CME Write Up

Below is a write up on CME I prepared as part of my job hunt.  CME is a much larger and better business than the ones I try to look at and gain an edge - not a frog I usually attempt to kiss.  I know nothing more about this business that anyone else can't figure out and its not at an evident cyclical low, so there isn't much of a psychological edge either.  Its competitive position and value are derived from intangible factors - I've danced around those ideas in past posts, but I have a hard time formulating an objective case and conviction in the businesses as an investment.  It clearly has a moat and seems to be in the process of more proactively returning cash to shareholders.  No position in the stock, but I figured it wouldn't hurt to share. CMEwriteup

What is so appealing about the razor-blade business model?

One thing I try to consistently identify is what I consider heuristics and biases specific to investing.  There are many business traits or market dynamics that cause the click, whirr that is based on some theory that doesn’t always hold up in practice.  It sounds appealing but it isn’t always.  I think presenting a business as a razor-blade business model is an example of this.  I don’t think it is that specific characteristic that makes a business good or bad, so I’m trying to figure out a better way to think of why it does or doesn’t create a competitive advantage.

One problem I have with theories is that there are always exceptions in reality (how's that for deep insight?).  And I think with investing, the right approach is to uncover the exceptions to theories/rules under the assumption that a business that doesn’t conform to expectations has greater potential of being mispriced.  Subprime auto lending sounds like something that screams, “run far far away in the other direction,” but there are compelling cases for some of the industry participants (see Rishi’s write up on NICK for an example, and the section on lending in his post on Leucadia, a company that has made a lot of money in the sector).

So I wrote a post about being a middleman and competition the other week and tried to draw on some of the businesses I have written about in the past.  Tangible examples help any idea really come to life.  Partially as a result of Buffett lauding the success at Gilette and partially because there are clear examples where it is very true, the idea of recurring revenue is something that I have found myself attracted to in the past.  I don’t think that’s the actual trait that can make a business attractive. 

Perhaps this is a pithy point and a needless nuance, but the most important result of recurring revenue is that it keeps the competition out.  There is no inherent characteristic of recurring revenue that drives superior operating results.  Furthermore anyone can identify a recurring revenue stream (maintenance/service contracts for example).  I think this is the proper way to look at it because it is a more adaptable perspective.  The answer to “why is it the way that it is?” is that implicit in a recurring revenue source is that the competition is kept out.  One of the more base appeals of a company like GMCR is this idea that it’s a razor business model.  That distracts people from other factors that David Einhorn pointed out. Maybe this the exception to the rule, but it's clearly something that can cause unnecessary losses stemming from unnecessary assumptions.

Even though it looks like a razor-blade business model, it can’t capture the economics typically associated with other businesses that claim the same quality – Rolls Royce, Immucor, Gilette, etc – judging by ROIC. But I don’t think that’s the point – a dollar doesn’t care what business model makes it and there is no single universally triumphant business model.  The ideal business model is something that keeps the competition out to the extent that it provides pricing power.  That is the one of the major underlying qualitative factors that will drive investment returns assuming a modest price is paid.  If a business can keep competition out, they have the potential to capture superior economics from their business dealing.  If they can’t, they won’t.  But I think it can be a distraction to focus on the razor-blade aspect rather than whether or not it effectively keeps out the competition and supports actual impressive returns, as opposed to expected.  Because nobody else can sell the blade, it acts as an impossible barrier to overcome for competitors.

To an extent GMCR is a straw man and so is Netflix, another example I’m tempted to dismiss.  Subscribers can create a position that keeps the competition out and so some people have decided to do a comparative valuation of Netflix on a price/subscriber metric.  This is the kind of issue I want to avoid in the future by noting this.  I don’t care if people subscribe to X, I care if X has something that keeps people from subscribing to Y.  A cell service provider, which may have spectrum, can keep certain amounts of competition out while maintaining some pricing power – think of the dumb charges for international roaming or not having unlimited texting.  People who want a lot of data available for their phones – I like having GPS, popping open my reader if I’m caught waiting for someone and didn’t bring a book, etc. – don’t have too many options because spectrum and cell companies are figuring out how to price appropriately.

