent exercise.

One investment mistake to study would be Pabrai’s own investment in Horsehead Holdings (ZINC). This investment would be a case study that maybe I’ll put together for a separate post sometime, as it’s one that I followed during the time he owned it. There are a few reasons why I always scratched my head at why he bought ZINC, and there are a few reasons why I think it ultimately didn’t work, but one thing I’ll point out is what Buffett said in his 2004 shareholder letter (thanks to my friend Saurabh Madaan who runs the Investor Talks at Google for pointing me to this passage):

“Last year MidAmerican wrote off a major investment in a zinc recovery project that was initiated in 1998 and became operational in 2002. Large quantities of zinc are present in the brine produced by our California geothermal operations, and we believed we could profitably extract the metal. For many months, it appeared that commercially-viable recoveries were imminent. But in mining, just as in oil exploration, prospects have a way of “teasing” their developers, and every time one problem was solved, another popped up. In September, we threw in the towel.

“Our failure here illustrates the importance of a guideline—stay with simple propositions—that we usually apply in investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%. In our zinc venture, we solved most of the problems. But one proved intractable, and that was one too many. Since a chain is no stronger than its weakest link, it makes sense to look for—if you’ll excuse an oxymoron—mono-linked chains.”

This sounds very similar to the problem that Horsehead Holdings (ZINC) had with its zinc facility in North Carolina. Without going into details, I think there were too many variables that needed to go right for ZINC to work out as an investment.

But let me just say that mistakes are part of investing. So many people are so quick to cast judgment on investors like Pabrai, David Einhorn, or Bill Ackman when they make big mistakes. I’m not apologizing for these investors, but I think that those who are criticizing these investors should look at their entire body of work to draw conclusions, not just one bad investment. These three are very good investors with outstanding long-term records that have vastly exceeded the S&P 500, and they should be judged on that record, not the underperformance of the past couple years.

But regardless of what you think of these investors, it helps to try and learn from their mistakes. I wrote a post on Valeant a while back, which is Ackman’s biggest error. I also looked at SunEdison, which was an Einhorn investment. It is infinitely easier in hindsight (the rearview mirror is always clear) to attribute reasons for why these investments didn’t work out, but nevertheless, I think it’s helpful to study these mistakes.

I don’t think a 100-point checklist would have been necessary to pass on any of these three investments (ZINC, VRX, or SunEdison). Two of the three companies were ultra-focused on growing revenue regardless of the return on capital associated with that growth, using the so-called “roll-up” approach. All three of these investments saw their losses dramatically accentuated by debt.

I think each of these investments hinged on a few key variables (in addition to debt), and I think rather than running through a generic “pre-flight” checklist, a better method is to have a few very broad checklist items, and then determine the key variables that really matter regarding the business in question.

What do I mean by “broad checklist items”? One general checklist that Buffett and Munger use:

Do I understand the business?

Is this a good business? (Competitive advantages, high returns on capital, etc…)

Is management competent and ethical?

Is the price attractive?

It doesn’t get much simpler than that, and I think this 4-point filter is a common denominator that could be used on just about every investment.

Obviously, there is a lot of thought and analysis that goes into answering those simple questions, and so there are sub-categories that might pop up.

Key Checklist/Concept #1

This isn’t really a checklist item. But it’s a takeaway I’ve had through my own experiences:

Whenever I find myself getting more attracted to the security than I am to the business, it’s often a good reason to pass

My mistakes have almost always come from investing in “cheap” stocks of subpar businesses. I’ve learned that I’m better off focusing on good businesses. This means missing certain opportunities, but for me, it also means reducing errors. Also, when it comes to managing other people’s money at Saber Capital Management, I don’t feel comfortable owning low-quality businesses, regardless of how attractive the valuation appears to be. I mentioned this on Twitter recently and it sparked some interesting discussions.

There are a number of investors who disagree with me on this point. Some investors make a lot of money buying crappy businesses that are beaten down to really cheap valuation levels. It’s possible to make excellent returns buying garbage that no one else wants and selling them when the extreme pessimism abates some. This is the approach that guys like Walter Schloss used to great success in the 1950’s-1970’s—the so-called “cigar butt” style of investing.

But I think one big difference between the cigar butts of yesteryear and the stocks that investors get attracted to today is the debt levels on the balance sheet. The cigar butts that I read being pitched today are often questionable businesses that are loaded with debt. If things turn around and the company survives, the equity can appreciate multiples from its current level. If not, the company goes bankrupt and the equity gets wiped out.

It’s possible to become very good at handicapping these types of situations, but it’s not my style of investing. I choose to pass on these overleveraged companies with minimal chances of success.

Low Probability, High Payoff Investment Ideas

This brings me to another point I want to make regarding estimating probabilities. I read investment pitches all the time that discuss the probability of various outcomes. This makes sense—Buffett himself has talked about assigning probabilities to various outcomes of an investment. And certain odds might tell you that even a low probability event can be a very good bet to take. For example, a bet that has a 25% chance of winning and pays out 10 to 1 is a very good bet. It is a low probability bet that has positive expectancy, and it’s a bet you should take every time.

