The natural hedge is a significant but often overlooked factor for business-perspective investors to think about the value and risk of a business.
Consider Copart (CPRT, Financial) as an example. The Texas-based online vehicle auction business primarily deals with the niche market of totally damaged, economically unrepairable and recovered stolen vehicles by connecting insurance companies, the sellers and various buying parties, such as dealers, dismantlers, rebuilders and exporters. With regards to this kind of business, one may intuitively start to think of a recession risk (i.e., a decline in used car pricing during an economic downturn) as well as the long-term headwind from the development of "smarter" vehicles (i.e., a reduction in accident rate thanks to the advancement of technology). However, the natural hedge comes to the "rescue" in both scenarios. In the case of decreasing pricing, the car would be worth less and, therefore, the insurer would be less likely to pay for repairs.
As a result, Copart would generate less revenue per vehicle but more sales volume. In terms of the technological threat from the auto industry, a decline in accident volume could be offset by the increase in the percentage of cars sent to salvage as it would be more costly to repair smart cars. According to a Deloitte analysis, Copart has been one of the most exceptional companies in the U.S., with consistently high returns on capital and superior, steady-eddy growths, even during those tough times of the past recessions. The chief financial officer of the company claimed that the business has "the most predictable cash flow of any company you can imagine" when responding to an interview question in 2015.
Our second example of the natural hedge, which is also related to the auto industry, may go beyond many investors' intuition as well. Michigan-based Credit Acceptance (CACC, Financial) provides subprime financing for vehicle buyers with weak credit in the U.S. Yes, this company is about underwriting the riskiest consumer loan in the country, but that does not mean the business can be severely impacted by the economic cycle (in a negative way). Why? Shouldn't a recession lead to an increase in the default rate among the lowest-quality loans? This is true, but Credit Acceptance employs a prudent underwriting approach compared to the industry average, along with its differentiated risk-sharing model.
More importantly, a recession can wipe out competition as more risk-seeking players tend to exit the subprime segment of the loan market. Moreover, a recession may even expand the total addressable market (i.e., subprime status borrowers) for Credit Acceptance. Hence, from a net-net perspective, the company can theoretically enhance the value of its business via an economic downturn by getting more customers in a less intensively competitive environment. Browsing through the company's data, we observe that the time when Credit Acceptance struggles the most appears to coincide with the period for a booming subprime auto loan market.
Both Copart and Credit Acceptance have generated tremendous shareholder returns over the last decade or so. But if investors following either name only concentrate on the "headline risk," it is very likely that they can miss the boat.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Credit Acceptance.
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