There are a couple things that interest me about this.  If you think of a company like Apple, which is not a razor-blade business model, they possess several characteristics that keep the competition out.  One factor is scale, which has several benefits.  If you read this article, it discusses how they get discounts, still squeeze cash flow from suppliers, have a more price competitive product, and keep out the competition by making certain basic components unavailable to them.  This compounds into their ability to force competitors to lose money if they want to make a tablet, mp3 player, or laptop that competes at the same price and quality point.  It’s an economies of scale that not only gives them lower per unit costs, but forces competitors to have higher per unit costs.  It’s a shame that they have these advantages in an inherently ephemeral industry – consumer electronics – but it’s still worth noting how they keep the competition out.  The shallow takeaway is to just design better products, but there is a lot more underlying the calculus that can be applied to other companies.

Another example of keeping the competition out is that of Walmart and Tesco, two incredibly entrenched and consistent retailers.  Walmart’s advantage was originally derived from near monopoly status in many rural areas that provided scale and consistent profits to reinvest into the business.  From there they have branched out and been able to build on that scale.  Tesco has an incredibly entrenched position at the opposite end of the spectrum: urban areas.  Their footprint in a densely populated area like London is incredibly hard to replicate simply as a matter of cost. 

Land is cheap in rural areas, so in that regard Walmart is not invincible.  They have a huge advantage in that no sane person really wants to go head to head with them over some scraps of business in some small village in the Ozarks or Appalachia.  The flip side of Tesco’s position is that even an insane person couldn’t afford to replicate Tesco’s land holdings and that is an enduring advantage in their cost structure.  This negates the negative lollapalooza effects of density – attractive market economics drive entrants, much easier to make money when a total addressable market is 500,000 vs. 5,000, etc - while capturing all the positive effects – volume that can be achieved in a dense area without sacrificing profit to competition. 

I think assessing a business on the grounds of whether or not they can keep the competition out – literally or figuratively – is a more effective way to assess the quality of a business.  While a razor-blade business model can generate that positive click, whirr that will indicate an attractive business, the idea of keeping the competition out is a more fool proof way of assessing a competitive advantage in that respect.  For thought.

Identifying great capital allocators

Berkshire-esque companies are an interesting corner of the market: Leucadia, Biglari, Loews, Markel, etc.  To an extent some of these companies court the comparison while others get lumped into the category by a mixture of value investing, insurance, owner-operators and holding companies.  These claims are hard to evaluate in regards to translating into a business that will compound book value at 15-20%.  None of the companies have valuation that imply much optimism about their futures, but what exactly would it take to know which would be capable of continuing their past records?

Company	P/B	BVPS CAGR 12/31/00-12/31/10
Berkshire Hathaway	1.15	9%
Biglari Holdings	1.75	3 year record, not useful
Leucadia	0.87	16%
Loews	0.85	9%
Markel	1.15	11%

Leucadia’s managers look like they are flirting with retirement in the next several years, so it would make little sense to plan on owning the business for 30 years.  Biglari Holdings is still mostly in the capital light business of franchising restaurants so the P/B is slightly misleading.  It is interesting that there is not much of a valuation premium for any of these businesses otherwise, despite great long term track records and very good relative performance over the past 10 years.  A Richmond paper wrote an articlef titled “Markel builds the next Berkshire Hathaway.”  To intelligently invest in any of these, the price is clearly important, but how can one evaluate the more abstract claim of possessing Warren Buffett’s ability to compound capital at a high rate over a long period of time?

Is it easier to identify someone else who can compound capital at 15-20% or a business that can compound capital at 15-20%?  While the latter is easier to identify, it probably offers lower potential investment returns.  Most people recognize businesses that can compound growth at a nice and profitable rate over a long period of time, so their valuations rarely create a buying opportunity.  Many of these Berkshire-esque companies currently trade at or below book value, so the valuation hurdle is lower.  So my thinking is that some of these may be interesting investments on the grounds that they have a broad mandate of possible actions, the proper judgment to compound book value at a nice mid teens rate and valuations that mean I could purchase the shares and get the same return.

There is an attraction in an open ended business plan.  Many companies – like, oh, I don’t know, Netflix? – are a lot like me and don’t know the first thing about capital allocation.  There are a lot of bad investment decisions made at corporations based on institutional imperatives, soft market enforced restrictions to focus on “core competencies” and just agent-operators looking to make a quick buck on their options.  But if a company’s only goal is to protect capital and compound it, all that nonsense should theoretically be repudiated from the outset.