But I generally pass on low-probability ideas for the following two reasons:

Unlike cards or dice (or other games of chance where probability can be more or less accurately determined), business and investing are dynamic with ever-changing odds. Cards and dice are closed-systems with a finite set of possible outcomes. Business is fluid, and there are an infinite set of unpredictable events that can greatly impact the outcome. It’s unreasonable to assign rigid probabilities to these types of situations.

Investors tend to overestimate the likelihood of success of low-probability events (to use the above example, an investor might assume a 25% odds of success and a 10 to 1 payoff; but in reality it’s just 10% odds with a 5 to 1 payoff. The investor might accurately describe all of the moving parts of the investment, and rightly understand that it is a low-probability event, but still be way off with his or her estimate of risk/reward and thus make a bad bet). It is too easy to arbitrarily assign overly optimistic probabilities to this type of investment in an effort to justify buying the stock.

A year or two ago I read numerous Dex Media write-ups (the company that published phone books), including one by Kyle Bass. DXM was an equity stub—a sliver of equity with a huge amount of debt on a dying business that was trying to make a transition to digital from print. All of the write-ups recognized the obvious struggles of the business, and all recognized that odds of success were too low. But I think those who bought the stock overestimated the odds of success and/or the amount of the potential payoff. One investor said the DXM payoff could be as high as 100-1. This reward could justify an investment even at a very low likelihood of success.

The Fannie Mae and Freddie Mac investment cases might be current examples of this type of low-probability, high-payoff type investment. Maybe these will work out, but I think many are overestimating the likelihood of success.

In my experience, it’s better to forego the low-probability investment ideas. They are too difficult to accurately judge, and they usually involve bad (or highly leveraged) businesses.

Key Checklist/Concept #2

Schloss invested in poor-quality businesses in many instances. How was he so successful? Schloss used a checklist of sorts, and the very last (but not least) item on his checklist was:

Be careful of leverage. It can go against you.

This seemingly oversimplified statement is really great advice. I think that while Schloss invested in businesses with subpar (or no) competitive advantages, he was able to do well because of his patience and his willingness to wait for the cycle to turn. Many of his investments were in capital intensive, cyclical businesses—but most of the companies he bought had clean balance sheets.

Today, our society is much more accepting of higher debt levels—both at the personal level and at the corporate level. Because of the availability of debt made possible in part through securitization, it is much easier for companies to gain access to credit than it was in the 1950’s. Most companies that Schloss would have looked at in his day are now saddled with debt in an attempt to improve their inherent low returns on equity through leverage. Schloss was satisfied with the low ROE’s, as he figured he wasn’t paying much for it, and eventually, the earning power would inevitably turn higher as the business cycle turned from bust back to boom.

The business cycle still has the same fluctuations of course, but leverage now magnifies the equity values. I see scores of oil and gas producers whose stocks have risen 500% or more since the February lows. Leverage has magnified the comeback in their equity values. It also would have been their death knell had oil prices not bounced in the nick of time.

Schloss said in a Forbes article in 1973—aptly titled “Making Money Out of Junk” that there are three things that can go in your favor when you buy cheap, out of favor companies:

Earnings turn around and the stock appreciates significantly

Someone buys control of the company (buyout)

The company begins buying its own stock

However, you need a clean balance sheet to put yourself in position to capitalize on a cyclical upturn and the corresponding rebound in earning power that could come with it.

Where the Puck is Going

Stanley Druckenmiller gave an excellent talk early last year where he mentioned one of the two key things his mentor taught him:

“Never, ever invest in the present. It doesn’t matter what a company is earning, (or) what they have earned. He taught me that you have to visualize the situation 18 months from now… Too many people tend to look at the present…”

Buffett has mentioned closing his eyes and visualizing where a company is 10 years from now, or being happy owning the stock if the exchange shut down for five years.

I don’t think it matters what the exact length of time is, but the point is that when you make an investment in a stock, you’re buying a piece of a business. When I look out to a certain point into the future, whether its 18 months or 5 years, I’d rather try to focus on a company that I think will be doing more business, have greater earning power, and be more valuable than it is today.

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

[johnhuber]

A 1977 Warren Buffett Interview From the WSJ Archives

Someone I’m connected with on Linkedin sent me this old article from 1977 in the Wall Street Journal on Warren Buffett. I thought I’d share it here, along with a few highlights. It’s an article I haven’t seen previously. There isn’t much new here, but I thought it was quick read with a couple passages worth commenting on.

One thing I don’t recall Buffett ever describing were the pressures of money management that he felt while running his partnership. This is Buffett describing the relief he felt after closing his fund:

“I’m having a lot of fun because I’m only going into businesses that I find interesting and where I like the people running them, and their products,” Mr. Buffett says. “It’s a tremendous relief being out of money management. I’m not constantly thinking about business anymore. During the partnership my ego was on the line, and I was trying to lead the league in hitting every year.”

