Price Dictates Questions

It’s been an interesting couple months in the market. While the blog has been quiet, the market certainly hasn’t. Thankfully, the portfolio emerged unscathed. In fact, it’s arguably the best it’s ever been.

We added TransDigm as a core holding. Most of the position was added between 3/16/20 and 3/20/20. We initiated a position and quickly took it to 10% of the portfolio at cost. In retrospect, 10% may have been too small but it would take a truly exceptional opportunity to purchase more than 10% at cost.

TransDigm, at that time, was one of the easier additions to the portfolio I’ve ever made. Investors appeared worried TransDigm might have covenant problems, which brought the possibility of bankruptcy into play. Those fears were misplaced as TransDigm’s covenants only “sprung” when TransDigm drew more than 35% of it’s revolving credit facility. As of 3/16/20, it was pretty clear that TransDigm could survive for at least 1.5 years without tapping at least 35% of the credit facility.

Investor fear wasn’t completely unwarranted (though it did lack nuance) as TransDigm runs a highly leveraged strategy supplying parts to the aerospace industry. Aerospace was one of the hardest hit industries from COVID-19. While many were, and some remain, concerned that travel would be permanently altered by COVID-19 that concern is misplaced. At worst, a recession would potentially impair the long term growth rates in travel. But the desire to travel is highly unlikely to disappear. Just look at history.

At a ~$15.5Bn valuation the free cash flow yield to equity, on a normalized basis, appeared to be ~6-7%. Not screamingly cheap in absolute terms, but pretty solid considering:

  • near 0% interest rates,
  • potential upside from additional efficiencies from the Esterline acquisition
  • future acquisitions
  • the quality of the company.

People will push back on business quality. The most common criticism involves TransDigm’s “aggressive” pricing. That criticism has an element of truth to it but seems far closer to convenient criticism than reality. Yes, TransDigm increases the prices of some parts when they acquire companies. Yes, those parts generate absurd margins when viewed in isolation. However, people need parts and low volume parts need to cost a lot in order to justify production. That’s true in every industry. For instance, there are businesses that warehouse odd bolts, screws, and springs in order to sell them to refineries for thousands of dollars per bolt, screw, and/or spring.

While that may seem crazy to some, it’s also how business works. I’d rather partner with the people smart enough to find those opportunities than complain about them existing. After all, we live in the world that exists not the one we think “should” exist.

The most difficult question to answer was whether TransDigm would be able to refinance its debt maturities. A large portion of the company’s debt is due in 2026. The company’s ability to refinance that debt will be a function of whether (a) travel returns by 2023/2024 and (b) (1) the rate environment and (2) why rates are where they are.

It’s important for travel to return, or begin to trend in that direction, by 2023/2024 because lenders are going to want to see solid trends to refinance into. As stated, it’s highly likely that travel substantially returns. Thus, we are comfortable accepting the refinancing risk despite it introducing a potential total loss to the equation.

As of this writing, TransDigm’s stock increased ~70% from our cost basis. To be sure, today’s price might be insanity. In fact, we trimmed a bit of the exposure on 6/5/20 as Transdigm became 13% of the portfolio and the quoted price gives your manager indigestion. That said, TransDigm will remain in the portfolio regardless of quoted prices. It will leave the portfolio only if travel doesn’t return. Consequently, we look forward to a long partnership with TransDigm.

In conclusion, today’s buyers need to have much more nuanced views of when travel will return, how many acquisitions TransDigm can accomplish, and whether the company can increase pricing. Those are much tougher questions to answer. Thankfully the panic sellers helped us avoid those hard questions. Price dictates due diligence and the market rewards patience. Try to avoid the difficult questions by swinging big when you see the easy ones.

Beta is Risk

Yes, you read the headline correctly. The academics got it right. Sort of…

Public market investing rewards those who can identify assets trading at discounts to what they will be worth in the future. But what about the time in between initial purchase and the future? That’s where Beta comes in.

Beta, for those that don’t know, is the measure of a stock’s movement compared to the market. So, if a stock has a Beta of 1.25 a stock holder should expect to see 1.25x the volatility (good or bad) of the market. That volatility can cause some pretty costly errors.

Many, if not most, people have the capability to pick businesses that make sensible investments. Many, if not most, people have the ability to decide a sensible price to pay for an asset. Few people, however, have the ability to consistently see how assets are trading and remain rational. Moreover, the faster the prices move, the less rational people are. Why?

