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Preview of School Specialty: Underfollowed, Underappreciated Micro Cap

January 10, 2018 in Best Ideas Conference, Ideas

This article is authored by MOI Global instructor Patrick Retzer, founder, president and chief investment officer of Retzer Capital Management, based in Milwaukee. Patrick is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

School Specialty filed for Chapter 11 in January 2013, largely due to a debt-financed acquisition program and dramatic cuts in school budgets resulting from the real estate crisis. Apparently, the acquisitions were not fully integrated in the whole and many inefficiencies resulted. The Company emerged from reorganization in June of 2013 and hired a new CEO in April of 2014, who brought in several new team members and embarked on a plan to make to the Company efficient and position it for growth both organically and from modest acquisitions that would leverage SCOO’s sizeable presence in the marketplace.

Over the past few years (see slides 15 and 16 in the attached Q3 investor presentation), SCOO has successfully refinanced their debt (April 2017) to reduce interest expense and provide flexibility to execute acquisitions, enhanced the IT systems and technology platform, launched Process Excellence initiatives (resulting in multi-million-dollar annual reductions in SG&A), implemented a Team-Based Selling Model and launched the 21st Century Safe School value proposition. Revenue, on a seasonally adjusted basis, troughed in 4Q2014, in fiscal 2015 SCOO saw revenue growth in 2 of 7 categories, in 2016 in 5 of 7 categories. Over the past 3 years, current management has reduced SG&A over 8%, or about $19 million while growing TTM revenue from $628 million to $661 million. Their Q3 investor presentation provides excellent insight and detail of their progress thus far. Specifically, I believe SCOO currently presents a compelling investment proposition, for the following reasons:

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Preview of McCarthy & Stone: Largest UK Retirement Homebuilder

January 10, 2018 in Best Ideas Conference, Ideas, Letters

This article is authored by MOI Global instructor Mark Walker, a global equity investor at Seven Pillars Capital Management, based in London. Mark is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

The following is an excerpt from a letter of Seven Pillars Income Opportunity Fund.

We believe there are three sources of permanent capital loss: (1) business risk: the risk that intrinsic value declines due to a change in the competitive or regulatory environment, or declining standards of stewardship for example; (2) balance sheet risk: the risk that the capital structure is imprudent given the characteristics of the business and industry, and that equity value may be transferred to debt owners, and (3) valuation risk: the risk that we pay a price that is inconsistent with a wide margin of safety. Buying companies at steep discounts to private business value lowers the odds of permanent capital loss, even if the future unfolds in a less favourable way than expected.

We believe that our ownership of the shares of McCarthy and Stone (MCS) is consistent with our focus on downside protection. MCS is the largest retirement housebuilder in the UK. MCS buys land, secures planning consent, builds, sells and manages housing developments specifically designed for retirees.

Business risk

In our view the risk of intrinsic value erosion is modest due to a number of factors:

Competitive position. In MCS’s 40 years of operation, it has enjoyed a dominant position within a largely uncontested niche. Major homebuilders have tried and failed to enter this market. MCS is the dominant provider of owner-occupied retirement housing in the UK; it built its first development in 1977 and has a 70% market share today. Private competitors include Churchill (MCS’s nearest competitor but with only a fifth of the volumes), Pegasuslife and Beechcroft but these are much smaller, regional operators. A significant portion of retirement housing is publicly owned and takes the form of ‘sheltered housing’, owned by local authorities, the majority of which was built in the 1960s/70s. Apartment design is fairly standardised; MCS’s scale and ability to utilise repeatable processes is a cost advantage. MCS also enjoys planning advantages due to the social value of its products. It is subject to less onerous Section 106 and CIL charges than mainstream developers and other land users, which relate to obligations to contribute to local infrastructure.

Low development risk. MCS acquires sites through conditional purchase contracts, mainly conditional on the granting of planning consent. In many cases contracts will include commercial viability clauses which give MCS the flexibility to cancel purchases for projects which become uneconomic. In market downturns, MCS can exit conditional contracts and sell land to non-residential interests such as supermarkets and other commercial interests. Customer credit risk is modest; retirement homes are typically sold to equity rich cash buyers not usually reliant on cheap debt.

Long-term and aligned management incentives. The prior management team was focused on operating margins but not asset turns/capital efficiency. They were therefore not incentivised to maintain through-cycle capital discipline. An incentive plan was put in place by the current management team, a feature of which is a three year vesting LTIP in part driven by return on capital employed.

Balance sheet risk

MCS finances its operations from operating cashflow; shareholder equity represents 90% of long term capital. Financial gearing has dramatically reduced since the financial crisis from 10x net debt/operating profit to 0.3x today. Working capital is a much larger use of cash than fixed assets; this low level of operating leverage complements the prudent capital structure of the business.

