Keith Smith of Bonhoeffer Fund discussed the themes of “it gets better when it gets bigger” and “interest rate adjustments” at Best Ideas 2023.

Keith also presented his investment theses on Asbury Automotive (US: ABG), Combined Motor Holdings Group (South Africa: CMH), and Sixth Street Specialty Lending (US: TSLX).

Overview:

When do firms get better when they get bigger? Economies of scale are key in answering this question. Economies of scale provide higher margins with larger velocity of sales or size. There are two levels of economies of scale — local and national. Local economies of scale can be seen at the local and at the national levels. The number of synergies associated with each depends upon the nature of the customer relationship. For more relationship-driven sale businesses (like auto and home sales), local economies of scale can dominate. In more commodity- and brand-driven sales (like CPG), national economies of scale dominate. For products that require a post-sale service (like autos), since service is locally provided, local economies of scale dominate.

These economies of scale can be generated from organic or inorganic growth. M&A growth or consolidation can occur geographically or functionally along a value chain. If done geographically, cluster or customer density is important, as more synergies can be realized locally than nationally. Generally, fragmented markets are consolidated via either organic growth (stealing market share) or consolidation. Depending upon the difficulty and timing of taking market share and the price of an M&A target, sometimes M&A is a better approach to consolidation than organic growth. Innovation can be the cause of the fragmentation of a market. An example is the internet providing a new distribution channel for products.

An interesting question is where in the consolidation life cycle does it make sense to invest. Early on in the life cycle (top five firms have less than 10% of market share), many of the economies of scale and synergies may not be reflected in the financials of the acquiring firms, so the valuations are typically lower and potential for growth is higher. Later on in the consolidation lifecycle, the economies of scale and synergies are more evident in the financials, but the valuation is typically higher.

The first firm Keith looks at is Asbury Automotive, which is rolling up car dealerships in a fragmented US market. The US auto dealership market is fragmented, with the top five firms only holding 8% of the total US market. Auto dealers can achieve local economies of scale (clustering) through shared advertising, auto selection, and service opportunities. The internet has also fragmented the customer base — most notably through age demographics — and provides high incremental sales and service opportunities for firms such as Asbury. In addition, Asbury’s management team has used traditional earnings growth techniques such as leverage and share buybacks when Asbury’s stock price is low and there are no immediate consolidation opportunities available in the market.

The second firm is CMH Group, which has historically rolled up and gained market share in its clustered automobile dealerships in South Africa. The SA auto dealership industry is more consolidated than the US market. The SA market has fewer consolidation opportunities than the US market, so CMH has generated total shareholder return growth via offering car rental services, dividends, and share repurchases. As with Asbury, CMH uses leverage to increase shareholder returns, and the amount of leverage can be easily serviced and paid down with current and projected cash flows.

The recent rise in interest rates has made bond-like investment competitive with stock returns. In the past, when both stock and bond real rates of return have been negative with inflation present, it has been a good time to purchase corporate and high-yield bonds. Currently, well-underwritten BDCs with an expertise in distress provide solid cash flow returns, as well as the ability to capitalize on distressed situations. BDCs are yielding 10% based upon current interest rates and, with anticipated and known increases in SOFR, can add 1 to 2% to those yields. 12% yields with upside options from distress and a return of BDCs to more normal yields of 8 to 10% can yield high-double-digit expected returns from recent prices.

The third firm is Sixth Street Specialty Lending, which provides primarily first-lien secured loans to clients whose size is under the syndicated loan and publicly traded bond sizes. Sixth Street performs lending with nonstandard collateral. This includes lending against recurring revenue streams, intangibles, and hard assets such as inventory in distressed situations. They also have a proprietary deal flow from the private equity groups and a first right to any loan originated in the US from the Sixth Street Partners platform. They have generated close to 20% pre-fee returns for Sixth Street shareholders since IPO in 2014.

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The following transcript has been edited for space and clarity.

Keith Smith: This presentation is a carryover of sorts from some previous presentations, but it will have some additional enhancements for people to think about in terms of consolidation and interest rate adjustments, which have made for some interesting investment opportunities.

Before I get into it, let me note that none of this is investment advice. It’s for informational purposes only.

Over the past few years, I have talked a bit about consolidation. I thought it’d be good to step back and say, “What are the advantages of consolidation? Why is consolidation good?” Primarily, consolidation is an expression of economies of scale. The question then becomes why and when bigger is better.

In most industries, you do get economies of scale, and things get better. What happens is you get higher margins and more inventory turns with larger size because you’re able to spread fixed cost across a larger base of revenue over time. There are basically two types of economies of scale. In some cases, there are more local economies of scale, which are in a lot of businesses. Many of those are more focused on local service-oriented type of sales transactions. Then you have national economies of scale, which are more for a national audience.

An examples of local economies of scale is retail, which tends to be a very local business. Car dealerships are also a very local sort of a business. There are some aspects of e-commerce that are national, but it has historically been more of a local business. National economies of scale are more of the larger consumer product companies. A lot of those are national, so the economies of scale from a national perspective are associated with those types of companies.

One thing to avoid are dis-economies of scale. There are a few areas that can make you think, “When things get bigger, when does it get worse?” This primarily happens where you have personal services and in some high-end restaurants. Those are two specific areas with almost dis-economies of scale – as things get bigger, it doesn’t get better – but in most products we see out there, there is some aspect of this, and it varies by industry and by the thing you’re looking at.