Upside volatility in stocks people don’t own causes FOMO (fear of missing out). This can lead to investors chasing stocks that run at exactly the wrong time. Downside volatility in stocks people own cases the flight response nature ingrained in our psyches. This can lead to people bailing on stocks they own at exactly the wrong time. Joel Greenblatt summarized public investing well when he said he gets paid more to have a strong stomach than for his analytical ability. See http://cfany.gallery.video/fullconference/detail/video/6053271135001/joel-greenblatt—keynote-presentation:-ben-graham-vi at 17:20 and 21:00ish.

So yes, Beta is risk. To the investor’s behavior. Beta, however, is not investment risk. Nor is it business risk. Thus, the academics got it right. Sort of…

Buybacks: An Inside View

Delta bought $1Bn+ of their own shares in February 2019. In doing so, Delta accelerated management’s planned capital return to shareholders. My first thought was “Delta thinks its stock is cheap.” Today, I view the move as smart capital allocation with potential upside.

Delta funded the transaction with a seasonal working capital debt facility. Usually a company has to pay an upfront fee to obtain a new debt facility. Let’s assume the upfront fee was ~37.5bps given Delta’s credit profile and ongoing bank relationships. Like all debt facilities, there’s an associated interest expense with the facility. These facilities are usually priced in relation to LIBOR. For this discussion, I assumed Delta has to pay LIBOR + 150bps. That said, I suspect the cost is closer to LIBOR + 75bps or LIBOR + 100bps. Either way, the example yields the same conclusion.

Assuming Delta obtained the facility in January, the cost of the facility looks something like this:

Note – the repayment assumptions accelerate during the summer because that is peak travel season.
Note also – Delta’s 2020 bonds yield slightly more than 2.60% to maturity. The facility above assumes a 4.15% interest rate. Thus, I suspect these calculations prove overly punitive to Delta’s ultimate interest expense.

As shown above, Delta incurred an incremental interest expense of roughly $13.8mm. What did Delta gain?

Delta’s dividend savings during the period almost exceeded the cost of the facility. On an annualized basis, the dividend savings exceed the assumed facility cost by 138%. Obviously, this math can get taken to an extreme because the company can retire more shares as it borrows more money. That said, this is a great example of how an investment grade balance sheet enables a company to play offense when opportunities present themselves.

Delta’s decision carries some risk. If the summer travel season is poor then Delta may not be able to pay the facility off as quickly as I assume. In that case, the facility costs will exceed my projections. Nevertheless, the company could manage an additional billion dollars of debt, if necessary (it had $1.9Bn of cash as of 3/31/19).

Importantly, despite any temptations, management didn’t get too carried away on the facility size. Accordingly, Delta made a low risk, potentially high reward bet. Those are exactly the kinds of bets I want my management teams making.

NOTE: Delta increased their dividend from $1.24/sh/yr to $1.40/sh/yr following the repurchase. This reduced the annualized savings from retiring the February shares from $24.3mm to $2.2mm. Personally, I would prefer for them to retire the shares and pay special dividends rather than raising the promised dividend. That said, I understand management’s decision and remain pleased with the corporate finance decisions.

ROIC And Returns

Warren Buffett discussed his Kraft Heinz mistake with Becky Quick. While he still views Kraft Heinz as a wonderful business, he paid too much. Here is a screenshot of the transcript:

Source: https://www.cnbc.com/2019/02/25/full-transcript-billionaire-investor-warren-buffett-speaks-with-cnbcs-becky-quick-on-squawk-box-today.html

Investors often say that overtime your returns will converge with the business’ returns. As Buffett mentions above, that is simply not true. What is true, however, is your returns converge with the underlying business when you purchase a business and it grows substantially following your purchase. The higher the entry price, the more the business has to grow in order to provide the owner with the business’ underlying economics.

The reason is simple. As an owner/partner, you earn your proportionate economics on the earnings a business generates. However, each partner has a different entry price based on a different earnings base (depending on when they purchased shares and/or LP interests). Therefore, each owner/partner is entitled only to his/her purchase yield on the base he/she acquired. Following the purchase, however, an owner’s economics on the incremental earnings base mirrors the underlying economics of the business.