Valuation risk

MCS’s current market cap is £800mn and its enterprise value is £830mn. With reported net assets of £700mn, invested capital in the business is currently £730mn; the quoted value of the enterprise is just 14% higher than this. This for a business currently generating 20% ROCE (return on capital employed) and targeted ROCE of > 25% on new investments. There seems to be a substantial opportunity to reinvest operating cash flows into the development of more homes for a long time. MCS estimates that almost one million households are in the optimal bracket of being 75+, living alone/with a spouse, and having high housing wealth. Yet only 140k units have been built to date in the UK. This c800k shortfall is large in the context of the market leader’s targeted production of 3k pa.

Yet the current valuation implies that MCS can barely out earn its cost of capital, let alone reinvest significant levels of cash into value accretive projects. Our variant perception is that this is a better managed and more appropriately capitalised business since the capital ill-discipline of the financial crisis, and that a significant runway for supernormal capital redeployment should facilitate satisfactory compounding of earnings, assets and dividends for a very long time.

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Preview: S&U, Underappreciated Non-Prime UK Auto Finance Company

January 10, 2018 in Best Ideas Conference, Financials, Ideas

This article is authored by MOI Global instructor Matthias Teig, co-founder and partner at Rothorn Partners, based in Geneva, Switzerland. Matthias is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

S&U plc is a family controlled British specialty finance company. After the sale of its home loan business in 2015, its main source of revenues is Advantage, a fast-growing non-prime motor finance business. Aspen Bridging is still in a test phase, but this real estate bridge finance business could potentially provide diversification and offer additional growth in the future. With a market cap of ca GBP 280mn and a free float of ca 26%, S&U shares are not very liquid and therefore the company is below the radar of most institutions and the sell side. A recent PE of ca 12 and a dividend yield of ca 4% seem attractive given its successful track record and growth potential. H1 revenues were up 33% and EpS increased 21%. The balance sheet is healthy with gearing at the end of July 17 at 56%. RoE of 16% in H1 can be improved as the business continues to grow and the balance sheet is levered up a bit more.

S&U was founded in 1938 by Clifford Coombs and is controlled by the Coombs family in the third generation with the twins Anthony and Graham Coombs as Chairman and Deputy Chairman. S&U is short for Sports and Utilities and in its early days, the company sold household goods (pots and pans, towels, blankets, …) door to door and collected payments on a weekly basis. The original consumer credit business was transformed into a home loan business in the 70ies, which was sold to Non-Standard Finance plc in 2015. Since 1999, S&U has built a non-prime motor finance business called Advantage. Non-prime is a type of loan, where the customer is not perceived to be credit worthy by a traditional bank. Usually, there were issues in the client’s credit history, but clients at least have a regular income.

On average, a typical Advantage car finance loan amounts to GBP 6100 with 4 years maturity at a relatively high flat interest rate of 17.9% pa. Loans are structured as hire purchase financing, which is paid off in monthly instalments secured against a car. Hire Purchase is different from PCP (Personal Contract Purchase), which is generally used for new cars. With PCP, payments cover only the depreciation of the car and the PCP provider keeps the residual value risk of the car. With hire purchase, the loan covers the full value of the car and ownership is transferred to the client, when the last payment is made. PCP is a bit like leasing and very much in the news recently because of concerns about its increasing use and residual value risks especially for diesel cars. Hire purchase is different, because the financing provider carries only the residual value in the case of default or early termination. Also, used hand cars have already gone through the steep part of the depreciation curve.

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This document is for informational purposes only and should not be construed as investment advice. While the author has tried to present facts he believes to be accurate, the author makes no representation as to the accuracy or completeness of any information contained in this note. The author and related entities hold a long position in the described security at the time of writing, but he might change his opinion and position without notifying readers. Please do your own research and with all investments, caveat emptor.

Stress-Induced Mental Changes

January 10, 2018 in Human Misjudgment Revisited

“Here, my favorite example is the great Pavlov. He had all these dogs in cages, which had all been conditioned into changed behaviors, and the great Leningrad flood came and it just went right up and the dog’s in a cage. And the dog had as much stress as you can imagine a dog ever having. And the water receded in time to save some of the dogs, and Pavlov noted that they’d had a total reversal of their conditioned personality.” –Charlie Munger

This article is part of a multi-part series on human misjudgment by Phil Ordway, managing principal of Anabatic Investment Partners.

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Munger also cited the connection to programming/de-programming and cults.

Update

Also known as Stress-Influence Tendency.

  • “Everyone recognizes that sudden stress…will cause a rush of adrenaline…and everyone knows that stress makes Social-Proof Tendency more powerful.”
  • Light stress can slightly improve performance – say, in examinations – whereas heavy stress can cause dysfunctions or depression.

