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Sydnee Gatewood
Sydnee Gatewood
Articles (3362) 

David Rolfe's 4th-Quarter Wedgewood Funds Letter- 'Trampoline or Tightrope'

Discussion of markets and holdings

"If I could avoid a single stock, it would be the hottest stock in the hottest industry, one that gets the most favorable publicity, the one that every investor hears about in the carpool or on the commuter train - and succumbing to the social pressure, often buys."

Peter Lynch, Magellan Fund

Review and Outlook

For calendar 2020 our Composite (net)i gained +32.1%. The S&P 500 Index gained +18.4%.

The Russell 1000 Growth Index gained +38.5%. The Russell 1000 Value Index gained +2.8%.

For the fourth quarter of 2020 our Composite (net) gained +12.2%. The S&P 500 Index gained +12.2%. The Russell 1000 Growth Index gained +11.4%. The Russell 1000 Value Index gained +16.3%.

We are pleased to report that our Composite (net) has outperformed the S&P 500 Index over the past 1, 2, 3, 4, and 5-years. (+32.1% vs. 18.4%, +74.4% vs. +55.7%, +67.4% vs. 48.9%, +101.7% vs. +81.4% and +110.8% vs. 103.0%.)

Top performance detractors for the year include Booking Holdings, Fastenal, Fleetcor, Ross Stores, and Motorola Solutions. Top performance contributors for the year include Apple, PayPal, Tractor Supply, Facebook, and NVIDIA.

Top performance detractors for the fourth quarter include S&P Global, Tractor Supply, Progressive, Bristol-Myers Squibb, and Microsoft. Top fourth quarter performance contributors include Alphabet, Keysight Technologies, PayPal, Starbucks, and Edwards Lifesciences.

We were unusually inactive during the fourth quarter. We purchased Progressive and trimmed Tractor Supply.

S&P Global (NYSE:SPGI) announced the acquisition of IHS Markit, a provider of financial indexes, fixed income data, and industrial market data. S&P Global offered about $40 billion in their equity to IHS at a modest premium to IHS' price at the time. S&P Global's management has done an excellent job managing costs and we expect this discipline should translate well to IHS' expense base. In addition, the high level of recurring revenue and competitively advantaged positioning of both businesses should auger well for continued top-line growth.

Tractor Supply (NASDAQ:TSCO) reported +27% growth in same-store sales ("comps") as the Company's value proposition continues to resonate in the pandemic-affected U.S. We do not expect Tractor Supply to report similarly stellar comps next year and trimmed some of the gains to fund a new position in Progressive. However, we still think the market continues to under-appreciate the long-term benefits that have accrued to the Company. The Company should be able to sustain its new customer base due to investments made both pre-pandemic and post-pandemic which should drive double-digit earnings growth rates at very attractive returns on capital. As such, we continue to maintain Tractor Supply at a full weighting in portfolios.

Progressive (NYSE:PGR) was a new addition to portfolios during the 4th quarter. Growth investors have widely eschewed financial stocks over the past decade, often for good reason. But we think there are a handful of superior financial service companies, including First Republic and S&P Global, that can generate attractive growth at superior returns. Progressive fits the bill as a Company capable of driving double-digit top-line growth, thanks to a decade-plus of property and casualty underwriting innovation, combined with an aggressive, but prudent, marketing strategy. As mentioned, we funded our Progressive position with proceeds from an overweight in Tractor Supply. (See more on Progressive below.)

Bristol-Myers Squibb (NYSE:BMY) recently reported accelerating sales as much of the medical services industry returned to work. The Company continues to expect double-digit earnings growth over the next few years, driven by existing drugs, in addition to a broad pipeline of new drugs and indications. While the market remains fixated on a couple of patent expirations that could occur over the next several years, we think this is well-known at this point, yet the market still undervalues a couple of key acquisitions the Company has made in the past few years, particularly Celgene, which was acquired for a song.