Kraft cannot grow the earnings base Buffett paid for. Thus, he is stuck (for now) earning $6Bn on his $100Bn purchase price. His economics will only improve if KHC (1) repurchases shares when they yield more than 6% on the enterprise (he is effectively averaging down in that transaction), (2) grows again and is able to earn more than $6Bn pretax without needing to raise additional equity, or (3) successfully executes an accretive acquisition.

As the greatest of all time shows, price is extremely important on slow growing businesses. More importantly, he provides some clarity on an often misunderstood investing idea.

Note: This discussion assumes Buffett purchased Kraft with 100% equity. That’s not factually accurate. Financing decisions can change the specifics of the discussion above, but the points made above are accurate for teaching purposes.

CPG and Capital Theory

The book Capital Returns is too good to summarize. The book itself is a summary of Marathon Asset Management’s investor letters from 2002-2015. The intellectual flexibility that firm demonstrates is inspiring.

One key takeaway is analyzing industries through a capital cycle theory lens. The capital cycle can be described as follows:

  • High returns on capital lead to competition entering an industry.
  • The new competition increases the amount of assets chasing the same dollars of profit.
  • More assets fighting over the same profit dollars reduces margins.
  • Reduced margins decentivize entrants, drive out competition, and enable the surviving companies to begin increasing margins.
  • Repeat

Accordingly, firms and sectors with the lowest asset growth tend to outperform. The phenomenon is called the asset-growth anomaly. See https://www.aqr.com/Insights/Research/Journal-Article/Investing-in-the-Asset-Growth-Anomaly-Across-the-Globe for a solid paper on the topic. That theory is a major reason I like the beer industry so much despite the rise of craft entrants. Globally, I still perceive the industry to be very rational and I view brewpubs more as restaurant competition rather than brewer competition. That said, it’s impossible to view more assets chasing beer sales dollars as bullish for Big Beer. But I digress…

A lot of traditional consumer brands discuss disruption. Why? Historically, traditional large brands leaned on retail distribution channels, dominated shelf space everywhere, scaled production and distribution to enhance margins, and pushed their messages out via advertising. See https://www.forbes.com/sites/antoinegara/2018/04/30/jorge-paulo-lemann-says-era-of-disruption-in-consumer-brands-caught-3g-capital-by-surprise/#2607284d1f9b. Today, the internet eliminated traditional advertising and distribution barriers. Therefore, it is easier to have launch a new brand.

Moreover, consumers are willing to trust brands quickly. Therefore, the brand equity that used to serve as a consumer short cut has eroded. That said, social media influencers and internet marketing are not very discerning. Time will tell whether brand equity makes a comeback. Watch the documentaries on the Fyre Festival on Netflix or Hulu to determine whether you think its plausible that consumers begin to crave the certainty of Big Brands again.

Regardless, barriers to entry are clearly lower than they used to be.
The perception of viability attracts assets to the industry. When new assets chase returns faster than industry profit pools grow, total profit declines. Importantly, Mr. Market knows that. So it’s worth looking to see how entities are priced given the facts. Kraft Heinz is a traditional CPG company impacted by these trends; though mostly because of consumer’s willingness to trust private label brands. Its valuation relative to history looks like:

Source: Bloomberg

I’m not extremely excited about those multiples because a 16x EV/EBIT equates to less than a 5% unlevered (EV/NOPAT assuming no interest expense) cash flow yield on a firm that isn’t growing. Moreover, competition remains strong and private label attacking market share is likely to continue. Personally, I’d like to see Kraft Heinz offer a return on equity north of 12% (PE of ~8.3x) before I got excited given the facts as I understand them.

But, I will continue to watch “melting ice cubes” because when facts and/or results change they can offer very attractive risk/rewards. More importantly, no one else likes to own them. Historically speaking, out of favor companies outperform the most loved companies. Though this last “bull run” makes me wonder whether that rule changed. Time will tell.

The Merits of Writing

First and foremost, SCG is not an investment advisor and does not recommend buying shares in AB InBev.  The investment discussed below has substantial risk and should only be considered after lengthy due diligence.  That said, I recently purchased shares of AB InBev @ $68.37/sh.  Therefore, readers should presume I am promoting my own position when I am talking about AB InBev going forward. 