One of the more vivid – and financially tragic – examples I’ve seen of this tendency was in the GFC. Many, many people were acting in their personal and professional portfolios based on responses to these tendencies rather any reasoned thought process. Many people’s lives were ruined or considerably worsened because they listened to someone on TV and sold at the depths. Many others were forced into it by practicalities, of course, but even Steve Bannon cites the example of his father sitting glued to the TV in October 2008 and being convinced to sell his entire retirement savings – a grubstake in AT&T amassed over five decades working for the company. “As he toggled between TV stations, financial analysts warned of economic collapse and politicians in Washington seemed to mirror his own confusion….[On] Oct. 6, financial analyst [sic] Jim Cramer told ‘Today’ show viewers to pull money from the stock market if they needed any cash for the next five years…So he did the unthinkable. He sold. Steve Bannon says the warning[s] spooked his father. ‘I could see his confidence in the system was shattered,’ Steve Bannon recalls. ‘He was older, in his 80s. But all these guys from the Depression, it’s a risk-averse generation because of the horrible things they saw in their youth. He was rattled.’ Marty Bannon, now 95 years old, still regrets the decision and seethes over Washington’s response to the economic crisis. His son Steve says the moment crystallized his own antiestablishment outlook and helped trigger a decadelong political hardening.”[66]

“Rationality is essential when others are making decisions based on short-term greed or fear. That is when the money is made.” – Warren Buffett[67]

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[66] https://www.wsj.com/articles/steve-bannon-and-the-making-of-an-economic-nationalist-1489516113
[67] Fortune, October 30, 1989

The Evolution and Revolution of the Electric Grid

January 9, 2018 in Best Ideas Conference, Letters

This article is authored by MOI Global instructor Ian Clark, managing partner of Dichotomy Capital, based in New York. Ian is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

The basic model for the electric grid has gone largely unchanged over the past 100 years. Large generators would send electricity out to consumers who would pay bills with no input to costs. The more consumers, the more money a grid owner/operator would make.

This has begun to change over the past decade as distributed generation resources are upending the model. Grid operators now have to balance an onslaught of new power sources from numerous locations. This increases the complexity of the grid and wreaks havoc on normal electrical grid modeling. How hard will the wind blow today? When will cloud cover increase? How quickly can the grid ramp conventional resources? Will load growth go up or down this year? All these questions need to be answered every second of every day.

This uneasiness has caused many investors to wonder about utilities, independent power producers (IPPs), and now, renewable energy companies. Merchant rates remain depressed, but excess capacity is quickly leaving the grid, and eventually a balance will form. Some areas of the country, like ERCOT in Texas, went from having a large excess capacity reserve margin to being very short supply just a few years out. When incentivized, things can change fast.

Since my presentation on Dynegy in 2017, the IPP space has seen a lot of changes, consolidation, and some improvement in valuation. However, there are still pockets of undervaluation out there, including a name that I will present this year. This company has some very valuable assets that most market participants do not appreciate – a large hydroelectric fleet coupled with very predictable cash flows thanks to long-term power purchase agreements.

I believe that hydroelectric power is the silent winner in the grid of tomorrow. It is green, it is dispatchable, it is rampable, it is near load centers, and it provides ancillary benefits.

First, regardless of what the Federal government does, many State governments have made it clear that renewable assets are the energy resource of the future. While a lot of attention has gone towards solar and wind, these will not be the only assets to fulfill renewable goals. Hydro will complement these resources, and with the right planning, hydro can enhance solar and wind by filling in energy gaps during the day.

Second, storage will be given a premium over time. While most people will speak of chemical batteries as storage, the largest batteries are in our lakes and rivers. Hydroelectric power can both ramp and store energy more efficiently than batteries and at a lower cost. State and Federal regulators are beginning to incorporate hydroelectric assets into grid reliability plans.

Third, hydroelectric facilities provide many ancillary benefits to the economy. Unlike solar or wind, hydroelectric assets will often increase property values and they also require ongoing labor/maintenance to keep the facility running.

Investors in hydroelectric get these benefits plus an asset base that can produce cash flow for decades and decades. The trade-offs to solar and wind will likely enhance the value of hydroelectric facilities. Investors have the opportunity to catch this tailwind at a deep discount thanks to the long cycles of the power sector coupled with years of excessive leverage. As always, if an IPPs can service their debt, maintain their fleet, and eventually start to grow, investors can find significant upside by investing in the right assets.