Why is this important? The other aspect are cash flows. We’re all looking for companies with growing cash flows. There are two aspects of when bigger can get better. There are two ways to get bigger – you can either do it organically or through consolidation. The advantage of doing it organically – and you can get economies of scale before organic growth – is that you have more control over what’s going on in terms of the experience the customer gets in the end. You can generate returns without having to pay goodwill. Consolidation is the other way, but in this case, you are always going to pay goodwill, at least initially, in an area. If you expand organically from there, you don’t have to pay goodwill again, but you will have that initial goodwill you’re paying via consolidation.

There are two types of consolidation. You can consolidate geographically; you can start out in a small area and expand. Peter Lynch talks a lot about this in terms of retailing. It starts out in a regional area, then it can go to a different area and grow and expand that way. There’s also a functional area – you can start in one function and then expand. For example, if you’re a car dealer and you’re in retail, you can expand into distribution, and there are other parts of the value chain you can join and grow there.

Basically, consolidation happens either through entry into a new geography or a related functional area. Usually, consolidation in dissimilar businesses doesn’t work out too well, but I’m focusing here primarily on consolidation areas that are along a specific value chain or more geographically.

The key aspect of this consolidation concept or idea is being able to consolidate fragmented markets. Fragmented markets have long runways associated with consolidation or organic growth. You get the associated scale/scope economies which can lead to cash flow growth in excess of market growth. The key aspect behind this when you’re looking at companies is that people don’t include acquisitions in most projections.

If you build this skill over time, you’ll notice that future acquisitions are not captured in the price of a company. If there’s a way you can find that out – or at least be able to get a sense of what’s going on in terms of it being a good acquire and doing this over time – it can truly be a value add. If you look at a lot of companies in consolidation – like auto dealerships and other retailers where this has happened – you’ll notice the charts go up into the right. This tells you that the market is not anticipating the growth these companies have going forward.

Part of that whole process is being able to say, “Can we identify the companies with these opportunities and the management teams that can take advantage of these opportunities going forward?” The market will reflect what’s currently known, but projecting into the future is where it becomes a little more speculative and where there are some interesting opportunities from a value perspective.

How do markets become fragmented? One way is innovation. The internet has fragmented markets into online, offline, and omnichannel. What that’s done is brick and mortar before the internet has created an online audience and some combination of both. Markets can get fragmented over time, then they can be consolidated again. There’s an evergreen aspect of this fragmentation and consolidation. It’s a longer-term theme that can be followed across a number of different companies.

One of the things we didn’t get to say last year is where in the consolidation lifecycle it makes sense to invest. Some markets are not consolidated at all and are very small, as in the top five competitors control less than 10% of the overall market. For example, auto dealerships in the U.S. is a highly fragmented market. If you look at all the major public players in it, even though they’re called competitors, they very rarely compete against each other – they compete against the smaller players in those markets. Equipment leasing is another highly fragmented market.

One of the key things we did last year and are doing it again this year is examining incumbents and seeing whether they can adopt innovation to enhance growth and whether the enhanced growth may be reflected in the stock price.

There are a number of different frameworks people have come up with that I think are particularly useful when looking at consolidation. There are categorizations of consolidators. Scott Management has come up with four types: roll-ups, platforms, accumulators, and holdcos. In roll-ups, it becomes much easier because the synergies become much more quantifiable. That’s where I’ve been focusing most of my time. Other people go towards platforms and accumulators, where you have to accept that the process is somehow going to work in other industries. It has happened, but it does require more skill to apply processes across different industry sectors.

The risks with roll-ups include multiple escalation. Given my valuation background, that’s something I feel qualified to take a look at. It’s also tough to expand the TAM. Among the things to monitor is the market share of the top consolidators. The real question is, “How is this expandable internationally?” Sometimes it works out great, and sometimes it doesn’t, but you need to understand those aspects of such businesses.

Canuck Analysts Substack has a great chart that gives you a benchmark of what kind of return on capital you can expect, depending on the number of acquisitions made by the underlying consolidators. As the acquisitions are smaller in more fragmented markets, you’ll get a higher return on equity. The benchmark provided here return on invested capital plus half the organic growth rate, which is roughly a metric people use to estimate the value add of a specific acquirer, a segment, or a market to take a look at. As the number of acquisitions get bigger, the market becomes more consolidated, and the rate of return goes down.

We try to look at the ones that are probably more in the middle. Sometimes, in markets that are really small, it’s tough to see the advantages of consolidation right now. In the bigger ones, it’s going to be a lower amount, but if you get somewhere in the middle, I think there’s a nice, sweet spot where you can see some advantages of consolidation. Those will be reflected in the stock price today, but you still have a lot of potential in the future to see more of those aspects of the business, of the synergies, and the other things coming out of the businesses from a growth perspective.

A specific example of roll-up is the auto retail sector – the dealers and distributors. One way to look at it is to look at relative velocity and velocity trends as a measure of recurring sales. By velocity, I mean inventory turns. If you take a look at how fast the inventory turns on a relative basis and also on a trend basis, that gives you some idea of the velocity. Among the main players in this market, Asbury has one of the highest inventory turns, and it has decent margins, which is going to lead to higher return on equity.

It’s a combination of the two they’ll give you. The car business is multiple businesses. If you look at new and used sales, the return on equity equation there is turns times margin times leverage. Higher turns and higher margins have higher returns on equity. They’re all financing with maybe a bit of debt, but they’re all financed similarly. A good portion of the debt is also floorplan financing, which is secured by the inventory. That can also be relatively low cost.

