(Geoff’s Note: The blog post you’re about to read is Quan’s discussion of the results of stocks he wrote notes on and the two of us scheduled for a Singular Diligence issue. Results were calculated as of March 31st, 2015. The newsletter’s publication schedule is set several months in advance. So these results are a review of our process. They are not a review of the newsletter’s record. These are not the results a newsletter subscriber would have gotten by buying each of our picks the day the issue came out. For example, no issues were ever published on Greggs and PetSmart because the stock prices rose before their turn in the publication schedule came up. We picked them internally. We never published them externally. So subscribers couldn’t benefit from those picks. Note also that Atlantic Tele-Network is now $68 versus the $58 when it was planned as an issue. A stock like that could – especially if the price falls back toward $58 – become a future issue of Singular Diligence. We definitely reserve the right to publish on stocks like Greggs and Atlantic Tele-Network if they ever get back to a price we like.)
It’s been 1.5 years since we launched The Avid Hog (now Singular Diligence). We think that’s long enough to review the performance of the stocks we picked. The purpose is to see what worked and what didn’t to improve our process. I calculated the total return of each stock pick in the following table:
We have 2 losers, sadly by a huge amount and 12 winners. The median return is 24%. We have 4 stocks that returned more than 40% (Greggs, PetSmart, Car-Mart, and Life Time) and 6 stocks that returned between 15% and 40% (Wiley, HomeServe, Village, ATNI, Babcock, and Ark). Progressive and Ekornes are two recent picks. WTW and CLUB are disasters.
We actually published only 11 issues. We analyzed PetSmart (PETM), Atlantic Tele-Network (ATNI), and Greggs (GRG:LN) and these stocks were scheduled for July, August, and September 2014. However, we didn’t publish our research on these stocks because share prices went up significantly before and during the transition to Singular Diligence. I think it’s helpful to look at both these stocks and the winners to see what worked.
It’s also worth mentioning three companies that aren’t included in the table. I analyzed FirstGroup (FGP:LN), Higher One (ONE) and Neustar (NSR) but we didn’t pick these stocks. If we did and if our clients bought these stocks, they would have lost more than 50%. Let’s call these stocks “Near Misses”. I think it’s useful to look at both Near Misses and Losers to analyze errors.
One or two years are a short period of time to judge performance of individual stock. Some stocks can go up not because of improvements in business fundamental but because of Mr. Market’s optimistic mood. So, we’ll only take a brief look at group performance and pay more attention to our Losers and Near Misses.
We can categorize our stock picks into 3 groups:
Growth: Greggs, PetSmart, Car-Mart, Life Time, and Home Serve
Value: Village, ATNI, Ark, and CLUB
Franchise: WTW, Ekornes, Progressive, Babcock, and Wiley
For the lack of a good word, we will simply call the first group “Growth” stocks. These are stocks with concepts that can expand geographically. Peter Lynch would love to buy these stocks.
This is the best performing group with an average return of 51%. This is much better than I expected. I only expected investors to make double-digit returns by holding these stocks for 10 or 15 years. I underestimated how quick the multiple would change.
I think there’s one reason for the outperformance. These stocks can have many years of growth as long as their concepts are relevant. That results in high “perception elasticity of multiple.” Whenever same store sales or some other data are negative, the market sentiment turns pessimistic and multiples collapse.
All of the stocks we picked had some concerns. Greggs had weak same store sales performance. PetSmart faces online competition. Car-Mart experiences competition from used car loan securitization. Life Time has weak recruitment due to competition from private studios. HomeServe has a crisis in the U.K.
However, the multiple expands quickly when more upbeat data comes out. I think that’s the case for Car-Mart, Greggs, and HomeServe. For PetSmart and Life Time, business performance wasn’t strong but private equity buyers are confident in the long-term prospects.
Business fundamentals of these stocks didn’t change as much as stock price. I think the key to analyzing these stocks are moat, durability, and debt.
The Value group includes stocks with a strong core but little opportunity for redeployment of capital. They have moat and conservative capital allocation (except for CLUB). They tend to hoard cash. The group’s average return is 8%. Excluding CLUB, the group’s average return is 22%. CLUB deserves special attention as we’ll discuss later.