I recently presented an investment in AB InBev to a group I belong to, The Manual of Ideas, as my “Best Idea of 2019.”  That was my first presentation to the group.  Thus, I took career/reputation risk discussing this investment.  Moreover, it’s an investment with a credible bear thesis so I have a reasonably high chance of looking “obviously foolish.” As if that weren’t emotionally taxing enough, yesterday I saw some numbers released that created some “fast thinking” panic.  Bud and Bud Light both apparently saw U.S. volume declines in excess of 6%.  See https://adage.com/article/special-report-super-bowl/ab-inbev-reveals-super-bowl-ad-plans/316173/?mod=djemCMOToday.

My first reaction to the story was “Great, it took exactly one day for my ‘Best Idea of 2019’ to blow up.” Then I started to do some math and write. 

To begin, I have a high degree of confidence the cited numbers relate to AB InBev’s U.S. business.  The U.S. market accounts for ~31% of sales attributable to AB InBev (AB InBev only owns ~62% of AmBev but consolidates 100% of the entity’s sales).  In 2016 Bud and Bud Light accounted for ~60% of AB InBev’s U.S. volumes.  Presumably this percentage declined as brands like Stella and Michelob grew their percentage share in AB InBev’s portfolio.  But, let’s assume 60% is the correct number and volume production equates to sales.

If 60% of 31% of sales are fading at 6.6% the result is a 1.2% decline in total sales.  That sales decline doesn’t account for the offset in growing brands such as Stella Artois and Michelob Ultra.  That’s actually not that bad. My projected returns rely on U.S. sales declining at 2% per year.  See below.

Do I wish Bud and Bud Light were growing in the U.S.?  Yes.  But I knew they weren’t.  The 6.6% number scared me emotionally.  But once I got rational and “thought slow” I realized I had accounted for that possibility via a conservative underwriting.  That said, rapid volume declines could put my margin assumptions under pressure but as of now I think those margin assumptions are reasonable.  Time will tell.

Without writing I probably couldn’t be so rational about the results because of how badly I want this idea to work.  The presentation induced emotion that otherwise might not have been there.  Thankfully, writing has me thinking slow.  This investment may not work.  But at least the investment’s success or failure won’t be caused by my emotional reaction.

What Should AB InBev Do About Bud and Bud Light?

The investment thesis in AB InBev is not a U.S. focused thesis. That said, the U.S. business is important for AB InBev’s debt repayment. Therefore, data points such as Bud and Bud Light falling 6+% y-o-y are concerning.

I’d like to see more resources diverted towards the craft beer portfolio, Stella Artois, and Michelob Ultra. Those brands are growing nicely. See https://www.bizjournals.com/birmingham/news/2018/10/01/here-are-the-top-20-best-selling-beer-brands-in.html. The recent repackaging in the “Taste of Belgium” 12 pack (Stella, Leffe, and Hoegarden in one 12 pack) is a good packaging innovation. While Bud Light remains important, I don’t believe marketing will solve the consumption trends in that brand; it’s more about milking the cow rather than driving growth.

Longer term, I’d like to see the company figure out how to activate the craft beer portfolio they’ve acquired. Perhaps they should borrow a page from Starbucks and create the beer equivalent of Starbucks Roasteries. A group of really awesome beer shrines in urban environments could be a decent way to remain corporate but also authentic to beer lovers.

Most importantly, AB InBev should focus on emerging markets. The relative scale advantages AB InBev enjoys matter immensely in those economies. Expanding the beer category and offering consumers a reasonably cheap alcoholic beverage solution offers true growth potential in EM. Furthermore, any and all potential distribution advantages should be solidified over the next 3-5 years. Those investments would generate solid ROIC for years to come.

After paying down debt and widening the emerging market moat AB InBev should probably diversify further away from beer. This would be natural as the company already bottles and distributes Pepsi and Gatorade in LatAm. Whether the diversification efforts lead to non drug related beverages or marijuana related beverages remains to be seen. For the near future, let’s work with the portfolio we have and pay down debt. Acquisitions can wait.

Disclosure: Long AB InBev

Cash Flow is King, But Sometimes it Isn’t

In my younger years I was too focused on hard and fast rules.  Rule 1 was cash flow is king.  Rule 2 was buy cheap.  If a company wasn’t generating meaningful cash it fundamentally wasn’t worth investing in.  I wouldn’t even consider Rule 2.  After all, a company is worth the cash it generates in the future; discounted to today’s values.  Below is a model that illustrates this concept.  Each cash flow has a 10% discount rate applied to it.