I think there are a couple things to note here. First, Buffett knew that his overall record was due to his skill as an investor. But I think he also knew that his individual yearly results, where he beat the market each and every year for 13 years, was very unlikely and almost certain not to be repeated (or continued if he kept his partnership open). He knew that over 5 year periods, he would beat the market handily. But he also knew that any given year was much more up for grabs.

If we compare the results of Charlie Munger and Walter Schloss (who also ran partnerships during the same time), all three produced fantastic records, but Munger and Schloss underperformed the market about 1 in every 3 years, despite beating the market overall by huge margins (see this post for details on their performance records).

So I think the unrealistic expectations that Buffett thought his investors were placing on him began to wear on him. It’s unlikely these investors would have been so demanding (after all, Buffett made them all rich), but I can understand—being in the money management business and actively managing money for clients—that there is pressure when it comes to other peoples’ money. You treat it with much more importance than you do your own capital. That said, I was surprised to hear Buffett say he was glad to be out. I personally couldn’t imagine wanting to do anything else.

But Buffett felt a relief after shutting his partnership, and in the early years, it almost sounded like a semi-retirement. This is ironic of course, because he now is a fiduciary on a much larger scale than he was in the 1960’s.

But ultra-competitive people have a hard time staying away from the game, and Buffett is certainly no exception.

Retail is a Tough Business

“Mr. Buffett has taken some lumps. Several years ago, for example, Berkshire Hathaway lost half of a $6 million investment in Vornado Inc., a discount retailing concern based in New Jersey. ‘The stock looked undervalued when I bought it, but I proved to be incredibly wrong about the discount department-store business,’ Mr. Buffett says. ‘It turned out that the industry was over-stored, and Vornado and the rest of the discounters were getting killed by competition from K mart stores.’”

What’s interesting is that this quote is as relevant now as it was in 1977. It’s the same game with different players. Macy’s, JC Penney’s, Kohl’s and other struggling department stores have replaced Vornado, and the competitor wreaking havoc is no longer K-mart, but Amazon.

But it’s also interesting that Buffett says, “The stock looked undervalued when I bought it.” It’s strangely reassuring to know that Buffett himself was tempted by mediocre businesses that looked cheap. And most retailers are mediocre businesses that look cheap.

Whenever I review my own investment mistakes, they almost always come from situations where I was attracted much more to the valuation than to the business. These are the so-called value-traps—catnip to most value investors, but very often poor choices as investment candidates. I’ve learned to steer clear.

The problem for many investors is that sometimes these so-called value traps work out. You’re able to buy them and sell them for a 50% gain. But a year or two later they are often trading at or below (often well below) your original purchase price. The investment looked smart based on the realized gain, but was it really being smart, or just fortunate timing?

Each investment situation is unique, but the general lesson from this particular passage is that retail, specifically discount department stores, is a very tough business. Your competitors are offering the same merchandise you are (for the most part), and Amazon can match or surpass you in terms of price, selection and convenience. This puts you between a rock and a hard place—either cede market share to Amazon or other competitors (which isn’t really an option because that means lower revenue to spread across a largely fixed cost base), or cut prices to compete for customers (which, unless your lower prices lead to faster inventory turns, will still lead to lower revenue on already thin margins).

For some store concepts, this operating leverage can be a positive driver of margin expansion, returns on capital and earnings growth, but when your store that was once a favorite with customers begins losing its luster, this leverage works in reverse. All along the way, competition is brutal.

As Buffett has said regarding the retail store he ran in Baltimore (paraphrasing), “If the guy across the street started offering a 15% weekend discount, we had no choice but to match that promotion.”

It’s a very difficult game. There will be some winners for sure, but there will be a lot of losers. And it’s hard to predict (other than maybe Amazon) who will win. Some will “win” for a period of time before losing (K-mart and Sears once dominated before getting disrupted by Wal-mart, which itself is now getting disrupted by Amazon, etc…)

Inflation

“Wall Street sources close to Mr. Buffett say that his stock investments in the past few years have been largely dictated by his concern over inflation. David Gottesman, senior partner of the New York investment concern First Manhattan Corp says:

“Warren has been largely restricting himself to companies which he feels offer some protection against inflation in that they have a unique product, low capital needs and the ability to generate cash. For example, Warren likens owning a monopoly or market-dominant newspaper to owning an unregulated toll bridge. You have relative freedom to increase rates when and as much as you want.”

I don’t think Gottesman’s reasoning is completely accurate here. I doubt Buffett necessarily was buying companies as an inflation hedge—although that was a byproduct of the types of investments he made. I think his preference for durable businesses with strong competitive positions and excess free cash flow would have been his preference regardless of whether the economy was experiencing high inflation, low inflation, or even deflation.

I am not suggesting Buffett didn’t consider inflation as a major factor (he did discuss inflation often in his letters as well as this famous piece in Fortune), but I don’t think he changed his investment preferences much, if at all, based on what inflation was doing.

Regardless, it was an interesting piece from the Wall Street Journal archives.

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

[johnhuber]

WeChat’s Huge Moat in China

This is just a quick post on some interesting articles I read over the weekend as I caught up on some newspaper reading.