In a broad statistical sense, the ability to compound book value is easier when it is $100 vs. $1,000 or $100,000.  If the capital allocator is capable of identifying the best opportunities for compounding, there is a higher likelihood of identifying the absolute best if the size is irrelevant.  So a short time span wouldn’t offer an empirically sound backdrop for identifying someone who could compound 15-20% over 30-40 years.  Ideally, the smaller the business is, the lower my mental hurdle for confidence in the ability for the manager to compound book value.  At the same time, a manager who could compound a company with $100m in book value to $500m in 10-15 years would clearly be a very capable person, but what if they can’t scale up?  So I can’t really claim there is an ideal size.

I don’t think I’ve ever heard anyone really speak unconditionally highly of Sardar Biglari, and a recent WSJ article did a pretty good job marshaling some of the reasons why.  According the article, Biglari claims not to court comparisons to Buffett and Berkshire (the article also mentions how the initials of the companies are the same and Biglari and Buffett share the same birthday, but that has nothing to do with anything).  At the same time, it is hard to believe he isn’t doing certain things inspired by Buffett and Berkshire.  He has a lengthy Q&A based annual meeting.  He has a high share price to encourage long-term shareholders.  He tried to take over an insurance company, ostensibly for float to invest.  The data points don’t completely match for a direct comparison, but there is a narrative arc that is complimentary to Berkshire's.

I don’t think the discontent with his personality or compensation necessarily negates his ability to compound at a high rate.  He has a very short record to judge, which is the inherent paradox.  I can’t know if he can compound book value at a high clip until at least partially after the fact.  This isn’t good enough for me, because most people (anybody?) did not expect Buffett to do what he did with Berkshire circa 1970.  I don't think anyone would expect anyone to do that.  His earlier years did not consist of the straightforward application of the distilled wisdom and advice he dispenses today.  He originally took over Berkshire the textile company based partially on a grudge against the then CEO – not the perfectly rational decision making he is praised for today.  So first impressions can be misleading (measured in ~5 year periods).  I don’t think the “system” I’m trying to devise has to be able to go back to 1965 and identify Warren Buffett, but it’s necessary to take into consideration where the flaws may be.

The reason I bring up Biglari is that even though he hasn’t really established himself as a superinvestor or anything of that nature, he is young and seems inclined to be one.  It will be interesting to see the transition that Berkshire goes through in coming years.  I would think that the modern crop of investors who many people probably expect to compound at high rates would rather do so in the comfort of a hedge fund with a handful of investors and less focus on the day-to-day operations of the businesses they partially own.  This is partially untrue – David Einhorn has Greenlight Capital Re and Bill Ackman recently raised money for a SPAC.  Seth Klarman hasn’t jumped into the arena though and it's not like Todd Combs or Ted Weschler wanted to start their own little holding company.

To track back to the idea that $100 is easier to compound than $1,000, growing from $5bn to $25bn is a lot harder than the journey from $1bn to $5bn (neither are easy) for a number of reasons, if only the fewer potential investments that can support such growth while still receiving a margin of safety.   On one hand, it isn’t a mistake that they have the track record they do, but on the other it’s still uncertain that they continue the path.  Nobody just loses their ability to identify the opportunities and on the issue of luck, that would mean the person never had the ability.  Increasingly, my impression of intelligent investing is that the person is the problem, not the process.  Leucadia invests based on the same underlying theory as Berkshire (price is what you pay, value is what you get), but the practice is completely different.  There’s a human element on the downside – the companies are hard to own on the premise that there is downside protection in an idiot running the company one day and doing fine.

Maybe it’s my poor imagination, but while the "why" part of the equation is easily answered, the "how" part is not for this type of business.  Why?  Because an intelligent capital allocator is in charge.  How?  Because capital is allocated intelligently - but this is circular and abstract.  The way that Coke grows is more people are born, more people drink Coke, and they can raise prices every year.  Mastercard and Visa need more plastic transactions, which will be driven by higher penetration globally, population growth, and gains relative to paper.  I don’t doubt that every single year there is some investment opportunity that offers the identifier 15-20% compound annualized returns over a period of time measured in years.  I just have a hard time envisioning it as something that benefits from broader demographic trends or an inherent business characteristic (e.g. Coke is such a low priced product, that a 1-2% price increase doesn’t get noticed like it would on a car).  Whatever it is that enables a capital allocator to compound wealth requires judgment, which isn’t exactly something that is telegraphed ahead of time.