*Assumes a 10% required rate of return

You can see how much weight the early cash flows have to the calculation. Which is to say that $100 generated in “Year 1” is worth $90.91 in today’s dollars while the $100 generated in “Year 10” is only worth $38.55 in today’s dollars.  Therefore, the cash flows at the end of a 10 year model need to be substantially larger than the near term cash flows in order to be worth the same amount in today’s dollars.  This impact is exacerbated when near term cash flows are negative.   

That has always been a hurdle for me because I lack the confidence to  accurately foresee cash flows 10 years from now.  Furthermore, the required growth in cash flows caused greater uncertainty and doubt.  A negative consequence of that mental barrier/bias is I almost always missed out on growth companies because they tend to use cash while they grow.  Thus, current cash flows in growth companies are not representative of mature cash flows.  A recent presentation by Aswath Damodoran illustrated this point with this slide:

Source: https://www.youtube.com/watch?v=c20_S-QgvsA&t=2s

Damodoran highlights the cash needs of companies in different life cycles very well in that slide.  In my experience, a lot of money can be made investing during the high growth part of the life cycle (assuming you pay a reasonable price).  I believe the reason stems from the fact that the future is still uncertain so it’s still possible to have  investing edge (Note: the dispersion of future cash flows in growth companies arguably means there is more risk associated with investing in them). 

Most people can reasonably forecast the future of Coke.  Forecasting LaCroix’ future is more difficult.  Furthermore, Coke’s valuation very driven by existing cash flow rather than future cash flow.  Thus, it’s less likely to be materially mispriced because everyone is looking at the same information in the same way.  This makes buying Coke very cheap very difficult and probably limited to severe market corrections.  Waiting for those opportunities probably isn’t the best investing strategy because holding cash and waiting for a crash can cause behavioral mistakes.

I’ve learned from my mistakes and now try to look at a business or investment at the time of maturity.  I would not summarily dismiss purchasing a building during the construction phase while it was not earning maximum rent and was consuming cash while contractors completed renovations/build out.  Buying a business is no different.  

Making money investing is a difficult pursuit.  Nuance and flexibility are rewarded much more than hard rules and style conviction.  As I’ve let go of my style as a “value” investor looking for cheap cash generation I’ve begun to see opportunity in buying smaller firms at growth inflection points.  The key is determining which part of the life cycle a firm is in and analyzing that particular situation accordingly.     

The Importance Of Entry Price

When is an investor most likely to permanently lose money?  When he/she enters an investment.  Therefore, investors should be extremely cautious before entering an investment.  In theory this sounds nice, but in practice the fear of missing out (FOMO) can cause investors to buy too early.  

Some basic math shows the risk of buying at elevated prices.  I recently looked at Adobe Systems Inc.  I haven’t done enough work on the company to have informed opinion about the success of their recent acquisitions and whether management is capable.  That said, I am used to their Adobe branded products because I use them frequently.  Therefore, I understand Adobe’s core product is fairly integral to a business setting and they are priced on a subscription basis.  

Wall Street loves subscriptions because they tend to reduce churn and increase revenue certainty.  Consumers tend to renew subscriptions (sometimes without even realizing it), tend to not request their money back once billed, and cannot defer purchases because a company simply bills their credit cards.  Therefore the existing revenue streams of subscription companies are very likely to continue.  Furthermore, price increases tend to be easier to pass on to consumers since there is less sticker shock (many consumers don’t even check their subscription bills). 

Another thing Wall Street loves is software companies.  Why?  Because once a software company gets traction with customers there is minimal incremental capital to signing up the next customer.  Therefore, most of the additional revenue becomes cash flow to the business.  Thus, once a software firm achieves a minimum viable scale each additional customer becomes immensely valuable (assuming the cost to acquire that customer is less than the lifetime value of the customer). 

Adobe is subscription based and has hit scale.  Therefore, Wall Street loves it.  I decided to take a look because there has been a sell off in tech stocks lately.  Below is a very simple back of the envelope model I built.