There were a couple recent pieces (one in the Economist and one in the NY Times) on WeChat, the Chinese messaging app that now boasts over 700 million users. WeChat is also generating a significant amount of revenue (unlike Facebook’s WhatsApp and Messenger apps that haven’t monetized their networks yet). WeChat is also estimated to be very profitable for its owner, Tencent Holdings ($TCEHY), an online gaming and social media giant in China.

Here are a few notes as I read the two articles:

What is WeChat?

From the Economist piece:

“Like most professionals on the mainland, her mother uses WeChat rather than e-mail to conduct much of her business. The app offers everything from free video calls and instant group chats to news updates and easy sharing of large multimedia files…

“Yu Hui’s mother also uses her smartphone camera to scan the WeChat QR (quick response) codes of people she meets far more often these days than she exchanges business cards. Yu Hui’s father uses the app to shop online, to pay for goods at physical stores, settle utility bills and split dinner tabs with friends, just with a few taps. He can easily book and pay for taxis, dumpling deliveries, theatre tickets, hospital appointments and foreign holidays, all without ever leaving the WeChat universe.”

Here is a snapshot of the app compared to the two other huge messaging apps (both owned by Facebook):

Why/How was WeChat able to grow so quickly:

SMS messaging is costly in China. This is unlike the US where large telecoms bundled text messaging services with other basic phone services to make texting affordable.

In the US, this affordability of texting via your phone provider also meant that there wasn’t as much of a need for a separate dedicated messaging app. This is partly why messaging apps like Facebook’s Messenger or WhatsApp, while very popular in the US, aren’t completely ubiquitous like WeChat is in China. There are 700 million users despite there being “only” 600 million smartphone users in the country. Just about everyone uses WeChat in China.

The higher cost of text messages in China led to a gap that WeChat was able to fill. Users eager to text one another quickly led to mass adoption and a foundation for WeChat to provide other offerings to its suddenly vast network of users.

China consumers largely skipped right to smartphones—many never purchased a PC. The lack of experience using a desktop made it more natural for Chinese consumers to complete tasks on a mobile device that Americans and Europeans might still be using their PC’s for. Half of all online sales in China take place on a mobile device, versus roughly a third in the US.

The app ecosystem didn’t grab hold as much as it did in the US and Europe. Instead of smartphone users utilizing hundreds of apps that each perform unique functions, firms in China like Baidu, Alibaba, and Tencent have developed apps that can perform many different tasks (messaging, social media, games, mobile payments, ecommerce, videos) all within the same app.

Network Effect

WeChat’s exponential growth in users has created a platform that has allowed the app to branch out into mobile payments and ecommerce, among other offerings. Consumers can make purchases directly from merchants (who are increasingly attracted to the vast potential customer base), with WeChat taking a cut on every transaction. As the number of users grows, so does the value proposition for potential merchants, advertisers, and developers (who can create their own apps inside of the WeChat universe).

The Economist summarizes the network effect:

“E-commerce is another driver of the business model. The firm earns fees when customers shop at one of the more than 10m merchants (including some celebrities) that have official accounts on the app. Once users attach their bank cards to WeChat’s wallet, they typically go on shopping sprees involving far more transactions per month than, for instance, Americans make on plastic. Three years ago, very few people bought things using WeChat but now roughly a third of its users are making regular e-commerce purchases directly through the app. A virtuous circle is operating: as more merchants and brands set up official accounts, it becomes a buzzier and more appealing bazaar.”

WeChat’s First-Mover Advantage

The more fragmented app ecosystem in the West will make it harder for any one messaging app (including WeChat) to build as powerful a network effect as WeChat has done in China. Western users already use many different apps for a variety of services, and so it will be difficult for any single app to achieve the winner-take-all status that WeChat was able to grab in China. But as the article summarizes, this also creates a moat for WeChat on its home turf:

“Nor is there much chance that Facebook could make a significant dent in WeChat’s dominance in China. The Silicon Valley darling enjoys incumbency and the network effect in many of its markets. That has sabotaged WeChat’s own efforts to expand abroad… But the same rule applies if Facebook enters China, which could happen this year or next. ‘We have the huge advantage of incumbency and local knowledge,’ says an executive at Tencent. ‘Weixin (the Chinese name for WeChat) is quite simply more of a super-app than Facebook.’”

Tencent’s Potential Crown Jewel?

The app that is there “at every point of your daily contact with the world, from morning until night” is a very valuable asset for its owner Tencent Holdings.

I haven’t spent any time looking at Tencent, but I did pick up the annual report this weekend and skim through it. Here are the numbers of for the past five years that I converted into USD at the current exchange rate as of today:

The company makes most of its revenues and earnings from online gaming, with advertising generating most of the rest of the revenue. WeChat’s revenue was an estimated $1.8 billion last year, which is a small piece of the pie at this point. Time will tell if the company is effective at monetizing the platform that it has built (which is needed to justify the stock’s current valuation), but it appears to be building a lot of momentum.