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Widen the Lens But Narrow the Focus, and Deepen the Learning

January 9, 2018 in Best Ideas Conference, Letters

This article is authored by MOI Global instructor Brian Pitkin, founder and managing member of URI Capital Management, based in Indianapolis, Indiana. Brian is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

In Michael Lewis’ book “The Undoing Project,” he writes, based on the extensive research done by the two psychologists and behavioral economists Daniel Kahneman and Amos Tversky, that we take too little information and draw too big of conclusions. People often ask or wonder why it takes me years to get comfortable before investing in a particular company. The pithy answer is that, in the end, the tortoise beats the hare. This also has the benefit of describing in fable terms our investing philosophy; slow and steady wins the race. But a more complete answer to the why of our seemingly extreme patience lies in our desire for deep learning that can lead to deep understanding. It takes a long time to find this deeper understanding that allows for the conviction we crave.

I share the five bullets below in nearly everything I write or present about the partnership. These are not sound bites. They are guiding principles in how we approach investing well.

  • Perspective that moves past the noise of the day
  • Patience to think and invest with a long term horizon
  • Temperament to withstand emotions and volatility
  • Passion for deep intensive research
  • Conviction to our best ideas

We seek to move from a collection of facts, knowledge you might say, to understanding and, someday, to wisdom. And it takes Perspective (widening the lens of your perspective to move past the noise of the day), Patience (allowing accumulated thinking over long periods of time), Temperament (moving beyond the emotional ups and downs of a 24/7 news and information cycle), and Passion (having the passion to narrow the focus of our studies so we can go topically deep and wide) to deepen our learning and move down the spectrum of knowing to understanding. And with this deeper understanding we can carry Conviction to our best ideas.

Our long term perspective is a critical differentiator in our thinking and our investing. And I am grateful for you, my partners, in bringing a mindset that allows for such differentiating advantages. Most trading volume has a horizon of minutes, seconds and even milliseconds. Even the most long term minded investors tend to think in years. We think and invest for decades, and longer. Thank you for partnering with the tortoise.

As an aside, my son got a tortoise for his birthday last summer. Beyond my concerns about a lifespan that should far exceed Tyler’s time in our home (anyone want a tortoise in about a dozen years???), I was amazed at the surprising speed at which “Shelton” moves when free to do so………

The dangers of scratching the surface are often made apparent in headlines. Headlines are meant to grab our attention; they are not meant to inform. Let me provide just one example from the preeminent Wall Street Journal.

Headline: “Household Debt Hits a New High” –WSJ, Wednesday, November 15, 2017

Article Excerpt: The Federal Reserve Bank of New York said Tuesday that household debt totaled $12.955 trillion last quarter, up 0.9% from the spring for a 13th straight quarterly increase. That was the most on record, though the figure wasn’t adjusted for inflation of population growth. As a share of U.S. economic output, household debt was about 66% last quarter versus a high around 87% in 2009.

The headline was entirely accurate, if incomplete. So, is household debt higher or lower than in 2009? Is the headline or the article correct? The answer, of course, is, “yes”. They both contain accurate statements, or facts. Facts alone are not understanding.

The Wall Street Journal is one of the most, appropriately, well respected newspapers in the world. This is not to degrade the WSJ. Consider the headline click baits elsewhere and how they have impacted our understanding. But, as you will see, even the articles can provide incomplete understanding:

There have been repeated instances of the following portrayal, often in my beloved Wall Street Journal: in writing about the newer, online-focused banks, the rate paid on online deposits often comes up as a point of discussion. In one article about Goldman Sachs’ new online bank offering, it was stated that Goldman Sachs can pay more on these deposits because they lack the cost of a traditional bank infrastructure. While that sounds well and good, it is patently absurd. Goldman Sachs does not purposely pay people more, any more than a grocer chooses to pay higher prices for the food they sell because they might make too much money. They pay more for deposits because they must in order to grow and retain them. A higher rate paid on deposits is a sign of relative weakness, not strength. And, ever so importantly, lower rates paid on deposit are a sign of relative franchise strength.

GK Chesterton in “St. Thomas Aquinas” said the following:

“In so far as there was ever a bad break in philosophical history, it was not before St. Thomas, or at the beginning of medieval history; it was after St. Thomas and at the beginning of modern history. The great intellectual tradition that comes down to us from Pythagoras and Plato was never interrupted or lost through such trifles as the sack of Rome, the triumph of Attila or all the barbarian invasions of the Dark Ages. It was only lost after the introduction of printing, the discovery of America, the founding of the Royal Society and all the enlightenment of the Renaissance and the modern world. It was there, if anywhere, that there was lost or impatiently snapped the long thin delicate thread that had descended from distant antiquity, the thread of that unusual human hobby, the habit of thinking.”

Let us not fall into the same loss of habit. Reading can and will bring you facts and knowledge. And fewer things are more powerful than voracious reading. But it is incumbent upon us to turn those facts into understanding and, someday, to turn that understanding into wisdom. Read and learn deeply. Seek understanding and wisdom.