If you look at Loews over the past 10 years for example, they have compounded their book value per share at ~10%, absolutely trouncing the S&P.  Is the S&P the right benchmark?  It's essentially a proxy for the business performance of the US.  Since 1960, Loews has compounded BVPS at 15.9% (12/31/60-12/31/10).  The recent relative underperformance based on the declining rate of growth shows how the law of large numbers just makes this model of capital allocation difficult over a 50-year period.  Loews witnessed management transferred from Larry Tisch to his sons, which is an issue all of these companies face.

They haven’t done poorly, but the results of the past decade aren’t necessarily at a high enough rates to warrant a “next Berkshire Hathaway” type of label.  Current management was smart in the acquisitions that created Boardwalk Pipeline, which now contributes a big slug of value to the overall business.  They bought 2 pipelines in 2003 and 2004 when they were not popular and combined them to create Boardwalk. 

Even though Loews sold off a portion of the shares at a nice profit, they still own a little over 50% of the business plus the 2% general partner interest and class B units, which will convert into regular units in 2013 on 1 for 1 basis.  Their regular units in BWP are worth $2.5bn at current prices and Loews paid a total of $2.2bn originally for the pipelines that formed the foundation of BWP.  They have another 22.8m Class B units, which will convert in 2 years and would be worth another $600m based on current prices.  They also control the GP interest, which entitles them to a portion of the distributions - $26.2m in 2010.  This is clearly worth something as well.  I wouldn’t be too sad had I been able to make this same kind of investment.  The current Tisch generation is clearly not stupid, but is that enough to justify the belief that they will compound book value at a high rate over the next decade?

At the same time, their Highmount deal has yet to prove a huge winner.  It may eventually, but it seems like they paid a price that had more optimistic predictions for natural gas prices.  The business is primarily natural gas acreage in the Permian basin in Texas.  Acreage has been selling for $10,000+/acre and Highmount has leases to 700,000 acres – not worth applying that price to the entire lease, but there is clearly value there.  Based on a current book value of $1.4bn and another $1.1bn in debt, the $100m in pretax earnings doesn’t reflect well on the investment returns.  They are still in the early stages of drilling wells.  Judged over a longer time period, there may very well be profits to justify the investment. 

I’m not implying that everything the Loews does has to be a home run.  They have pretty consistently hit singles and doubles over the years.  They recently invested in a JV with BWP to buy some storage facilities that tie in with the pipelines nicely and put $500m to work.  They spun of Lorrilard in a tax efficient way.  They seem to be turning around CNA – although I’m no expert on judging that.  They finally seem to be spending some money at Diamond after intelligently profiting from the upswing starting in ~2003, but waiting to expand capacity until rig prices came down in the past 2 years.  The inaction was intelligent because the long-term outlook for deepwater drilling remains positive, but Diamond’s nominal investment will be lower and returns higher simply as a result of patience.  Loews was also in a position to support their partially owned subs in 2008-2009, securing their value and transferring money to the holding company in a tax efficient manner.  That said, it doesn't seem intellectually honest to assume that 15.9% long term track record is repeated int he next 10 years.  It could happen, but that seems like a scenario that doesn't take into account that they could just as easily continue to underperform relative to that growth.

So obviously, none of this is easy to identify before the fact. There is a much more abstract risk in assuming 1 person will be able to generate the same results as he or she has in the past than assuming 1 business will be able to generate the same results as it has in the past.  The intriguing part about buying them close to book value is that investment returns will mirror that of the growth in book value, assuming that’s the performance metric being used.

If you hold any of these types of businesses, how do you get comfortable with their ability to compound in the future?  Would you rather just invest in a business at a slightly higher valuation that doesn’t require the skill of an individual?  

Some historical perspective from The Predator's Ball

I just finished reading The Predator’s Ball: The Inside Story of Drexel Burnham and the Rise of the Junk Bond Raiders by Connie Bruck and I liked it a good amount.  It’s about junk bonds, Michael Milken and Drexel Burnham Lambert in the 1980s.  Probably my first exposure to the subject came from Margin of Safety by Seth Klarman a few years ago as an example of what not to do as an investor.  What struck me reading about junk bonds in the 80s was how similar it was to subprime over the past decade.  It’s really some eerie stuff due to the similarity of human actions during both periods.  The book really gives some worthwhile perspective on the era.