I had never looked at Tencent before, but I put it on a watch list to study more in depth. I’ve been wary of investing outside the US (which is my own geographical circle of competence)—especially in a company that isn’t listed on an American exchange. But investing is a game of connecting the dots, as Ted Weschler said recently, and reading articles about growing businesses like this adds a few new dots to the mix.

Here are some other pieces to help connect the dots:

WeChat’s World (The Economist Article refenced above)

China, Not Silicon Valley, Is Cutting Edge in Mobile Tech (The NY Times piece refenced above)

Some other articles that discuss WeChat or the business of apps in general (some are old, but I thought still provided helpful context):

When One App Rules Them All

Chinese Mobile Apps UI Trends (Excellend blog post that was recommended by a reader)

A 2014 Economist piece on WeChat

Business of Apps: WeChat Stats

How Messaging Apps Make Money

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

[johnhuber]

Calculating the Return on Incremental Capital Investments

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” – Warren Buffett, 1992 Shareholder Letter

We’ve recently discussed the concept of return on capital, and I have received many questions about the various ways to calculate ROIC. I think the exact nuances to calculating the figure are less important than understanding the overall concept. For more on our multi-part series on ROIC, see these posts. Keep in mind the overall importance of ROIC, as Buffett points out in the 1992 shareholder letter referenced above. But in this post, let’s discuss some of the questions readers have had. 

It’s simple to calculate ROIC: some use earnings (or some measure of bottom line cash flow) divided by total debt and equity. Some, like Joel Greenblatt, want to know how much tangible capital a business uses, so they define ROIC as earnings (or sometimes pretax earnings before interest payments) divided by the working capital plus net fixed assets (which is basically the same as adding the debt and equity and subtracting out goodwill and intangible assets). Usually we’ll want to subtract excess cash from the capital calculation as well, as we want to know how much capital a business actually needs to finance its operations.

But however we precisely measure ROIC, it usually only tells us the rate of return the company is generating on capital that has already been invested (sometimes many years ago). Obviously, a company that produces high returns on capital is a good business, but what we want to know is how much money the company can generate going forward on future capital investments. The first step in determining this is to look at the rate of return the company has generated on incremental investments recently.

One very rough, back-of-the-envelope way to think about the return on incremental capital investments is to look at the amount of capital the business has added over a period of time, and compare that to the amount of the incremental growth of earnings. Last year Walmart earned $14.7 billion of net income on roughly $111 billion debt and equity capital, or about a 13% return on capital. Not bad, but what do we really want to know if we were thinking about investing in Walmart?

Let’s imagine we were looking at Walmart as a possible investment 10 years ago. At that point in time, we would have wanted to make three general conclusions (leaving valuation aside for a moment):

How much cash Walmart would produce going forward?

How much of it would we see in the form of dividends or buybacks?

Of the portion we didn’t receive, what rate of return would the company get by keeping it and reinvesting it?

Our estimates to these questions would help us determine what Walmart’s future earning power would look like. So let’s look and see how Walmart did in the last 10 years.

In 2006, Walmart earned $11.2 billion on roughly $76 billion of capital, or around 15%.

In the subsequent 10 years, the company invested roughly $35 billion of additional debt and equity capital (Walmart’s total capital grew to $111 billion in 2016 from $76b in 2006).

Using that incremental $35 billion they were able to grow earnings by about $3.5 billion (earnings grew from $11.2 billion in 2006 to around $14.7 billion in 2016). So in the past 10 years, Walmart has seen a rather mediocre return of about 10% on the capital that it has invested during that time.

Note: I’m simply defining total capital invested as the sum of the debt (including capitalized leases) and equity capital less the goodwill (so I’m estimating the tangible capital Walmart is operating with). I’ve previously referenced Joel Greenblatt’s book where he uses a different formula (working capital + net fixed assets), but this is just using a different route to arrive at the same basic figure for tangible capital.

There are numerous ways to calculate both the numerator and denominator in the ROIC calculation, but for now, stay out of the weeds and just focus on the concept: how much cash can be generated from a given amount of capital that is invested in the business? That’s really what any business owner would want to know before making any decision to spend money.

Reinvestment Rate

We can also look at the last 10 years and see that Walmart has reinvested roughly 23% of its earnings back in the business (the balance has been primarily used for buybacks and dividends). How do I arrive at this estimate? I simply used the amount of incremental capital that Walmart has invested over the past 10 years ($35 billion) and divide it by the total earnings that Walmart has generated during that period (about $148 billion of cumulative earnings).

An even quicker glance could simply be to look at the retained earnings on the balance sheet in 2016 ($90 billion) and compare it to the retained earnings Walmart had in 2006 ($49 billion), and arrive at a similar reinvestment rate: basically, Walmart is retaining roughly $0.25 of every $1 it earns and reinvesting it back into the business. The other $0.75 is being used for buybacks and dividends.

As I’ve mentioned before, a company will see its intrinsic value will compound at a rate that roughly equals the product of its ROIC and its reinvestment rate (leaving aside capital allocation, which can increase or decrease value per share as well).