I built the model assuming that Adobe continued trading at roughly 30.2x free cash flow.  I decided to increase Adobe’s buyback ratio over time and allowed for free cash flow growth in excess of GDP growth.  These are reasonable assumptions because Adobe probably won’t need all the cash it generates and should be able to raise prices.   

This seems reasonable so far, but the results rest on the assumption that Adobe will continue to trade at 30.2x free cash flow.  Is that reasonable?  Perhaps.  The current yield on 30 year treasury bonds is roughly 3.4%.  The current yield on Adobe is 3.3% (1/30.2; the inverse of the free cash flow multiple).  So, investors are willing to accept slight less free cash flow yield than risk free bonds today because they deem Adobe’s growth and earning certainty worthy of that bet. It’s important to stress that Adobe currently trades at a lower cash flow yield than risk free assets. 

Interest rates have been depressed for a long time now.  I have no idea whether they will continue to stay at these levels or not.  But, its reasonable to ask what happens if rates revert to their long term average of ~4.5%.  For purposes of this illustration lets assume that happens over the next 3 years.  The investment result is below (assuming Adobe trades at a similar yield to 30 year bonds). 

In the example above the business performs exactly as it does in the first scenario.  However, the multiple contraction decreases a shareholder’s 5 year return from 35.3% to 9.0%.  In that scenario, a shareholder would earn less than 2% per year.  That return is certain to reduce a shareholder’s purchasing power over time.  

Therefore, identifying a business worthy of investment is a necessary but insufficient condition to becoming a good investor.  Tradeoffs must always be made.  Bad businesses will sell at extraordinarily cheap prices at times.  They may be worth buying.  Conversely, good businesses selling at extraordinarily high prices may not be worth the risk of wealth destruction.  Reasonable minds can differ about which companies to buy and sell.  But price and risk must be a critical part of the discussion.  

The Same Investment Mistakes Occur Everywhere In Life: The Too Hard Pile

The more I look at different “deals” the more I get convinced everyone is looking at the same stuff in different wrappers.  My first home purchase was located at the corner of Division and Clybourn in Chicago.  It was a very cool property with an incredible view of Chicago.  In fact, it probably had the best views of the city I’ve seen.

Why was I able afford it?  Because it had a massive downside.  The home was located near Cabrini Green.  See https://en.wikipedia.org/wiki/Cabrini%E2%80%93Green_Homes

I was betting on Cabrini Green coming down and the neighborhood drastically changing.  I figured even if I paid a little too much for the property the neighborhood would change so much that the price I paid would look like a bargain.

So why was this “investment” unsuccessful?  For starters, the global financial crises came and development completely stopped.  I probably should have known the housing market was phony when I could get a loan as a law student and provide no documentation.  But, at the time I wasn’t able to think the way I do now.  So let’s put the greater housing market in the “outside of my control bucket” for now.

More importantly, I was the dumb money.  I should have done more research to figure out whether the neighborhood changing was a realistic expectation.  Once I moved into the home I learned that my alderman and the alderman for the low income housing across the street were different people.  That means they were serving different masters. Therefore, they had different incentives.

Those incentives are massively important in a city like Chicago.  Alderman have a ton of power.  That was a fact that I could have known but didn’t even think to look into.

Which leads me to comment on the most important piece of advice Warren Buffett has ever given: create a too hard pile.  I am fairly confident in my ability to see a home in an existing neighborhood and determine whether that home is a reasonable value.  What I am not comfortable with is my ability to determine (1) which neighborhoods will gentrify and (2) the rate they will do so.  Therefore, an investment that requires gentrification by a certain date should be “too hard.”

For the longest time I thought Buffett said things were “too hard” when he couldn’t really understand them.  But, can’t Buffett understand almost any business concept?  Yes.  So how do 90% of the things he looks at end up in his “too hard” pile?  Because their success is too difficult to determine.

At the moment I believe the common stock of General Electric is incredibly cheap.  In fact, I think it’s quite possibly the deal of a lifetime.  Yet, Buffett isn’t buying.  Why? I believe there are issues within the entity he thinks are “too hard.”  I suspect he looks at some of the business lines and views turning them around in a similar vein to how I should have viewed the potential gentrification of my first neighborhood.

Remember, there is no requirement to play a game you don’t understand and/or want to get involved in.  No is a perfectly fine answer.  Get in the habit of saying this is “too hard.”  It will help your results over the long term.