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The Story Behind India’s Valuation Premium

January 8, 2018 in Best Ideas Conference, Letters

This article is authored by MOI Global instructor Gaurav Aggarwal, co-founder and co-portfolio manager of Metis Opportunity Fund, based in Mauritius. Gaurav is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

We recall very few investor meetings this year where the issue of India’s ‘expensive’ valuations didn’t come up. In a world where the vast majority of investors take a top-down approach while allocating capital. India often gets bundled within a highly heterogeneous basket of emerging markets, and its valuations, therefore, get benchmarked against an assorted universe of such markets.

Given that India’s headline PE multiple reflects a premium versus other emerging markets, it often appears as a richly valued investment destination in comparison to other markets. Comparing emerging markets via headline PE is similar to comparing two investment firms based on only assets under management.

Unfortunately, such an overly simplified observation ignores critical underlying factors such as the difference in industry representation within indices, and differentials in profitability, growth, capital intensity, and cash cycles across geographies.

Similarly, to compare such a headline multiple to how it trended historically is a forced simplification, if one is not taking profitability and cash cycle shifts into account. Just take Nifty 50 as an example. While Nifty’s revenue growth (ex-financials) has slowed considerably over the past five years, as compared to the prior 5-year period (9% versus 20%), it remains the fastest growing market among major emerging market peers. Its cash cycle has been slashed in half over the past five years (without compromising underlying profitability) as certain infrastructure and real estate constituents got replaced and working capital efficiency has broadly improved.

It is critical to provide an appropriate context when evaluating Nifty’s headline PE premium versus emerging market peers. The two vital areas one should stress upon are:

1. Industry composition differences. BRICS make up nearly half of MSCI Emerging Markets Index and little over 40% of the index if one excludes India. The low-teens PE multiple of MSCI Emerging Markets is therefore also suppressed by some of these markets where low PE industries make up most of their respective indices. More than half of China’s index constituents are financials while energy constituents have a similar weighting in Russia. A more relevant comparison, if one could call it that, would be an inter-industry comparison across these markets. While most Indian sectors still trade at a premium over EM peers, the overall valuation premium is particularly skewed by telecom, financials, industrials, and consumer discretionary sectors, which collectively comprise just under half of Nifty. In contrast, energy, which makes little under a fifth of Nifty, trades at a discount to emerging market peers. Sectors such as healthcare and materials meanwhile trade at 25-35% premium.

Exhibit 1 – Sector-wise 2017 P/E Comparison of Nifty vs. EM Peers

Note: All comparisons are made between constituents of the most liquid large cap index in respective markets. For China, FTSE China 50 index components were used. Other markets used for comparison here are BRICS, Indonesia, Malaysia, Poland, Korea, and Mexico.

2. More reliable earnings estimates: Our work across earnings announcements within emerging markets confirms that Nifty constituents report among the least differentials between actual earnings and estimates, lending more confidence to forward valuation multiples. This is a direct function of the number of estimates per company, and no emerging market benchmark components are as well covered as Nifty’s.

So, what should an ideal Nifty PE be?

When we create a sizeable intrinsic value framework at an index level, we are better positioned to provide an appropriate context to headline multiples. Based on such work, in our view, at current levels of growth and profitability, Nifty (ex-financials) 50’s ideal C2017 PE should lie in the 22-24x range, as compared to the current ~25x C2017 earnings. As we had mentioned earlier, one shouldn’t benchmark current headline multiple to how the index has traded previously since underlying fundamentals and constituents have shifted materially. However, if we were to benchmark India’s intrinsic value based multiple against arguably its most comparable BRICS peer, South Africa (on the basis of similarities within underlying growth, working capital intensity, underlying debt levels, profitability, and taxes) we conclude that Nifty50 (ex-financials) can support 45%+ premium over JSE FTSE Top-40 (ex-financials) versus the 25%+ it currently trades at.

In summary, we would discourage investors from reading too much into headline PE multiples without further evaluating differentials beyond headline earnings growth. While we wouldn’t categorize Indian large caps as cheap, we certainly aren’t in the camp that views Nifty 50 as particularly expensive in comparison to the emerging markets universe.

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The Phillips Conversations: Christopher Risso Gill

January 8, 2018 in Audio, Full Video, The Phillips Conversations, Transcripts

The following interview is part of The Phillips Conversations, hosted by Scott Phillips of Templeton and Phillips Capital Management.

MOI Global has partnered with Templeton Press to bring you this exclusive series of conversations on investing and the legacy of Sir John Templeton, one of the greatest investors of the 20th century.

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About the interviewee:

Christopher Risso-Gill was a director of the Cundill Value Fund for ten years. Christopher is the author of a new book on Peter Cundill, There’s Always Something to Do: The Peter Cundill Investment Approach. Christopher lives and works in London.