The Franchise group includes stocks with wide moat and steady long-term growth, say 3-5%. They tend to have competitive advantages that allow them to hold or gain market share over time. They’re boring stocks with little catalyst. If we forced Warren Buffett to buy 3 stocks out of 14 stocks we picked, he would have bought Wiley, Progressive, and Babcock. These stocks are all in the Franchise Group. They are safe enough to hold “forever”. Competitors can’t really kill them. Only they can kill themselves.
WTW and Ekornes are a bit different. They’re more of a niche player that attracts a small number of total customers. And WTW can really kill itself because of the debt it took. But both WTW and Ekornes have qualities of a franchise. They’re durable and can make more money overtime.
Wiley is the oldest pick in this group and returned 30%. Progressive, Babcock, and Ekornes are the latest picks. Babcock returned 18% for no obvious reason. Babcock will have a spinoff in Mid-2015 so that can be a catalyst. Long-term, I expect Progressive and Ekornes will perform like Wiley. WTW is a disaster and we’ll discuss it in the next section.
Two stocks we picked have declined by a huge amount. Our original thesis on WTW still holds. We think we made a mistake in CLUB. But let’s look at our Losers and Near Misses to see what we can learn.
We picked CLUB at around 5.6 times EV/2013 EBITDA, 7.6x EV/Pre-tax Owner Earnings, and 6.5x Market Cap/FCF. We thought that the business was durable because of barrier to entry in cities like NYC and Boston. We noticed that customers aren’t really happy with CLUB. But we thought that it’s okay because CLUB is a “necessary evil”. We saw a very low fixed charge coverage ratio but we thought that CLUB was in the strongest financial position in its history. They survived the Great Recession. They had a lower debt level than in the past. There were also rumors that they would sell a property in NYC for about $70 million. They eventually sold it for $82 million.
Yet, what killed our thesis was the rise of private studios. We had a blind spot to societal change with change in new studios, habits, and the ease of this happening.
People are lazy. They don’t like to workout. That’s the problem in the fitness club industry. To grow, a chain usually has to recruit more than 1/3 of lost members each year. Private studios are more “mentally” accessible to people who don’t like to workout. That makes recruitment more difficult for traditional clubs. Combined with high operating leverage and debt, that’s a formula for disaster.
Our thesis on WTW still holds. All recent statistics I looked at show that free apps or activity trackers help people reduce on average less than 2 pounds. If the 80-20 rule applies, 20% of people account for most of total weight loss. In other words, 80% of people achieved almost zero pound loss on average. And the other 20% of people still reduce less than 10 pounds on average. Meanwhile, studies show that 35% of WTW members achieved at least 10% weight loss. So, I think most people still need support in reducing weight. In the long run, efficacy will prevail.
The biggest problem with WTW is debt. I was fond of the pattern of WTW’s capital allocation. They tend to increase debt every few years and use the proceeds to repurchase shares. And then they focus on reducing debt. The last time they levered up the balance sheet was in 2012. I thought that they will have fewer shares over time.
I knew that the business would decline for several years. But I was looking out to 2018 and I expected that they would make record earnings that year. I forgot that high leverage would magnify the impact of declining EBIT on share price in the short run. So, it’s been a tough ride for clients who bought WTW.
Debt also reduces financial flexibility of WTW. Fortunately most of their debt is due in 2020. It’s quite a long time for a turnaround.
Neustar is a stock that we almost picked. Neustar makes most of its money by providing routing information to telecoms in the U.S. When a customer of Verizon calls a customer of AT&T, Verizon must access Neustar’s database to know where to route the call. Neustar provides the service under a contract with North American Portability Management (NAPM), a telecom industry consortium. Neustar has been the sole provider for over 15 years.
The switching cost is huge. It’s estimated that it costs billions of dollars for carriers to transition to a new provider. The current contract is due to expire in June 2015. Neustar’s management was so confident that they asked for a high price when bidding for the next contract.