In terms of the auto retail sector services, in addition to the new and used sales, it provides high cash flow margins and customer stickiness. Again, this is a highly fragmented market – the top five players in the U.S. hold about 8% of it. We’re at the beginning of the lifecycle in auto retailing in terms of the overall fragmentation and consolidation of the market.

When and where should we invest in the consolidation process? One of the areas we looked at is early on, which means the top five control less than 15% of the market. The advantages of looking at this timeframe is that there’s a long runway. We can see the advantages of more local economies of scale. A company like Asbury buys a dealership to enter a market, but then continue to buy dealerships that add to that. This gives you the local economies of scale.

The future advantages of larger consolidation are yet to be seen, but you can observe some local ones. Examples of these types of businesses include U.S. and European car dealerships, international auto rental, U.S. equipment rental, and plastic packaging. These are ones where we’re early in the consolidation cycle.

Later in the cycle, you’ll see the scale advantages include international economies of scale and the pricing. At this stage, a more relative valuation can work really well because, in essence, you have a much more stable type of a business. Examples of industries in that position are U.S. auto rental, North American building products distribution, and can packaging. In those types of businesses, you can take a look and say, “We’re later in the lifecycle. Therefore, it’s more traditional.”

The earlier ones are where there’s more growth potential in the future, which is our area of interest. We try to identify these companies before the growth happens.

In some of these industries, there’s a lot of family ownership, which can be good, but it can also be a constraint. For example, if you look at car dealerships in the United States, the ones that are growing and rolling up are more professionally managed. Most of them are non-family, but they can buy from families. In other parts of the world, it’s all family ownership, and it’s tough to find out how things work from that perspective. The other favorable factors are the regulatory and cultural climates. Consolidation is much more widely accepted in the U.S., Australia, and Canada than in other markets – in some places in Europe, for example, it’s a bit more difficult from a cultural perspective.

There’s also supplier support. One thing that historically has been an issue with automobile dealers is that some of the OEMs (specifically Toyota) wanted to prevent the distributors from getting more than a 10% share in a given market, but that’s been pulled back a little. The issue was market power, but now there’s a focus on the OEMs wanting to provide a consistent experience to customers, and they found that larger guys can do that and provide the upgrades needed to ensure this consistent experience.

I’m going to focus on the auto retailing sector in the U.S. and South Africa to give you an idea of some of the opportunities. The first company on my list is one that we talked about last year – Asbury. The specifics here are also applicable to other companies in the U.S. going through consolidation. It provides some interesting opportunities, especially when the market is pricing these businesses as though they’ve worked in the past.

If you think about the consolidation lifecycle, it’s evolving. As the consolidations get bigger and bigger, the economies get better and better, but the market is still pricing it as though it’s the last cycle. There are opportunities to get some upgrades in terms of multiples. As the businesses get better, and the markets fail to recognize it, that’s where the opportunity lies.

If we look at the business models of auto dealerships, we can see six different parts: new, used, service, finance and insurance (F&I), parts, and online. You can also have rental in some cases. There’s a large number of customer interactions. The larger number of customer interactions versus online is an interesting aspect of this. The advantage over the online-only type of car companies which have been struggling lately is that with the brick-and-mortar guys, you can get both. You can get more interactions with the customer, which can provide some more stickiness from a customer perspective because we are people. To a certain extent, you can get stuff online, but in the end, developing personal and customer relationships on a one-on-one basis is important in the business.

Clicklane is an online-only sales capability added in 2020. What Asbury has found with this online-only capability is that it’s reaching a whole new customer demographic – more than 90% of the customers are new customers that weren’t Asbury customers originally. This provides an additional area of growth.

Gross profit is split as follows: 20% from new cars, 14% from used cars, 43% from service, and 23% from F&I. Since only 20% of gross profit is from new cars, you’re going to have some buffeting against new car sales.

The other interesting aspect of Asbury and of many other publicly traded dealers is that if you look at the brands they have, most of them still have inventory shortages versus inventory surplus. There’s clearly a difference right now in the marketplace. The ones with inventory shortages are primarily the Japanese, some of the Japanese import cars. The ones that have surpluses are primarily the domestic producers. If you look at it right now, even from a short-term perspective, the pricing power is still going to be with the places where you have shortages, which is going to tilt more towards the publicly traded dealers. This can change over time as the supply chain recovers, but at this point, it’s providing some interesting pricing power to these folks.

Right now, Asbury’s mix is 45% luxury, 40% imported, and 15% domestic. The company has low debt and high ROE overall. This partly has to do with the turns, the margins, and Asbury’s clustering strategy.

The company has a quiet approach to growth, which is to pay down debt, buy new dealerships, focus on Internet growth, and buy back shares. If it can’t find a new dealership in the market, its stock always seems to be trading at a relatively modest price – right now, it’s about five times earnings. If you can buy back your stock at those types of numbers, you’re getting a 20% return on your money. I think that provides management with a nice alternative if they can’t find deals meeting their parameters.

The dealerships are clustered to take advantage of the economies of scale. One interesting aspect of this business is that it has the highest U.S. margins despite not being the largest operator. The largest company is AutoNation, but Asbury has higher margins due to the clustered economics. AutoNation has more dealerships, but they are more spread out, so it’s not taking as much advantage of the economies of scale.

We think there’s a good potential for 20% EPS growth. The online purchase options are providing some interesting aspects. It’s going to accelerate. Right now, the online option has a 60% penetration rate, so there’s an additional 40% that the company plans on moving out to next year. This is somewhat of a buffer.