Auctions and Power

January 8, 2018 in Best Ideas Conference, Diary, Letters

This article is authored by MOI Global instructor Steven Wood, founder of GreenWood Investors, based in New York. Steven is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

Many thanks go to David Easley and Jon Kleinberg at Cornell for making their research on auctions publicly available.

It’s a great time to discuss the distribution of power in auctions. Not only is this highly relevant for all users of Google paid search and our investment in TripAdvisor, but Leonardo da Vinci’s Salvator Mundi recently broke a record for the highest price paid for art at auction, clearing for $450 million (for a good article describing the process of bidding, click here). Your author had the good fortune of seeing this beauty in person before the auction, and dare we say, it’s probably worth it. For a far cheaper and more educational look at the painting, we’d highly recommend Walter Isaacson’s latest biography on this genius that was 200-300 years ahead of his time. But we digress.

Everyone has experience with auctions. If you’ve bought a home, you have perhaps unwittingly participated in an auction. Didn’t the whole process feel like you (the buyer) were sort of being taken advantage of? Don’t hate the player, hate the game.

At least that’s exactly what Google would have its users and advertisers think. As profiled in Scott Galloway’s recent book The Four, the auction gives Google the ability to claim innocence on all of the value it extracts from online transactions – it simply lets its advertisers set the price.

Professors David Easley and Jon Kleinberg at Cornell have studied equilibriums in various forms of auctions and have publicly shared their work. They prove through game theory that auctions are systemically designed to capture the highest possible value that a bidder is willing to pay for the particular asset under consideration. The price paid is directly related to the number of bidders in the auction. The more competitive an industry, the more expensive the Google clicks will become.

Exhibit 1: Equilibrium Clearing Prices in Auctions

Source: Easley & Kleinberg.

As if that wasn’t enough, Google eventually moved to a Vickrey, or second-price, auction which is designed to raise competitors’ bids up to exactly fair value, as opposed to a fraction of fair value.

This results in decaying economics to the advertisers, as more advertisers join the auction to bid on keywords and clicks become more expensive. Google will counter that the overall statistic that its cost-per-click has been routinely getting cheaper on the aggregate even though this is a direct result of the mix shifting from desktop to mobile, where clicks are nearly ⅔ lower than on desktop.

Since Google is effectively a toll road on the internet, capturing over 90% of the searches performed in nearly every country it touches, advertisers are forced to play ball. But they’re not happy. Not many bidders to an auction come away saying, “wow, we got such a great deal.” In fact, the entire online travel industry is starting to find television advertising an equally compelling offer for their businesses over time. In real estate transactions, even if there are just two parties bidding on the property, the auction is designed to capture the highest value from the buyers.

Speaking of real estate, one of the mistakes we’ve made this year was New York REIT, where we had a realized loss of just under 16%. Unbeknownst to us, Chinese and Middle Eastern buyers have withdrawn from the bidding pool for marquee New York properties. Over the past few years, these buyers represented as much a third of the bidding pool. Almost exactly in line with Easley and Kleinberg’s work, pricing has compressed by 15-20% from the peak as the bidding pool has shrunk. Auctions typically hold up better than one would expect, because they are systematically designed to wring all perceived value from buyers.

Why else would Warren Buffett repeatedly advertise that he never participates in auctions? Notice, however, when a charitable cause is the beneficiary, he has blessed the annual “lunch with Buffett” to be auctioned off to the highest bidder. Buffett is, once again, on the power side of the trade. He had a good teacher and partner in Charlie Munger. In 1995, Munger gave a seminal speech called The Psychology of Human Misjudgment. In it, he excoriates auctions:

“The open-outcry auction is just made to turn the brain into mush: you’ve got social proof, the other guy is bidding, you get reciprocation tendency, you get deprival super-reaction syndrome, the thing is going away… I mean it just absolutely is designed to manipulate people into idiotic behavior.”

Of course, while humans are not reliably rational, all rational buyers dislike auctions. Why did Amazon so quickly pass eBay to capture all of the growth in e-commerce? Because consumers trust Amazon. It will reliably give them the best price (or at least that’s the pervading perception even though it’s not correct) and will do so without demanding a lot of effort. Want the same item on eBay? Place a bid, wait 2 days, 16 hours and 3 minutes, to find out that you will probably lose the auction.

Yet, while eBay has lost the e-commerce war, auctions will persist throughout human exchange. Why? From the seller’s perspective, it’s essentially built-in dynamic pricing. There’s no better way to capture the value assorted buyers are willing to pay for a particular good. When Christie’s guaranteed the auction price for the Salvator Mundi, it was rumored to have been willing to guarantee it could deliver $100 million to the seller. Of course, the asset cleared for 4.5x the amount that the smartest person in the room was willing to underwrite. This auction captured the marginal price that only a handful of buyers in the world could have afforded.