I read Den of Thieves the other month and that was fine as well, but if you had to read one book on the subject, I'd opt for Predator's Ball.  Both books are journalistic efforts, but that doesn’t mean an investor can’t learn some interesting stuff.  While Den of Thieves paints the inside story of the crimes behind the fortunes, I found Predator’s Ball to be more relevant to my understanding the events of the time.  Call me crazy, but I wasn't shocked to hear that greed and ethical issues exist in Wall Street or anywhere else for that matter.  While Milken, Boesky, Siegel, and the other characters in Den of Thieves were major players at the time, they are less relevant today.  Predator’s Ball has about 100 pages on Nelson Peltz, Carl Icahn, and Ron Perelman, which I found particularly interesting since they remain relevant to this day and I’ve looked at companies with which they are involved.

Nelson Peltz is particularly relevant today as far as I’m concerned, because he is an activist at businesses I find fundamentally attractive: Heinz, Tiffany’s, Wendy’s, etc.  I wrote about Wendy’s a while back and Peltz plays a key role there.  What was interesting to learn is that Peltz was very much a minor figure at best in the world of finance in the early 1980s.  He had been in business for a few years prior to his Triangle Industries takeovers, but nothing in the public eye.  As Bruck portrays it, Peltz was doubly lucky in fortuitously being offered Triangle by Milken in a situation outlined in the book as well as the subsequent decrease in interest rates, which made the buyout really pay off.  Everyone has to start somewhere.

Has Peltz changed?  I’d say in most ways except one: debt.  One thing that bothered me about Wendy’s was the debt.  Maybe I’m just too dumb to realize that companies can do just fine with a far from modest debt load, but I’d rather play it safe.  Peltz still seems to like it a lot.  This is just speculation, but if you have had the success he had in the 1980s with Triangle and its debt load, you might think that the presence of debt correlates with positive outcomes.

Ron Perelman – still chairman of MFW and REV – was and still is an even bigger fan of debt judging by the current debt loads at the businesses 20 years later.  The book details his takeover of Revlon, which is certainly an interesting tale.  His buccaneering coincided with an attempt to take over Gillette, which opened up the opportunity for Berkshire Hathaway to swoop in with a white knight investment.

Just how much leverage did Peltz use?  When Triangle Industries took over National Can for $465m, Triangle contributed $70m, did a $30m preferred offering, and raised $365m in debt.  That’s kind of nutty.  It gets nuttier!  Since National Can already had $200m in debt, Triangle refinanced that with junk to bring the total debt up to $565m on a strict $70m equity base of $100m broadly defined equity base.  As Peltz reveals though, “We put the hundred million in the sub [the subsidiary, Triangle Acquisition Corporation, formed for the buyout].  But it was all debt!  We called it equity here [at Triangle Acquisition Corporation], but it was debt over here [at Triangle].”  

This is what bothers me about debt.  The “what if I’m wrong” side of the equation.  Clearly Triangle Industries worked out well.  According to Bruck – and I don’t think these are deep analytical insights, I just haven't independently verified this – consumer spending picked up, energy and aluminum prices went down, and glass pricing became positive for the business.  This basically happened in year 1 of the aftermath of the acquisition, so the debt load immediately became more manageable measured by cash flow.  Then they were able to refinance the debt at lower interest rates.  It’s not that debt negates the possibility of positive outcomes, it’s that it increases the possibility that one might not witness them.  

Carl Icahn is still doing the same old stuff.  I like these stories he tells in some comedy routine on YouTube (here and here).  They do as good a job as the book as giving you the gist of what was going on at the time.  I don’t really get intrigued when I see a 13-D by him.  He has made plenty of money, but it’s more difficult for a passive value investor to profit from it.  I would have lost money following him into Clorox.  I remember the other month when he revealed a stake in Oshkosh that it shot up a good amount, but it’s down 30% from that price.  This has nothing to do with Carl, but with people looking to piggyback.  He enters situations with downside protection for him, but not any subsequent investors in the business.  There's gossip that Carl will try to do something with his position in Oshkosh and Navistar, but he could just as well move on to a cheaper situation.  He can just as easily decide to cut his losses and move on if the share price falls as he can decide its worth the effort to push through some changes.  I wouldn’t be in a similar position if he decided to move on, so I’d probably be facing a loss of capital.  