What’s happening in the auto business is that you’re going to get a decline in sales prices due to more cars and the inventory adjusting to normal amount, but offsetting that for Asbury to some degree is that you’re still going to get this 40% penetration of a brand-new customer base that wasn’t there before. In addition, it also has a F&I product (Total Care) that’s only 40% penetrated. Those two factors in the short to mid-term are going to provide Asbury a bit of offset from the overall decline in overall sales from its normal business.

In the U.S. auto business, you’ve got a lot of recurring revenue. The key recurring pieces of revenue are service and after-market parts. It’s correlated more to miles driven versus new car sales. Demand is going to increase with autonomy, electric cars, and car sharing. Dealers provide services. I think we’ve seen this in a number of places.

A company called Inchcape has shown that electric vehicles need more service than normal vehicles. In addition to that, you have companies like Bilia in Scandinavia. I think there will be a need for continued service. What will happen with that service? In my view, more of it will migrate back to the dealerships because the cars will be more sophisticated, and the third-party shops will have a much more difficult time trying to keep up with the latest in terms of technology. Historically, service demand is growing about 3%. That’s dealer penetration. Again, the dealers will gain share from the independents as entertainment and autonomy become bigger parts of the autos out there.

An interesting thing about this business is that distribution is probably one of the higher return-on-equity parts of the auto value chain. Large auto dealers are a great business, getting 20% ROE. Distribution is also part of that. The dealers are vertically integrated into finance, service, and used cars. New car sales are lower-profit, but a lot of them can be financed by relatively cheap floorplan financing. Again, they’re consolidating this fragmented market.

Auto dealers play in probably the two most profitable portions of the value chain: distribution and financing. The interesting thing about distribution is that it’s a slow-changing business. A lot of these dealerships have been around for 50 or 100 years, which is a long time. A few of them go out of business, but many of them have really long tenures. They’ve got exclusive territories in the U.S. In the bottom line for an OEM, it’s an efficient way to distribute the products and services. Trying to do that directly would be very cost-prohibitive and difficult for them to do, especially the service aspect of the business.

Financing is a big piece of the business. There are different ways in which dealerships can provide financing. They can provide referrals to banks. There are OEM financing group options. Right now, some of them are starting to offer financing as part of the service packages they provide to customers.

In terms of incentives, Asbury’s management is highly incentivized. The equity ownership of the CEO is five times the salary, and three times for other management. They hold 0.8% of the shares. Overall, I think they’re well incentivized: 30% base salary and 70% incentives. They focus on key metrics, which I deem important, and they incentivize those metrics. Right now, they get 1.1% of equity granted each year for stock grants, which I see as modest.

The interesting thing about Asbury when compared to other publicly traded companies is that it has a capital allocation committee that’s part of the board. The guy that leads it used to be at Michael Dell’s office, and he’s still part of that board. I think it’s a really interesting arrangement, and the numbers historically have shown that they’ve been able to deliver over time.

What’s this thing worth? What can we expect for this type of business? Going forward, let’s say you’ve got 4% to 5% same-store growth, M&A growth of another 4% to 5%, and internet growth of around 10%, which gives you an overall growth rate in the 20% range. This is based upon the company’s actual plan. Another large competitor – Lithia – has the same plan going forward. That’s where these numbers come from. The question is how realistic they are. You have the same sort of scales. It’s primarily going to be driven by continued service growth from that perspective. Internet growth is going to provide a large amount, which I think is buffeted by the fact that there are a bunch of new customers there and a large amount of M&A available in this business.

One of the things you can look at from a consolidation perspective is that most of these publicly traded dealers are not competing against each other. They’re competing against smaller local or regional companies that will come up for sale at some point in the life cycle if the owner families aren’t interested in running them. I think that’s a really interesting aspect of this business.

With regard to operational leverage, Asbury has shown it primarily because of its clustering approach. Margins tripled with revenues going up 70%. There are local economies of scale in these clusters. That’s the way these guys focus on things. There’s operational leverage from growth from that perspective. This isn’t just Asbury – Lithia is doing a similar thing.

Right now, Asbury is selling for around five times earnings. If you put the numbers going forward, you’re getting to two times. These businesses are incredibly inexpensive. Why is it trading at five times? That’s because people are expecting. Granted, in certain portions of the business, there is overearning, but there are other aspects of it that will create growth going forward, which is not reflected in the valuation here. If you incorporate those, you can see it getting down to some very interesting numbers going forward.

Its competitors are all trading like this. The two that seem to have the most consolidation potential in terms of numbers going forward and have big plans are Asbury and Lithia. Their multiples are the same as of the companies that don’t have their expectations of growth through M&A and other activities. You’ve got a relatively low valuation across the set. Specifically the ones growing more are selling at the same multiples as those that aren’t going to grow or don’t have a plan to grow at the same level. From that perspective, I think it’s a very interesting way to take advantage of not only buying an inexpensive company, but getting an inexpensive company where the growth rate is relatively high.

I think Asbury is a really interesting opportunity at this point. It’s selling at five times current earnings and 2.3 times 2027 earnings. Clearly, the multiple should be higher with the growth expectations here. I guess what people may have an issue with is that maybe the growth expectations aren’t met, but even if they aren’t, that’s 4% organic growth. You’re at 16 times, which is 3X multiple there. If the company gets anything up from there – which is in its plans – it should be more. This is indeed an interesting situation.