I had as much confidence Neustar would keep the contract as the executives did. Geoff was reluctant because of the big customer concentration risk. And his reluctance saved us from a big mistake. Neustar surprisingly lost the contract to Telcordia, the only other bidder. Neustar’s share price has declined by more than 50%.
Neustar has been lobbying aggressively. The FBI and CIA basically told the FCC to pay more attention to security risk. The FBI and CIA said they won’t be able do their work if there’s any disruption during the transition. So, it’ll be interesting to watch the final outcome.
I spent about a month on Higher One (ONE). I looked at the company because my favorite investor Glenn Greenberg put about 7% of his portfolio into the company at that time. Higher One basically sells debit cards to students. Effective marketing can make this business very profitable.
But Higher One makes money by charging hidden fees like overdraft fees. That makes students unhappy. And I feared that making money this way would damage its image at each school and reduce marketing effectiveness in later years. We didn’t have a lot of past financial results to learn about its durability. So, we decided to drop the stock.
That turned out to be the right decision. The business later deteriorated. The share price has declined by about 75% ever since.
I looked at FirstGroup in May 2013 (before we launched The Avid Hog.) FirstGroup is a transport operator. They have rail franchises in the U.K. and operate local buses in some U.K. cities. They also run student busing and Greyhound in the U.S. I was attracted to the stock because of the low EV/EBITDA at around 4.
I spent about two weeks on FirstGroup. I was uncertain. The business didn’t have a good unlevered return on capital. They only achieved great growth by using debt. Also, the price wasn’t really good based on my estimate of maintenance capital expenditure.
When I was unsure if I should continue analyzing FirstGroup, they suddenly announced a recapitalization plan. They raised money through a rights offering to reduce debt. Existing shareholders would experience dilution if they don’t participate. The share price declined over 40% in a week, and has performed poorly ever since.
Two Noticeable Traits of Losers and Near Misses
The two noticeable traits of Losers and Near Misses are debt and customer problem.
Debt led FirstGroup into the recapitalization. WTW’s debt reduces financial flexibility in the turnaround. It also depress share price when the business declines. CLUB is even worse. CLUB has both a lot of debt and high fixed operating costs.
CLUB, WTW, Neustar and Higher One all have customer problems. CLUB and WTW have low retention. Neustar makes most of its money from one big contract. Higher One makes money off unhappy students.
How to Analyze Customer Problems
To analyze customer problems, Geoff suggested 3 questions:
Is the customer fickle?
Is the customer happy?
What is the buyer/user situation?
And I add one final check:
Is customer concentration high?
Each poor answer raises a warning. It’s not necessarily bad when there’s one warning. But two or more warnings combined can create a big problem.
Is the Customer Fickle?
Customer is fickle when there’s a lot of quitting and signing up. WTW shares this problem with CLUB. Dieters are quick to quit, and quick to follow fads. If WTW doesn’t replace most customers who attrite in 9 months, they’ll have a problem quickly. That makes WTW a cyclical franchise instead of a stable franchise that Warren Buffett would love to buy.
On the contrary, car insurance buyers aren’t fickle. They tend to take the new price for the policy they’re given. They only switch when they have a bad experience with their insurer or when they have a life-changing event like marriage. Similarly, Wiley’s customers aren’t fickle at all. A university librarian doesn’t change the journals he subscribes to without a very good reason like a budget cut.
Is the Customer Happy?
Both Life Time and CLUB have fickle customers. They have to replace lost members all the time. There are 3 types of people they recruit. The first type is people who have just moved into the area. The second type is people who go to clubs for the first time. The third type is people who go to clubs again.
CLUB provides a basic product. There’s nothing memorable about CLUB’s customer service. There’s no good word of mouth. Customers aren’t really happy with the rundown gyms. The key selling point is convenience. When private studios offer a more convenient option, CLUB is doomed.
Life Time has happy customers. Unlike other fitness chains, they don’t sell annual subscriptions to retain members. Life Time sells only monthly subscriptions. They retain members through customer engagement. It’s possible that Life Time has very strong word of mouth. I suspect that partly explains why Life Time performed better than traditional clubs.