Probably my favorite piece of tangential trivia was a Mitt Romney appearance at the end.  When Drexel was under investigation by the SEC, Bain was doing an LBO of Palais Royal and Bealls, clothing chains in the Southwest.  Drexel was dong the financing for the LBO.  Milton Pollack was the judge for the case the SEC was pursuing and his wife was chairman and a major shareholder in Palais Royal.  Anyways, Mitt called up Drexel to make sure that the deal would still go through since Drexel was asking that the judge step down from the case.  Oh, how the times have changed.

Anyways, if you’re looking to get some historical perspective on financial markets, Predator’s Ball isn’t a bad book to pick up.  Will it directly help with your investment process or result in any ten baggers?  No.  It’s interesting to see how the past decade was not some unique occurrence of Wall Street all of a sudden facilitating transactions solely to generate fees, even though all the discussion about proper incentives at banks would have you think otherwise.  It’s interesting to see how some people were perceived many years ago, while they are now just viewed as smart money based on having billions.  My impression is that a lot of people reference the events of the 1980s based on more recent interpretations of the era, so while it doesn't markedly differ, I'd prefer to get a more in-the-moment representation of the period.  And as a final note of meta thoughts on the book, it’s not a particularly dense book so it’s a nice combination of education and entertainment while on the train or waiting on people, etc.  

Eagle Materials Summary

I thought I’d summarize my Eagle Materials (EXP) write up since it’s a wee bit long.  Eagle is a construction materials manufacturer that produces wallboard and cement.  These are straightforward commodity products, although Eagle seems to have at least a relative focus on costs compared to some peers.  My difficulty thinking about the business is whether or not they are genuinely a quality business or just the tallest midget.  They have remained profitable throughout the downturn, although this is as much a function of a more sane capital structure relative to peers. 

1.  Low cost?  Part of the answer lies in an abstract conception of “culture” while the other part is identifiable in numerous marginal factors that cut away at costs.  The cement and wallboard plants have expanded in efficiency over the years through a combination of operational improvement and capital spending.  The wallboard and cement capacity are vertically integrated with easy access to raw materials and rail and road access to markets.  Management expanded capacity at one cement plant over the past five years with high efficiency equipment and built one new wallboard plant in the backyard of a coal power plant which gives it a very low cost (due to production cost of gypsum, proximity to existing rail line, and energy source).  There are identifiable factors, which contribute to low costs, although it is wishful thinking to believe that these markets are not filled with aggressive competitors interested in replicating the contributing factors.  While none of this amounts to a truly enduring low cost position, there is a demonstrated operational nonstupidity. 

2. Capital Structure/What if I’m wrong? Perhaps they overreached in 2006-2008 in taking on some debt to repurchase shares, but the business has remained solid overall.  Eagle has remained conservatively financed and hasn’t had to reissue shares to shore up its capital position.  There is still $285m in debt on the balance sheet that does not present any short term financing issues, and amounts to a little under 4x debt/TTM EBITDA and interest coverage of 6x (EBITDA/interest) - both with depressed numerators.  While Eagle’s end markets are clearly at a cyclical low, the duration remains to be seen.  Due to Eagle’s ability to curtail capital expenditures – as well as the overcapacity and lack of pressing need for additional expenditures – Eagle should be able to continue to meet interest payments and generate excess cash to pay down debt.  Eagle has much more flexibility than its peers (especially USG and Texas Industries, which I highlight in my write up) to persevere through continued weakness.   While housing needs to recover in order to make money, the timing issue is not sensitive if the current environment persists for several years.

3.  Valuation Eagle would be quite overvalued if the current economic environment were extrapolated.  Eagle is very capable of earning $2/share in FCF mid-cycle of an economic expansion (see write up for why this is an intellectual honest and low hurdle).  There is some additional upside in the lumpiness of results.  Eagle is in a position to grow the company at the expense of overly indebted rivals looking to dispose of certain assets.  I think there is additional upside in Eagle’s ability to take advantage of a weak environment.