There are some growth challenges. There are changing service needs and requirements for hybrids and EVs. There will be more tire rotations and more sophisticated electronics that need to be calibrated. I think the dealers will be in a good position when it comes to meeting those service needs. Bilia is on the front end of the EV transition. Inchcape has also seen some of this, but Bilia is on the front end since its footprint is primarily in Scandinavia, which has a lot of EVs. Bilia is still generating great returns on equity. It has added some services as a result of EVs, for example, tire changes because tires are much more of an issue.

The big thing when it comes to service is that once you get into autonomous stuff, you’ll also have to do calibrations on all these vehicles, which will create a lot of service opportunities. For every service opportunity that goes away when you go from internal combustion, there will be as many or maybe even more service opportunity going forward. In addition to that, the OEM distributors will be in a better position to provide those services.

What you’re doing here is buying growth at more than a reasonable price. Specifically for Asbury, which has the best combination of inventory turns and margins in the U.S. dealer space, there’s upside for internet growth. From the company’s perspective, you’ve got a guy with a proven business model. There’s still a lot of runway for it and the other consolidators to roll this market up. We’re in the early to middle stages. This thing could continue for probably another 5, 10, or 15 years. If the trends continue, this could be a really interesting business from that perspective – from just growing.

You’ve got a situation where businesses like Asbury and Lithia continue to grow in a market that is overall flat. They say SARs are flat, but these guys are taking a bigger and bigger share of that market over time. The market seems to be pricing it as though that growth isn’t going to happen. That’s where the disconnect is. Over time, the philosophy we’ve tried to focus on is trying to identify those opportunities where, let’s say, the market says there’s going to be no growth, but there is growth, and then try to understand which way it’s going to play out. I think this is a perfect example of that.

Let’s now move to another auto company but in a market where the growth potential isn’t quite as great. This company, CMH Group, is doing stuff to increase shareholder value in a slightly different way.

CMH is an auto dealership group in South Africa. It has revenue from the various sources we mentioned before plus rental. Similar to Asbury has done, CMH has got three clusters – one in Johannesburg/Pretoria, one in Durban, and one in Cape Town. By focusing on those clusters, it’s been able to get nice economies of scale and return on equity. The interesting thing it has that many American dealers don’t – although some international operators have got more into it – is rental, which can add diversification and growth potential.

The consolidation isn’t as robust as it is in the U.S. in terms of people buying new dealerships. If you look at this, a large portion of the stuff is from typically getting this diversification. It also have this rental aspect, which adds some growth to it.

What’s different about CMH versus, say, Asbury is it has a huge mass market. These are the domestic or the lower-price cars. However, the company is still able to make great ROEs selling to the mass market. It’s got low debt levels. The ROE is something like 28%, which is similar to Asbury. It’s been getting 30% ROEs for the past 10 years by following a bit of a different strategy in a lower-growth market.

CMH is focused on increasing profitability. It has got the cluster growth dividends and uses them in buybacks in this slower-growth environment to enhance shareholder value. It has the highest turns despite not being the largest dealer in South Africa and also has very high margins.

There’s a large runway here, but the market isn’t consolidating. The consolidation potential now is not quite the same as it is in the United States. That may change in the future, and it could become an interesting aspect of it, but what this company has done is adapt to more of a low-growth market.

Over time, the financing and rental mix has increased the margins. The other thing this dealership has done is increase productivity. If you take a look at net income per employee per year over time, the company has done an excellent job of generating more net income per employee at a pace of 13% per year over time in addition to this rental mix. That’s how CMH has adapted in a lower-growth environment to provide enhanced shareholder returns.

Similar to the U.S., you’ve got recurring revenues. The difference is that the consolidation opportunity isn’t quite as great as it is here. Therefore, going into rental and other growth opportunities provides CMH with similar sorts of ROEs but in a lower-growth environment.

The market is less fragmented in South Africa – the top three players have about 30% of the market. One of them controls about 20%, so that’s the big gorilla in the market, then you’ve got CMH and Super Group with smaller shares. In essence, that’s the market structure, and the growth from a consolidation perspective is not what it is in the U.S. at this point.

CMH is focusing on what I would say are the most profitable segments in the automotive value chain: distribution and financing (including rentals/leasing). From an auto value chain perspective, it’s focusing on the right places.

This company is pretty much family-owned and controlled. The family’s ownership is about 44%. The CEO owns a lot of the company. Their compensation is 70% base salary and 30% incentive (which is cash and SARs). They seem to be granting equity at the same level as Asbury, but it’s a bit different due to the fact that it’s a family-owned business. They have the same goals and incentives and seem to be more cash-based versus equity-based for Asbury.

The EPS growth for Asbury was probably in the low 20s, while it’s closer to 10% for CMH, but in addition to that, you’re getting a nice dividend. Car unit growth is at 3%. What’s happened over time is that the mix has increased the margins. The rental and finance mix has gone from 5% to 14%, and it could continue to slant that way going forward, which will continue to create the value. The net growth is going to be roughly 3% to 4%. The higher rental margins have basically slanted, and we’re conservatively assuming the margins are going to stay roughly the same. However, you’re getting this combination of growth plus a really good dividend. The company has adapted to the environment it’s in. You can still get decent returns.

Looking at the numbers for inventory turns versus the U.S. players and some of the South African players out there, you can see they are pretty impressive on both counts compared to larger competitors. It’s got to do with the clustering strategy that CMH is pursuing. Right now, it’s at about 4.8 P/E (21% earnings yield), which is relatively low. Yes, you’ve got the growth challenge, but the key piece here is that you’re still getting small amounts of growth plus a nice dividend on top. The combination won’t probably be quite as high as with Asbury, but you’ll still get a decent rate of return from an overall perspective.