Microsoft (NASDAQ:MSFT) continued to generate solid double-digit top-line, and operating earnings growth. The Company's all-encompassing portfolio of "hybrid" cloud solutions is compelling for customers as IT organizations vacillate between on-premises and off-premises (and then likely on-premises again). For example, Microsoft 365 has added an array of features to make remote work easier, yet, as customer applications grow in compute intensity, those customers' on-premises and edge computing topologies retain or grow in importance. Microsoft's strategic pivot to be more customer-friendly and collaborative will sustain its growth and returns for several more years so we are happy with our position.

Alphabet's (NASDAQ:GOOG) (GOOGL) core Google revenues grew +9% during the quarter, a meaningful acceleration from the -8% decline during the COVID-19-impacted second quarter. The Google unit also unexpectedly showed some modest expense leverage after several quarters of heavy reinvestment, driving double-digit earnings growth at Alphabet. We would not be surprised if that leverage is short-lived. However, Alphabet continues to meaningfully under-earn relative to its potential, and we welcome any effort that brings forward, or at least highlights, the Company's pent-up earnings power. On the latter score, Alphabet announced it will be providing more detailed operating segment profit data in the coming year.

Keysight (NYSE:KEYS) generated +20% adjusted earnings growth during the quarter on +9% growth in revenue as its high-margin software sales continue to grow at attractive, double-digit rates. Keysight's hardware and software solutions are increasingly tailored to research and development departments working on cutting-edge technology standards, such as 800 gigabit Ethernet and various upcoming iterations of 5G for wireless. The Company is also positioned well to serve the automotive industry's aggressive shift into electric vehicle (EV) and autonomous driving (AV) development. Keysight has not traditionally served the automotive industry to any great extent, prior to the EV and AV boom. However, Keysight sells laboratory solutions to help test protocols across the rapidly increasing ecosystem of EV and AV system and sub-system manufacturers. For example, during the quarter GM announced a $7 billion increase to its $20 billion AV and EV development budget. Keysight's focus on this attractive end-market growth is underappreciated as the stock continues to trade at below-market earnings multiples. We think the Company's superior profitability profile, combined with attractive and sustainable growth and undemanding forward earnings multiple, warrants a full position in the portfolio.

PayPal (NASDAQ:PYPL) continued its torrid pace of payment volume growth, up +38% during the quarter, driven by over 15 million new accounts (almost double the pre-pandemic rate) and continued increases in transactions per account. This led to +25% growth in revenue and hefty margin expansion as the Company continues to effectively leverage its fixed cost base. PayPal's addressable market continues to be a multitrillion dollar opportunity, with the Company particularly focused on the faster growing and more lucrative e-Commerce channel.

Starbucks' (NASDAQ:SBUX) sales trends improved substantially relative to the second calendar quarter, led by markets that were further along the post-COVID-19 reopening path, particularly mainland China. While the Company has experienced a challenging year due to the effects of the pandemic, Starbucks has quickly adapted and made investments that should move it into a better competitive position as society returns to normal. For example, it has ramped up opening more stores with drive-through and pick-up capabilities, in addition to continued digital and loyalty program expansions. We also think the Company has the opportunity to drive higher margins over the next several years as the growth rate of its store base inevitably matures.

Company Commentaries


"Progressive is at its best imagining the unimaginable and doing the impossible. We will create an auto insurance experience that exceeds consumers' highest expectations."

Peter B. Lewis, Chairman, 1990 Annual Report Letter to Shareholders

"Insurance companies enjoyed some terrific advantages, as compared to manufacturers. Insurers offered a product that never went out of style. They profited from investing their customers' money. They didn't require expensive factories or research labs. They didn't pollute. They were recession resistant. During hard times, consumers delayed expensive purchases (houses, cars, appliances, and so on), but they couldn't afford to let their home, auto, and life insurance policies lapse. When a sour economy forced them to economize, people drove fewer miles, caused fewer accidents, and filed fewer claims-a boon to auto insurers. Because interest rates tend to fall in hard times, insurance companies' bond portfolios become more valuable. These factors liberated insurers' earnings from the normal business cycle and made them generally recession-proof."