Intrinsic Value Compounding Rate = ROIC x Reinvestment Rate

There are other factors that can create higher earnings (pricing power is one big example), but this simple formula is helpful to keep in mind as a rough measure of a firm’s compounding ability.

So if Walmart can retain 25% of its capital and reinvest that capital at a 10% return, we’d expect the value of the company to grow at a rate of around 2.5% per year (10% x 25%). Stockholders will likely see higher per-share returns than that because of dividends and buybacks, but the total value of the enterprise will likely compound at roughly that rate. And over time, the change in value of the stock price tends to mirror the change in value of the enterprise plus any value added from capital allocation decisions.

Here is a table that summarizes the numbers I outlined above:

Not surprisingly, Walmart’s stock price is only about 45% higher (not including dividends) than it was 10 years ago. So unless you are banking on an increase in P/E ratios, you’re unlikely to achieve a great result buying a business that can only invest a quarter of its earnings at a 10% return.

Chipotle—A High Return on Capital Business

Let’s use the same principles to very briefly take a look at Chipotle, which is a business that has been able to reinvest its earnings at very high rates of returns over the past decade.

For Chipotle, we’ll look at the last 9 years of operating results starting at the end of 2006, which was the first year that Chipotle operated as a standalone company (McDonald’s spun it off in mid-2006).

Chipotle has great unit economics. In 2015, it cost $805,000 to build out the average restaurant which, when up and running, produces around $2.4 million in revenue and better than 25% restaurant-level margins. So an $800k initial investment produces around $600k of yearly cash flow. In other words, the average Chipotle restaurant has achieved an incredible 75% cash on cash return (this is restaurant-level ROI before corporate G&A expenses and taxes).

Over the past 9 years, Chipotle has grown from 581 restaurants to just over 2,000. They’ve invested a total of $1.25 billion to build out these restaurants which has increased its earnings by around $435 million. In other words, Chipotle saw around a 35% after-tax return on the capital it reinvested back into the business:

Chipotle was able to invest over half of its earnings at 35% returns, and using the formula described above to approximate intrinsic value growth, 57% reinvestment rate times 35% returns equals about a 20% increase in earning power.

The result is that the stock price has compounded at over 20% annually, very much in line with Chipotle’s intrinsic value.

Mature Businesses vs. Compounders as Investments

Of course, the hard part is finding these companies in advance. Also, we should remember that buying cheap and selling dear is a very good strategy, and there are plenty of opportunities in the market to do so with durable and established, but low-growth businesses. Peter Lynch called these companies stalwarts—they were big companies without a lot of growth potential, but occasionally you could buy them at a discount and sell them after a 30-50% rise (which largely comes from the valuation multiple increasing as opposed to the business value increasing).

That’s a good strategy, and there are probably more opportunities that Mr. Market offers in this particular category. But an investor should realize that these investments are not going to result in big compounding results. Lynch’s famous 10-baggers came from the rare companies that could retain their earnings and plow them back into the business at high rates of return for many years. The former is much more common and actionable, but it’s still worth hunting for stocks in the latter category in my opinion. You only need a few to make a career.

To Sum It Up

What you really want to know is this: At the end of the year, the company will have made a certain amount of money. Out of that pile of cash, you want to know:

How much can the company reinvest into the business?, and,

What the return will be on that investment?

If Walmart makes $16 billion, they might spend $4 billion on building out new stores. How much additional cash flow will come from that $4 billion investment?

Obviously, Walmart getting a 10% return on a quarter of its earnings is not nearly as attractive as Chipotle getting a 35% return on half of its earnings. The latter is going to create much more value than the former.

This is a really rough measure of how to think about return on capital, but it’s generally how I think about it.

Of course, there are different ways to measure returns (you might use operating income, net income, free cash flow, etc…) and there are many ways to measure the capital that is employed. There are also “investments” that don’t always get categorized as capital investments but run through the income statement—things like advertising expenses or research and development (R&D) costs. To be accurate, you’d want to know what portion of advertising is needed to maintain current earning power (akin to “maintenance capex”). The portion above that number would be similar to “growth capex”, which could be included when thinking about return on capital. R&D could be thought of the same way.

But hopefully this is a helpful example from a very general point of view on how to think about the concept. As a business owner, you want to know where you can reinvest your company’s excess cash flow and what rate of return you can get from those investments. The answers to those two main categories will in part determine how fast your business grows its earning power and increases its value.

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.

[johnhuber]

Notes on Credit Acceptance Corp

I recently made a list of a few shareholder letters I want to read, and one that I completed a few days ago was Credit Acceptance Corp ($CACC). This post is not a comprehensive review of the business, but I thought some readers might be interested in some initial notes.

Credit Acceptance Corp makes used-car loans to subprime borrowers. CACC has a different model than most used-car lenders. Instead of the typical subprime auto-lending arrangement where the dealer originates the loan and the lender buys the loan at a slight discount, CACC partners with the dealer by paying an up-front “advance” and then splitting the cash flows with the dealer after CACC recoups the advance plus some profit. The advance typically covers the dealer’s COGS and provides a slight profit, and CACC has a low risk position as it gets 100% of the loan cash flow until its advance is paid back. What’s left over gets split between CACC and the dealer. The bottom line is that the dealer gets less money up front, but has more potential upside from the loan payments if the loan performs well.

