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).


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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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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