Only those in a position of strength run auctions. If you’re a bidder, you’re already on the wrong side of the trade.

What It Means For Best Ideas 2018

So why have we gone into this level of detail on auctions? One of our best ideas for 2018, TripAdvisor, finds itself in the power position of running auctions for its hotel metasearch. The site has been the gorilla in the travel space, with over 3 billion annual users, nearly half a billion monthly active users, and the most downloaded and used travel app on mobile. Yet the company has historically not monetized this ecosystem well. The issue has not been cheaper auctions, but a conversion problem. So a few months ago, starting in June, the company embarked on public campaign to educate users that they could, in fact, book their hotels with TripAdvisor.

The company’s second largest customer, Priceline, suddenly realized this campaign would effectively make its traffic on this core channel more expensive and would simultaneously allow the site to capture more of the consumers’ bookings over time. Because Priceline is between 15-20% of TripAdivsor’s revenue, and its profitability and market cap dwarf that of TripAdvisor’s, the new management of Priceline decided that it, Goliath, would try and get TripAdvisor, David, to stop its new messaging campaign. It reduced its spending on the TripAdvisor platform outside of the U.S., where it has a far more dominant footprint than Expedia, which caused TripAdvisor to lower revenue guidance. This sent the share prices of the entire sector down, including Priceline’s. The reason for this pullback was cited as “lower ROIs,” coming from TripAdvisor metasearch, even though both lower cost and higher conversion claimed by TripAdvisor actually equals “higher ROIs.”

If Priceline wanted to acquire TripAdvisor, this is exactly what it would be doing. Its new CEO ran the company’s M&A division for the past couple of decades. Yet, whether or not Priceline wants to own TripAdvisor is beside the point now. Because nearly 15% of Priceline’s traffic comes from TripAdvisor metasearch, and this traffic has a higher purchase conversion than Priceline’s general traffic, it can ill afford to abandon TripAdvisor completely.

Yet we asked ourselves in the wake of this high profile public dispute between the two companies, what would happen if Goliath went scorched-earth and tried to pull off David’s platform completely? We ran our own metasearch surveys to find out what would happen to TripAdivsor’s cost-per-click, and because the typical hotel has 3-4 bidders, we used the equilibrium equation shown in exhibit 1 to calculate what a worst case scenario looks like for TripAdvisor.

It turns out, scorched earth is actually not that bad. Because metasearch will comprise just under half of TripAdvisor’s business this year, a pullback in pricing of 9-13% in this channel can be absorbed by the business. Furthermore, the shares have largely priced-in a good portion of this scorched earth happening. And thus, even though the dispute has turned public and carries headline risk, we do believe the investment still contains a very favorable risk-reward.

The worst case scorched-earth scenario is far worse for Priceline. It’s a particularly bad time for booking.com to open up space for hotels to be bidding on clicks in TripAdvisor’s auctions. Most European markets have outlawed old rate parity contracts that prevented the hotels from posting a better rate outside of booking.com. At the same time, ctrip.com is getting more aggressive in western markets and third party OTA supply on TripAdvisor has been building, with >80% of listings having a third, fourth or fifth OTA option. Because booking.com charges considerably higher commissions than TripAdvisor, hotels are highly incentivized to divert traffic away from Priceline’s channels.

As we know from other examples, the party in the position of power is the one running the auction. While Priceline’s size makes it look like the Goliath in the industry, we don’t believe paying for half of traffic is an indication of a strong ecosystem. If the company decides to increase the stakes in its war, it would do well to remember how the battle of David vs. Goliath actually ended.

We are looking forward to discussing TripAdvisor and two other top positions at out Best Ideas 2018 presentation.

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Case Study: Trinity Industries’ Cautionary Tale

January 7, 2018 in Best Ideas Conference, Case Studies

This article is authored by MOI Global instructor Danilo Santiago, founder of Rational Investment Methodology (RIM), based in New York. Danilo is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

During times when blocks of digital text are negotiated for thousand of US dollars, I thought it would be useful to remind you of some ancient dynamics that are still prevalent on the stock market today.

The “reversion to the mean” in terms of share prices is alive and well, even on the presence of a TINA (There Is No Alternative) market that has suffered from an increased influence from “indexing strategies” (e.g. ETFs) and algorithms (e.g. robot-traders). In other words, EPS is still on the driver’s seat in the short-term; a quest for true value commands the long-term.