The Davis Dynasty. John Rothchild

We purchased Progressive in late 2020.

The first American automobile manufacturing company was the Duryea Motor Wagon Company, founded in 1893 in Springfield Massachusetts. Henry Ford's first attempt to manufacture an automobile didn't end as planned. In late 1901, Ford sold his first car company to the Cadillac Motor Company. Ford's second attempt at auto manufacturing began in 1903, as we all now know, was a booming success. By 1908, Ford's Model T – the car for the masses – changed the automobile market forever. Over the next 20 years Ford would sell more than 15,000,000 "Tin Lizzies." In all, almost 2,000 companies would try their hand at manufacturing that revolutionary technology.

The country's nascent automobile industry would, in time, bring unimaginable societal change over the ensuing decades, but one of the first inevitable realities was automobile owners' operating errors, better known as auto accidents. Accordingly, the first auto insurance policy was issued by Travelers Insurance Company in 1898. According to the Company, this policy was a $5,000 liability coverage for a premium of $12.25. Thus, the automobile insurance industry was not borne out of ingenuity, but legal necessity. Interestingly, back in the day, Massachusetts must have had some unique combination of terrible drivers, terribly difficult cars to operate, and terrible roads as the state was the first to pass legislation requiring mandatory auto insurance. Massachusetts held that rather ignoble first for over 30 years.

The top five auto insurers all have a rich (both storied and lucrative) history of selling auto insurance for decades: State Farm (1942), GEICO (1936), Progressive (1937), Allstate (1930) and USAA (1922).

In early 1937, Joseph Lewis and Jack Green founded the Progressive Mutual Insurance Company in Cleveland, Ohio. Their stated desire at the time was to operate a different kind of an auto-only insurance company, hence the name Progressive. Over the years, the Company would introduce a number of industry firsts, including the industry's first drive-in claims office; monthly installment premium pay; public loss reserve reports; public monthly underwriting reports; and 24/7 claims reporting; comparison rates; buy by phone; 24/7 auto insurance comparison rating service; first industry website; online agent referral service; real-time buying; instant quotes for motorcycles, boats, watercraft, and RVs; and Name Your Price policy quotes.

Growth was relatively slow the first two decades with annual premiums reaching around $2.6 million. 1956 was notable in the Company's desire to focus on high-risk drivers when they formed Progressive Casualty. In 1965, Peter B. Lewis, the son of cofounder Joseph Lewis (along with his mother) bought out the Green family's interest in the Company and rechristened it as Progressive Corporation. Peter Lewis, who started at the Company at twelve years of age, would be the cultural driving force at the Company for the next 35 years. Lewis, the iconoclast, proffered a simple financial dictum, its North Star, that still serves the Company today: underwriting profitability over policy growth. Specifically, the Company's long-held goal is to operate at a combined ratio of 96. In other words, the Company wants to earn 4 cents on every premium dollar. The Company went public in 1971. Since Lewis stepped down as CEO in 2000, the Company has had only two other CEOs – Glenn Renwick (2000-2016) and current CEO Patricia Griffith.

The table below shows the significant and consistent market share growth of the three direct auto-insurers (Progressive, GEICO and USAA). In 2009, the three direct insurers held a combined industry premium share of just 20% – about the same as State Farm and Allstate combined. Today, these three direct insurers command a combined share of 32% – almost 20% greater combined share of State Farm and Allstate. Notably, too, most of the other industry competitors have bled premium share. Specifically, today the five largest auto insurance companies by market share are State Farm (16%), GEICO (14%), Progressive (12%), Allstate (9%) and USAA (6%). The cost advantage of the direct insurers is simply too great to think that Progressive and GEICO (and to a lesser extent USAA) won't continue to take industry share.

(An aside: GEICO continues to be the keystone owned company within our former, long-held portfolio holding Berkshire Hathaway. See this link for GEICO's rags-to-riches-to-rags-to-riches story. Wedgewood on GEICO)

Today, Progressive is the only public, pure-play auto insurer. Progressive is both a direct insurer, as well as an independent agency, with policies sold by independent agents. In other words, it is sold by agents who are not "captive" to Progressive and can sell policies from other insurance carriers.