That’s the aspect of looking at car dealerships as an example of consolidation. There are other businesses where this can happen, too. You can spread this out. We’ve also looked at other companies in this space with similar characteristics, and some of the interesting ones are maybe more in the leasing space, like Autohellas or Inchcape.

There are a lot of truly interesting aspects of this business that are underappreciated. If you look at its underlying economics and returns on equity, if this were any other business with such growth prospects and underlying equity returns, it would be trading at higher multiples. I think there’s been some bleed over of maybe more of the cyclical multiples being applied despite the fact that the underlying businesses have good economics, but that’s somewhat the nature of the business.

This wraps up the consolidation part of the discussion. I’ll move on to another area we’ve talked about in the past – bond-like investments. What’s made them interesting over the past year is the significant change in interest rates. It has created some opportunity for investors to get equity-like returns in some bond-like investments that are out there today. You couldn’t get those 12 months ago, but now there’s really interesting potential – not only for current returns but going forward, especially if you look at the guys doing distress and that kind of stuff.

In the past 12 months, they have reset positive real rates from negative real rates. If you look at TIPS, for example, they were trading at minus 0.5, and now they’re trading up to almost minus 1.5, so you’ve got a plus 1.5, meaning you almost have a 2% shift in real interest rates.

What’s interesting here is that both bonds and stocks declined at the same time. There are only a few times in history when that’s happened. Inflation is present, but future inflation is uncertain. Right now, the inflation seems to be coming down. Historically, when that’s happened, something interesting also happened. Now we’ve got 1.8% real rates, which is above the long-term trend.

Schmelzing and Rogoff have done a very interesting study on long-term interest rates. They’ve found that over time, there’s been a decline in long-term interest rates, which makes sense from a real rate perspective. As the world has become safer and more of this capital has not been destroyed in wars, famines, and epidemics, it accumulates, and when it does, supply and demand take this into account and real interest rates go down. According to Schmelzing and Rogoff’s long-term estimates, the current medium to long-term rate should be about 0.7%. Now, it has popped up to 1.8%, so we’re above that at this point. I believe it provides some interesting opportunities.

Some of the implications are that rising rates provide well underwritten financials, the ability to generate above-average profits if rates stabilize or go down. I think we’ll see some nice things from a combination of really high yields now and some tailwind from interest rates potentially going down.

Two areas that are quite interesting to look at now are BDCs and niche lending. In auto, you’ve got Capital Acceptance Corp, CRE, and Auto Kingdom. Those are focused guys that have really good, relatively low efficiency ratios and seem to be interesting opportunities given what’s going on with the interest rate.

Right now, what’s interesting is that the rates of return you can get on these assets are starting to become competitive with equities. For example, if you take a look at some of the BDCs, you can probably get a 10% current, probably going up to 11%-12% with the bump up and so forth in terms of how their rates are calculated. In addition to that, if interest rates come back down, you probably get another 30% to 50% on top. We’re probably talking mid- to high-teens rate of return, and that’s before the potential for some of these guys with expertise in distress to add some return on top of it. I think they provide some highly interesting opportunities that wouldn’t have emerged in the lower interest rate environment.

If we look at the past, there are three times where we had a combination of rising real rates and falling stock and bond prices accompanied by inflation. Those periods were post-World War II, post-Vietnam/Arab oil embargo, and the Iranian revolution. These were three times in history when both real stock and bond prices went down two years in a row. It was a good time to be a bond holder after each of these situations, and stocks did relatively well, too, because they came down, but sometimes there’s a lag in the stock comedown in terms of when they’ve recovered after.

Some interesting source materials for people wishing to look at these times in history are Buffett’s letters and John Neff on investing. Neff was a great guy. He kept an investment diary from 1971 to 1989, and it provides some very interesting insights into these periods of time. Another one is the first edition of The Money Masters, which John Train wrote in 1980. There’s also the revised 1973 edition of Ben Graham’s The Intelligent Investor.

Some lessons learned from a top-level perspective are that Buffett purchased high-return-on-capital, capital-light firms that were “royalties” on products and services at the time. These were TV stations, newspapers, and advertising agencies. These may have changed a bit now. Maybe more of the advertising agencies are like Google, which is getting royalties off of advertising as opposed to what the more traditional advertising agencies do. There are other aspects, but it’s interesting what he invested in at that time.

John Neff was a famous value investor who did well during this period of time. He invested in three different types of businesses – what he called cyclical growth (commodity and consumer), moderate growth (less than 8% per year with decent yields), and less-recognized growth (12%‐20% per year, single‐digit PE, high ROEs and participation in a definable growth area). One of the themes we’ve been trying to focus on at Bonhoeffer is looking at maybe moderate and less-recognized growth-type situations and combining with some of the cyclical. For example, Asbury historically can be looked at as cyclical growth, but it has less-recognized growth because of the high potential for consolidation. That’s exactly what Neff invested in. He successfully did this in an environment similar to what we have today.

We go back and take a look at what Ben Graham talked about. His thing is very interesting. I know there are a lot of parallels with today. One of the things he was looking at is bonds trading at a discount to par, which I think is an interesting area today. At the time, there were special bonds – savings bonds. The government now provides i-bonds, which were interesting to me. In a lot of cases, history rhymes. What was surprising to me is that when I went back and looked at it, I said, “Wow! These things are very similar to what’s going on today!” It was another thing that was pretty popular at the time and did well in the deep value stocks and workout situations. Those things in today’s environment are especially interesting from that perspective.