The model works like this (these are just general assumptions and round numbers to illustrate their model): Let’s say a used-car dealer prices a car at $10,000. Let’s say the dealer paid $8,000 for that car. The dealer finds a buyer willing to pay $10,000, but the buyer doesn’t have $10,000 in cash, has terrible credit, and can’t find conventional financing. CACC is willing to write this loan (CACC accepts virtually 100% of their loans). The buyer might pay $2,000 down, and CACC might send an advance to the dealer of around $7,000. So the dealer gets $9,000 up-front ($2,000 from the buyer and $7,000 from CACC). The dealer now has no risk, since it has received $9,000 for a car that cost it $8,000, and although the profit might be lower than if it got the full $10,000 retail value in cash, the dealer can make more money if the loan performs well. The $8,000 loan might carry an interest rate of 25% for a 4 year term, which is about $265 per month.

As the payments begin coming in, CACC gets 100% of the cash flow from the loan ($265 per month) until it gets its $7,000 advance paid back plus some profit (usually around 130% of the advance rate). Once this threshold is hit, if the loan is still performing, CACC continues to service the loan for around a 20% servicing fee, and the dealer keeps the other 80% of the cash flow as long as the payments keep coming in.

CACC has perfected this model and has achieved significant growth over time by steadily signing up more and more dealers. The result is a compounding machine:

But the conditions are always competitive in this business, and currently, lending terms are very loose and competition is brutal. But CACC is the largest in this space, and seems to be able to perform fairly well in periods of high competition by:

Allowing volume per dealer to decline (fewer loans get originated at each dealer as CACC is willing to give up market share to competitors who are willing to provide loans at looser terms)

Growing the number of dealers it does business with (developing more partnerships with new dealers helps offset the decline of business that is done at each dealership)

So overall, CACC has been able to grow volume consistently in good markets and bad markets by adding dealers to its platform. The company allows market share to decline during periods of high competition, and then when the cycle hardens (money tightens up), CACC is able to take back some of that market share.

Adding New Dealers Gets Harder

The problem is that CACC is now much bigger, and growing the number of dealers to offset the declines in volume that occur during soft markets is much more difficult. The company only had 950 dealers in 2003, which was the beginning of the last cycle. By 2007, the company had roughly 3,000 dealers. Dealers provide the company with customers. The ability to triple your potential customer footprint is extremely valuable as it allows you to lose significant market share at the dealership level and still write profitable loans at high returns on capital. Indeed, the company saw the number of loans per dealer decline by a whopping 41% during the soft (competitive) market cycle between 2003-2007. But during this time, its 3-fold increase in the number of dealers enabled overall volume to increase and earnings per share went from $0.57 to $1.76.

The market tightened up in 2007 (a good thing for companies like CACC because while economic conditions are difficult, higher cost competitors go out of business which makes life much easier for the remaining players). With a dealer count that was three times as large as it was just four years before, CACC could now focus on writing profitable loans and growing volume per dealer (i.e. taking back market share it lost at the individual dealership level).

The results are outstanding for a company that can successfully execute this approach, and CACC saw earnings rise from $1.76 in 2007 to $7.07 in 2011 thanks to a combination of growing profits and excess free cash flow that was used to buy back shares.

However, the cycle has gotten much more difficult again—starting in 2011 and continuing to the current time. CACC—to its credit—has continued to fight off competition by adding new dealerships (it has doubled its dealer count since 2011). But each year this becomes harder—CACC now has a whopping 9,000 dealers on its platform (nearly a 10-fold increase from 2003).

Competition is extremely tough currently, with dealers having the pick of the litter when it comes to offering finance options to its customers. CACC proudly states in its annual report: “We help change the lives of consumers who do not qualify for conventional automobile financing by helping them obtain quality transportation”. I think in the early years, this was true. Dealers could go to CACC for financing for its customers when no one else would lend money to that subprime borrower.

But CACC isn’t the only option currently, which means the terms CACC can demand are weaker. CACC used to write loans that were 24 months in the 1990’s. The average loan now has around a 50 month term. As competition heats up, dealers have more options as the third column in this table demonstrates:

CACC has grown mightily over the years, but since 2003 it has fought off a 50% decline in loans per dealer by dramatically growing the number of dealers it works with.

Can CACC Continue Compounding at the Same Rate?

The question for anyone looking at CACC at this level is whether the company can continue to perform well during increasingly competitive conditions. To produce attractive returns on invested capital going forward, the company needs one of two things to happen:

Conditions need to worsen (higher interest rates, tighter monetary conditions) which will cause weaker competitors to exit the industry and lower the capital available to borrowers

Absent better competitive conditions, CACC needs to be able to continue adding to its dealer count at a rate that more than offsets declines in loan volume per dealer

Thus far, the company has always been able to execute on the latter category. But it becomes harder and harder to move the needle as the company gets larger and larger. The company has 9,000 dealers and there are roughly 37,000 used-car dealerships in the US. So while growth is possible, a 10-fold increase in dealerships–which is what CACC has achieved since 2002–is no longer in the cards. I think the company will be much more dependent on the first category (competitive conditions) going forward, which unfortunately means they will be slightly less in control of their own destiny.