Business is full of unknowns. When customers are happy, there can be lower risk of having weaknesses in the business armor that no competitor has really attacked yet. This reminds me of Jim Collins’ Built to Last. To last, one can’t just focus on profit-making. There must be a balance between value created for customers, employees, and shareholders. This is exactly why we dropped Higher One.
What Is the Buyer/User Situation?
Sometimes buyers aren’t the end-users. Problems can arise when interests of buyers and users aren’t aligned, and one or the other is unhappy or fickle. In such a situation, competitors can try to change who to sell to. For example, they can try to serve the user better.
Higher One is an example. Colleges and universities are happy with Higher One because Higher One helps distribute financial aids to students for free. But some students are unhappy with the hidden fees. Even worse, students are usually activists. Unhappy students can kill High One’s image in each school fairly quickly.
Wiley doesn’t have that problem. Wiley’s end-users are much less likely to complain than Higher One’s. Even better, professors and students may complain if they don’t have access to the scientific journals they need.
Is Customer Concentration High?
The last issue with customer problem is high customer concentration. I don’t have a better answer than to pay special attention to moat in addition to the three questions above.
We walked away from most candidates with big customer concentration. Babcock is an exception. Most of Babcock’s nuclear business is manufacturing nuclear components for nuclear plants in submarines and aircraft carriers of the U.S. Navy. Let’s take Babcock through the 3 questions.
Is customer fickle? No, the U.S. Navy has a 30-year plan to procure weapons.
Is customer happy? Yes, there has been no nuclear accident in the history of U.S. Navy
What is the buyer/user situation? The U.S. Navy is the user and the negotiator. They want to build a certain number of submarines and aircraft carriers based on their long-term strategic plan. Submarines and aircraft carriers are their top priority program. They discuss with suppliers and propose a budget to the Congress. The Congress has a committee to consider the budget. The committee often consists of some congressmen from areas that make the weapons. Letting jobs in these areas go means letting their own votes go.
Finally, Babcock has a monopoly position. There’s no alternative. There’s no commercial nuclear provider in the U.S. after the Three Mile Island accident in 1979. There are few foreign competitors because a few foreign governments have scale to have a home grown nuclear program. And the U.S. government just can’t trust a foreign supplier.
At this point, I think Babcock has strong bargaining power. I’m comfortable with Babcock even if they have only one customer.
After this review, we decided to implement some measures to control risk.
First, we updated our excel template to calculate metrics like Z-score, Debt/EBITDA or EBITDAR/ (Rent + Interest). That helps raise a flag whenever a candidate has high leverage. Actually, all of our recent stock picks or candidates in the research pipeline have little debt.
Second, we’ll have two additional sections in the notes I prepare for Geoff in each research. One section is about financial strength. Another section is about customer problem. We avoided Neustar and Higher One in the past. But now we have a formal procedure to eliminate these mistakes.
I hope that there’ll be no loser in the future.
Value investing is risky. We screen for cheap stocks. But cheap stocks usually have some problems. The trick is to avoid real problems. Famous investors always tell us to watch the downside and the upside will take care of itself. Unfortunately, there are things that we can only learn from our own experience. Fortunately, we’re much more downside-conscious now.
Our short experience with Singular Diligence turned our preference to Franchise stocks. It’s not an issue of maximizing return. We tend to find Franchise stocks and Growth stocks at the same valuation, say 8 EV/EBIT. Growth stocks tend to be more attractive because of higher growth potential. Near-term return can be higher because perception elasticity of multiple is higher.
However, Growth stocks may attract more competition and change than Franchise stocks. We would have to follow a Growth stock more closely than a Franchise stock. But we already find it hard just to do research and find new candidates to deliver one good idea a month. We don’t really have time to revisit the stocks very often. So, it’s safest to buy Franchise stock that we can hold for 20 years like Progressive.
Ideally, we would love to pick only Franchise stocks for Singular Diligence. That way, there’ll be fewer occasions when our clients panic and sell because Mr. Market is pessimistic about our picks. But there aren’t that many opportunities. We’re sure that our future stock picks will be evenly distributed between the 3 groups. That’s just a natural result of our work.