The real question that Neff, Buffett, and Graham faced at times was the trade-off between bonds and stocks. Twelve months ago, when interest rates were so low, there wasn’t much of a trade-off to be made, but now there is. Buffett had recommended munis, even closed down his fund when it got 9% after-tax return (6.3% pre-tax) in February 1970. Neff also examined this specific issue. He said he held bonds versus stocks when the bond real yields were 5%-plus. We’re not quite there yet, but we’re moving in that direction, and these are some of the things equity holders need consider with bond yields going up.

Bonds are becoming competitive now, and they may become even more competitive in the future, depending upon what happens, but if real bond yields go above 5%, does it make sense to hold any stocks at that point at all? Those are some interesting questions we haven’t had to deal with because interest rates have been in decline since 1980. These are some of the things you deal with when interest rates snap back, as they’re doing right now.

What are the overall investment implications from the historical data out there? First, bonds are more competitive with stocks. An interesting area to look at is well-underwritten, high-yield bonds or loans. Shorter-duration value stocks should do better than longer-term ones. Opportunities in the stocks of efficient and good underwriting financial firms are an interesting aspect. I think consolidation growth can add value independent of rates, and looking for royalty-type situations as those Buffett had mentioned is another thing we can do at all times, but even in inflationary times, it becomes a very interesting aspect of this.

I have a specific company in mind. It’s in the BDC area and represents an example of a company that offers an interesting opportunity. There are other companies that may be similar to it, but this one at least provides that example of what’s in the marketplace today that probably wasn’t there 12 or 24 months ago.

The company in question is Sixth Street Specialty Lending. It used to be called TBG Specialty Lending. Right now, it’s a business development company. It provides senior financing (first-lien floating rate notes) for growth, acquisitions, and restructuring. In short, the company provides senior secured debt to its various customers.

The management team has a wonderful long-term history. They built the Foothill Capital Specialty Lending business starting in the mid-1990s. These guys have 20-plus years of experience. They are part of a commercial bank which – in my mind – provides them with a good view of the risk on that large proprietary deal flow (most of the deals are internally generated). It’s a larger private equity-type of company, but it has the first right to anything that Sixth Street originates in the U.S.

Sixth Street is specialty-focused. One of the areas it focuses on are loans based upon intangible assets (recurring software revenues and licensing royalties). Another is first-lien distress loans – it’s done a lot of stuff in ABLs, pre-bankruptcy ABLs turning into DIPs afterwards. Right now, I think it’s doing that with Bed, Bath, and Beyond. Historically, it’s done it with Sears and other types of retailers in distress. It’s a highly specialized area but, for Sixth Street, it’s a great one with some really nice returns.

On the loan size, it focuses below the syndication level. It doesn’t have quite as much competition in terms of these loan sizes. The five-year TTM return on equity is 14% versus 8% for its peers. Basically, it’s got 2%+ greater return than top quintile BDC and 6% greater than average. I think this company has a very good historical underwriting process which will continue to go forward. There are some interesting opportunities because it has done great in distress in the past.

Sixth Street provides debt financing to middle-market firms. Dodd Frank has created additional demand for these types of situations. Underwriting is more important than growth for the company. It has not grown during period of times when it couldn’t find the underwriting that it felt it needed to get a certain rate of return.

With its commercial bank background, this team has one of the better lenses on credit and risk. A good number of BDCs generate lower-than-average returns on equity. On average, these guys have 13% to 14% return on equity versus 7.1% for most BDCs, which, in combination with high distributions, has led to a declining book value and discounts to book value. This BDC is a bit different. It usually sell at a slight premium to book value, but in essence, its return on equity is a lot higher. In my opinion, you’re getting a much higher-quality product here.

In my mind, the key differentiator here is underwriting. Sixth Street underwrites the customer’s business. It focuses on growing firms with moats – a lot of software and recurring revenue. It has a lot of proprietary versus third-party source deals. There are a lot of proprietary aspects to the business.

The management team has been accumulating experience in specialty lending since the mid-1990s, when Foothill was bought by Norwest/Wells Fargo. This team is value-seeking. They try to do some unique things, like trying to take over another BDC. They’re really opportunistic and generate strong returns. Here is some of the stuff that they’ve done. Since the IPO (which was in 2014), they’ve got about 12% annual return (19% pre-fee) compared to 3.5% for the Vanguard High Yield Fund and 6.7% for the BDC index. These guys have also been able to create above-equity returns even after fees, which I deem quite impressive.

Most of the portfolio (90%) is first-lien floating rate secured loans. The loan loss rates are very low – 0.5% per year since 2013. The coverage ratio is 2.6, which is very interesting because the way coverage ratios are reported in this industry can vary. The company has got the most conservative one and its ratio has been flat. Everyone with a less conservative approach of things has seen coverage ratios decline. That’s saying Sixth Street’s underlying businesses are very healthy compared to other types of businesses in the BDC sector. Its top 10 customers represent about 25% of the portfolio, and the average loan maturity is about four years. The company’s fees are higher than the BDC average, but it does get a higher ROE.

How does it look from a total return perspective? The current yield is at 10%, but known SOFR increases are not reflected in Sixth Street’s interest. SOFR is going to push probably another 1% to 2% increase in the underlying interest income the company will be receiving.