Let’s start with the evidence for the reversion to the mean: figure 1 shows the average IRR [Internal Rate of Return] over the past 20 years for the companies I follow (60 in total; I call them my Circle of Competence) vs a Ke [Cost of Equity], calculated using a normalized Rf [Risk free interest rate] of 5% and a MRP [Market Risk Premium] of also 5%. It is clear that there is a strong correlation between the delivered IRR’s and estimated Ke’s. Also important – on averag – the sample companies delivered an IRR of 10.6%. The average Ke was 10.5%. There is only a 10 bps difference – and those figures were independently calculated (i.e. the IRR calculation is an observed fact; the Ke is “what an investor should expect to gain from assuming the risk of investing in a specific company”). This strong correlation of IRR’s and Ke’s is what I use to support the argument that – at least over the past 20 years – the “reversion to the mean” I mentioned above was a fact.

Those that are saying “this time is different” are ignoring that we haven’t seen yet an economic crisis – when EPS falls significantly for most companies – during this ultra-low/manipulated interest rate environment. I don’t believe the market will shrug off a widespread EPS decline: it should in fact offer great buying opportunities to those investors that are doing their homework today (after the crisis is too late to build meaningful knowledge that would allow you to quickly pull the trigger on new long positions – i.e. if you wait to start building your Circle of Competence, you will probably miss the opportunity).

A case in point is what happened with Trinity Industries [TRN] over the past few years. Share prices went up five-fold from late 2011 until late 2014 (I’m excluding the lows of 2009 since almost everything was absurdly cheap on that year – from those low levels, prices were up 15-fold). What caused such an exponential price increase was an abnormally strong EPS cycle – figure 2 above shows the usual bias of share prices vs. short term EPS. As a reminder, this short-term bias is essential to offer fundamentals-based investors a chance to buy-low / sell-high (the other necessary condition is the “reversion to the mean” discussed above).

From a fundamentals perspective, the cause of the strong EPS cycle was an abnormal number of orders of railcars to support the new “oil by rail” phenomenon, due to the shale oil & gas revolution. To give you an idea of the magnitude of the change, around 20K barrels per day were being shipped by rail in 2009. By the end of 2014, more than 1 million barrels were being shipped per day, an increase of 50-fold. Needless to say, railroad companies were scrambling to buy and lease tankers. To add insult to injury, most of the cars being used were the old DOT-111 and not the sturdier CPC-1232 (which became the standard choice supported by new safety regulations). Even by the end of 2015 close to 100,000 DOT-111 were being used, while only 60,000 CPC-1232 were in operation. Therefore, railroad companies were also trying to retrofit some of the older railcars.

Companies like TRN (which has close to 40% of the US market of railcars), benefited a lot. Figure 3 shows TRN’s operating profit by segment – the “Rail segment” went from zero operating profit in 2009 to deliver more than $900 MM in operating profit in 2015! Quick boom and bust cycles are not new to the railcar industry. Figure 4 on the next page shows the number of rail cars shipped by manufacturing companies since the early 60s (it includes my estimates on a “base case” for the next decade).

Over the past 20 years we had three major boom-bust cycles. A diligent analyst should have had on his/her forecasts – done pre-2015/2016 – (i) for sure a bust, (ii) maybe another boom, but (iii) certainly an eventual normalization of shipments. Nevertheless, most were keeping EPS forecast at very high levels and were “disappointed” when it became clear that EPS for 2016 (and 2017 or even beyond) was not going to be at abnormally high levels.

The EPS decline was inevitable – normalization would be achieved not only because, eventually, manufacturing companies would deliver all the necessary tankers but also because an over-supply of oil (even if momentary) could drag the commodity’s prices down, making exploration by some shale fields unprofitable. Well, that was exactly what happen in 2014/2015. Nevertheless, “The Market” was pricing TRN as if the boom would never end.

By early 2016, TRN shares were below what I consider a “low case” scenario. At that point, the offered IRR [Internal Rate of Return] for an investor that was willing to own the business forever (think Warren Buffett buying 100% of the company) was at 16.4%, assuming my base case would happen. Here is the inconsistency with the idea of an eternal plateau of US equities prices: how come a company that was created in 1933 (i.e. they have gone through a lot) and for sure would survive one of the many busts in its industry could offer double-digit returns when 10 year bonds yields were close to 2%? The reality is that “fear” trumps everything else – if EPS is falling, share prices fall. If it happened with TRN, why wouldn’t it happen with other companies?

That is why I say that TRN is a cautionary tale – it shows that share prices should fall, for most companies, when EPS falls during the next economic hiccup. On TRN’s case, their EPS decline was just moved forward by a sector-specific crisis. So there is nothing different this time – i.e. we are not waiting for a “black swan” to show up and offer compelling buying opportunities (and also its twin brother “terrible returns for those that were all-in long during the peak”). We are just waiting to the white-swans to complete their usual migratory pattern and show-up in droves!

As always, happy to talk more about this subject or anything related to the companies in my Circle of Competence.

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