Three Ideas with Disciplined and Repeatable “Underwriting” Processes

Keith Smith of Bonhoeffer Fund presented his in-depth investment theses on STORE Capital (US: STOR), TPG Specialty Finance (US: TSLX), and Ashtead Group (UK: AHT) at Best Ideas 2019.

Read Keith’s related article on fundamental alternative investments.

Summary:

A common characteristic among the following firms is recurring revenue, with a large addressable market and and a modest valuation. These firms also have disciplined and repeatable underwriting processes to weed out the best opportunities in each of their opportunity sets and have historically generated above average returns on capital.

STORE Capital (US: STOR) is an internally managed triple net-lease real estate investment trust, or REIT. STORE is one of the largest and fastest growing net-lease REITs and owns a large, well-diversified portfolio that consists of investments in 2,206 property locations, substantially all of which are profit centers, in 49 states. The addressable market for STORE is large as STORE only has a 2% market share and is one of the larger triple-net lessors in the business.

STORE has increased book value and dividends per share by 13% per year and AFFO per share by 7% per year over the past five years. The management team has great underwriting with credit losses at 0.2% of the portfolio per year since inception (2014). The firm focuses on profitable unit economics associated with leases which reduces the risk of these leases. The focus is also on growing segments of the real estate market including services, experiential retail and mission critical manufacturing in growing regions of the country. The average remaining lease term is fourteen years.

The common shares recently traded at an adjusted funds from operations multiple of 16x and dividend yield of 4.4%. The trailing gross cap rate interest margin is 5.5%. STORE is modestly levered with a debt/equity ratio of 0.8x and has an investment grade credit rating. While the multiple is not cheap for the average real estate equity, it is for a secure, stable and growing cash flow stream with the opportunity to re-invest cash flows at high rates of return, currently ~12%.

In June 2017, Berkshire Hathaway took a 9.8% stake in STORE, close to the maximum an entity can hold of a REIT (10%), which is another testament to its underwriting process. The price paid by Berkshire when adjusted for the lack of marketability of the stock of 10% is 14x adjusted funds from operations.

TPG Specialty Finance (US: TSLX) is a business development company. The BDC provides senior secured loans (first-lien, second-lien, and unitranche), mezzanine debt, non-control structured equity, and common equity with a focus on co-investments for organic growth, acquisitions, market or product expansion, restructuring initiatives, recapitalizations, and refinancing. The BDC lends to in business services, software and technology, healthcare, energy, consumer and retail, manufacturing, industrials, royalty related businesses, education, and specialty finance.

At this point in the credit cycle, 94% of TPG Specialty’s loans are first-lien collateralized loans. The management team’s background is primarily from a specialty finance lender purchased by Wells Fargo in the late 1990s called Foothill Capital so team has bank level of underwriting experience. The team has great underwriting with credit losses at 0.5% of the portfolio per year since inception (2014). TPG Specialty has increased book value and dividends per share by 10% per year and had an average return on equity of 12% over the past five years.

The shares recently traded at an earnings multiple of 8.9x, and dividend yield of 9.6%. The trailing net interest margin (including all fees) is 11%. TPG Specialty is modestly levered with a debt/equity ratio of 0.8x and has an investment grade credit rating. Recently, BDCs have had an option to increase leverage and TPG is pursuing this and is increasing the target leverage levels and corresponding return in equity by 20%.

Ashtead Group (UK: AHT) rents a range of construction and industrial equipment. It offers equipment for use in lifting, powering, generation, moving, digging, compacting, drilling, supporting, scrubbing, pumping, directing, heating, and ventilating works. Ashtead is the second-largest U.S. equipment rental firm through its Sunbelt Rental subsidiary. Although equipment leasing is tied to the cyclical construction market, given Ashtead’s higher operating margins (due to geographic clustering) and Ashtead’s product and geographic diversification, the historic cyclicality of returns should be dampened. Ashtead has only an 8% market share in the U.S. rental equipment market and is one of the larger U.S. rental equipment lessors in the business.

Ashtead has increased book value and dividend per share by 52% per year and net income per share by 47% per year over the past five years. This growth has been achieved by a combination of organic growth via consolidation, Greenfield site openings, increased product offerings and share buybacks. Ashtead is modestly levered with a debt/equity ratio of 1.1x, a debt-to-EBITDA ratio of 1.7x, and has an investment grade credit rating. Ashtead has a large runway to invest at rates of returns of return in the upper teens (group returns on capital have been above 15% since 2013).

The shares recently traded at an earnings multiple of 7x, EV/EBITDA of 6x, and a dividend yield of 2%. Of the publicly traded equipment leasing firms (such as United Rentals, HERC Cramo & Ramirent), Ashtead has the highest return on equity (30%) and the lowest leverage.

Listen to this session:

slide presentation audio recording

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.