Historically, NAV growth has been 2% to 3% per year, driven by a combination of reinvested cash flows, relatively low credit losses, and distressed investment opportunities. Sixth Street has done a lot in retail, things like ABL and DIP. The rerate where you’ll be able to get some pick-up here is reduced to a lower rate environment. Typically, these things trade at 8.5% to 10% fair value yield. That will give you a cumulative 20% to 40% or, let’s say over the next two to three years, another 10% to 15% per year. You’re getting an 11% yield plus 10% to 15% plus an option if these guys are good distress investors. Basically, you get an option there which could create some more value. You’re adding up to maybe high teens or low 20s with the option if they find some distressed stuff they can invest in. It’s a really interesting competitive opportunity with equities.

What’s interesting is that, historically, Sixth Street has had a very high net interest margin – 8.4%, or 2% higher than other very good comps. It has been able to find places where it can get it, and that’s part of the underlying underwriting discipline the company has – making sure it gets high NIMs with low losses.

You have here relatively low losses and investment-grade credit. The company has a modest amount of debt and a lot of assets available for liquidity – debt of 0.67x equity and 50% of asset value of liquidity. In essence, Sixth Street is in a pretty good position compared to its peers. The other distressed player in the market with a good amount of experience is Oaktree Specialty. Sixth Street is selling at a slightly lower multiple, but I think both are very interesting places at this point. To summarize, Sixth Street is at 7.8 times earnings, which is about a 13% earnings yield, and we’ve got an 11.5% dividend yield.

What are the catalysts going forward? In addition to increases in SOFR rates and the re‐rating of BDC to lower rates longer term, there’s some distressed experience. You’re not paying anything for it today, but it can provide some interesting upside for both Sixth Street and Oaktree. Then, you’ve got equity sponsors, which could provide some downside protection. Sixth Street does have a lot of relationships with equity sponsors. Those companies provide some nice backstops because if Sixth Street runs into problems, the sponsors have an incentive to provide equity for these deals. Even when it was Foothill, Sixth Street had a lot of relationships with many of the private equity firms. So do Ares and Blackstone.

That’s the interesting opportunity here. Sixth Street is just an example. Others include Oaktree, Blackstone, and Ares. This is a very interesting area that I haven’t heard discussed much, but I think interest rates have made this more interesting over the past 12 months in terms of a place for people to look for investments and ideas along those lines.

This wraps up the presentation. If you have questions, feel free to contact me at ksmith@bonhoeffercapital.com. I’d be more than happy to answer any question and discuss these ideas with you. The Manual of Ideas community has provided additional interesting areas to look at, as well as interesting feedback on specific theses that have been developed today and in the past.

The following are excerpts of the Q&A session with Keith Smith:

John Mihaljevic: Thank you so much, Keith. It was a fascinating presentation, as always. Let’s go back to Asbury and CMH. They do look extremely cheap. I’m wondering what you think they could do on the capital allocation front to take advantage of that cheapness? How would you like to see them allocating free cash flow going forward?

Smith: I think they both have decent capital allocation strategies at this point.

Let’s start with Asbury. If it can find a dealer that can bring good economics, it’s going to buy that. That’s the company’s first priority and where it will continue to grow. The second priority is doing buybacks, which I think it can and will do when it can’t find good dealerships. That makes sense to me. The third is dividends. Asbury is paying no dividend now, which I think makes sense given where it’s at.

CMH is in a somewhat different situation. It doesn’t have as many organic M&A opportunities as Asbury, but it has done buybacks. The concern with CMH is that the float is relatively low. Buybacks may not be as available or as advantageous as dividends. This company has returned a good portion of its money in dividends in addition to the occasional buybacks, but when you’re dealing with an illiquid stock, buybacks can become a bit trickier than when you’re dealing with a larger stock that has more float.

However, I think both companies have successfully adapted their approaches to capital allocation to the situations they’re in. Asbury has a much wider and longer runway to reinvest. Therefore, that’s what it is focusing on first. For CMH, the reinvestment opportunity isn’t quite as great, so it’s returning more to shareholders, but both have done a great job.

This is an illustration of how different companies can do capital allocation if they’re in different parts of the consolidation lifecycle. If you’re further along, there’s not as much consolidation and growth to do. Probably the best thing to do is buybacks and dividends. If your stock has enough liquidity to make buybacks happen, and if you’re early on, as Asbury is, then a lot of it is plowing money back into the company, which is exactly what they’re doing.

I think both of them have done a great job given the opportunities they have. Of course, it greatly depends on what the opportunities are. Part of what we’re trying to do here is look into the future and say in both cases, “We’re going forward. I’m trying to look for growth.” The interesting thing about CMH is that the growth you’ll get is not necessarily in the underlying earnings – you’ll get growth from the dividends.

I think there are different ways of doing it. You’ll see that with some of the BDCs, too. Stock prices aren’t going to take off, but you’re getting a lot of money returned to you as dividends and in other ways. There are different ways to get returns and, in my opinion, these two management teams are doing an excellent job.

About the instructor:

Keith Smith, the fund manager, brings over 20 years of valuation experience to the Bonhoeffer Fund. He is a CFA charterholder and received his MBA from UCLA. Keith currently serves as a Portfolio Manager at Bonhoeffer Capital and was previously a Managing Director of a valuation firm and his expertise includes corporate transactions, distressed loans, derivatives, and intangible assets. Warren Buffett and Benjamin Graham’s value-oriented approach of pursuing the “fifty-cents on the dollar” opportunities, underpins Keith’s investment strategy. The combination of his experience and track record led Keith to commit most of his investable net worth to the Bonhoeffer Fund model.

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