The hard part is trying to figure out when that cycle changes. And even when the cycle changes, I’m not sure that—short of a credit crisis—enough capital will leave to make life easy again for well-capitalized firms like CACC. Cycles will ebb and flow for sure, but there is a lot of data that points to how well auto loans performed during the credit crisis—which makes me think capital won’t flee the industry in a manner that many hope/expect.

Risks

The post is getting long, but I thought I’d briefly mention a few risks, which can be more thoroughly discussed in comments or another post.

One general risk is the regulatory risk as the CFPB has begun looking at subprime auto lenders. One related specific question I have asked myself while reading about CACC is this: why would the dealers agree to this model? Why would they accept a lower up-front cash payment (even with the potential added upside at the end of the loan term)? It doesn’t make a lot of sense to me. If you’re a dealer—why would you accept less cash up-front in the hopes that in 3 years you’ll begin to get some of that cash back from the dealer holdback (the amount that CACC splits with the dealer after it has been made whole)? You can likely maintain higher asset turnover and higher returns on capital by getting more cash up front and moving that money more quickly into new inventory than waiting 3-4 years for modest upside from interest payments.

I fear that there are two possible answers to why dealers participate in this structure. One reason could be because the dealers either can’t get this customer financing anywhere else (even from other subprime lenders–which means the customer is truly a bad credit risk by even subprime standards). The other possible reason is because dealers might be able to artificially inflate the price of the car above its fair market value–i.e. what a cash buyer or a buyer using traditional financing would pay for the car. If the car is only worth $12,000 but the dealer can get $14,000 by simply making sure the monthly payments are “affordable” (which is often the main point of concern for the typical subprime buyer), then the dealer can get an advance rate from CACC that is close enough to what the dealer would receive from one of the other traditional lenders or a cash buyer. This effectively gives the dealer nearly as much up front cash as well as the added kicker if the loan performs well. Meanwhile, the buyer overpays for a vehicle as a penalty for not being able to obtain traditional financing. That said, I don’t have evidence this is the case–but I am just posing these questions that crossed my mind as I read the 10-K, as I tried to put myself in the shoes of the dealers who willingly accept lower cash payments despite a seemingly unlimited array of options from other lenders.

One other aspect of this business that makes me uncomfortable is the very high default rates that exist across the subprime auto business. It is very hard to look through CACC’s annual report and get a clear answer on what the default rates really are, but they only collect about 67% of the overall loan values, which implies the average borrower quits paying 2/3rds of the way through the loan (it’s possible this number isn’t as bad as it appears since some cars might get sold, and the overall “loan value” includes projected principal and interest, but regardless–defaults rates are sky high). Looking at competitors like CRMT and NICK (which use more conventional provisioning methods)–reserves for credit losses are currently between 25-30% of revenues, and have risen dramatically in the previous five years or so.

Counteracting these risks are the fact that insiders have huge stakes in this company, and it does appear to be very well-managed business over a long period of time.

Brief Word on Valuation

It’s interesting how much higher CACC is valued than smaller (weaker competitors)—Nicholas Financial ($NICK) is one I’ve followed casually to use one example. CACC is currently valued around $4 billion. For that, you get around $3.3 billion in net receivables and $1 billion of equity. NICK is roughly 10% of that size ($311 million receivables and $102 million equity), but has a market value of just $80 million. In other words, NICK has a price to book (P/B) ratio of 0.8 and CACC is priced at 4.0 P/B, or five times as expensive. Both have similar levels of debt relative to equity as well.

CACC gets much better returns on its equity than NICK, and so its valuation relative to earning power is only twice that of NICK’s (14 P/E at CACC vs 7 P/E at NICK). But I think given that they are competing for the same general customer, there is a pretty hefty premium baked into CACC’s shares.

I think CACC will likely do well regardless of how long these soft conditions last. And when the cycle hardens up, CACC has a large amount of dry powder available to cash and credit commitments that will allow it to fully take advantage of better lending conditions. But given the size of the company and the increased level of difficulty that they’ll face growing their footprint, I’m not necessarily sold on the current valuation in the stock, especially given the risks in a business like subprime auto lending.

To Sum It Up

They’ve done an impressive job of growing through the cycle by willingly ceding market share to preserve profits at the dealership level during competitive markets and offsetting this by increasing the number of dealers it works with. Now that they have over 9,000 dealers, it’s impossible to achieve the same level of growth going forward, and so the high returns on equity will be much more dependent on the level of profitability they can get with each loan, which will likely require some help from the competitive landscape. I think CACC remains quite profitable, but I don’t think they’ll see anywhere near the same rate of earning-power compounding going forward.

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John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

John also writes about investing at the blog Base Hit Investing, and can be reached at john@sabercapitalmgt.com.