Along with our long admiration for GEICO's multi-decade juggernaut of growth and industry leading profitability, Progressive has long been GEICO's kissing cousin on this financial score.

The following annotated transcript from Berkshire Hathaway's Annual Meeting in May 2019 offers interesting insight into the lucrative rivalry between Progressive and GEICO:

Question: This question is on GEICO. Progressive is gaining the most market share among the major auto insurers, based on its presence in the direct and independent agency channels, as well as now bundling its auto and homeowner's insurance coverage. How does GEICO plan on responding to competitive threats so that it can retain its place as the second-largest auto insurer?

Warren Buffett (Trades, Portfolio): Progressive is a very well-run business. GEICO is a very well-run business. And I think they will, for a long time, be the two companies that the rest of the auto insurance industry has trouble not losing share to. Progressive has been very well run. They have an appetite for growth. Sometimes they copy us a little, sometimes we copy them a little. And I think that'll be true five years from now and 10 years from now. The big thing is auto insurance. And we grew in the first quarter about 340,000 policies, net, which will look quite good compared to anybody but Progressive, but I think that Progressive is an excellent company, and we will watch what they do, and they will watch what we do. And we will see, five years from now or 10 years from now, which one of us passes State Farm first. Ajit, would you like (comment)?

Ajit Jain (Vice Chair Insurance Ops): Well, the underwriting profit is really a function of two major variables. One is the expense ratio and the other is the loss ratio, without getting too technical. GEICO has a significant advantage over Progressive when it comes to the expense ratio, to the extent of about seven points or so. On the loss ratio side, Progressive does a much better job than GEICO does. They have, I think, about a 12-point advantage over GEICO. So, net-net, Progressive is ahead by about five points. GEICO is very aware of this disadvantage on the loss ratio that they are suffering, and they're very focused on trying to bridge that gap as quickly as they can. They have a few projects in place, and, you know, sometimes GEICO is ahead of Progressive. Right now, Progressive is ahead of GEICO. But I'm hopeful they'll catch up on the loss ratio side and maintain the expense ratio advantage as well.

Warren Buffett (Trades, Portfolio): I would bet significant money that GEICO increases its market share in the next five years. And I think it will, for sure, this year. So, it is a terrific business, but Progressive is a terrific business. As Ajit says, we've got the advantage in expenses, and we will have an advantage in expenses. They have a very sophisticated way of pricing business. And the question is whether we give some of that five points back… or six points back… in terms of loss ratio. We are working very hard at that, but I'm sure they're working very hard too to improve their system. So, it's a… to some extent it's a two-horse race, and we've got a very good horse.

Charlie Munger (Trades, Portfolio): But Warren, in the nature of things, every once in a while, somebody's a little better at something than we are.

Warren Buffett (Trades, Portfolio): Ha. You've noticed.

Charlie Munger (Trades, Portfolio): Yeah. I noticed.

Warren Buffett (Trades, Portfolio): Yeah. I'd settle for second place in a lot of the businesses.

GEICO's Jain is quite right to point out Progressive's advantage in loss ratio versus GEICO. On that score, we don't expect Progressive to cede much ground back to GEICO anytime soon as Progressive is relentless on its cost structure. (Chart below from Company reports.)

Understanding a bit of the auto insurance industry's nomenclature will help to better understand the import of the discussion above, as well as understand both Progressive's and GEICO's long-held, considerable competitive advantages depicted below. But first a few industry definitions:

Loss Ratio: The formula to calculate loss ratio is essentially losses divided by company revenues, (total earned premiums). The complete loss ratio formula is insurance claims paid, plus adjustment expenses divided by total earned premiums. So, for example, if an insurance company pays $50 in claims for every $100 in collected premiums, the loss ratio would be 50%.

Expense Ratio: The expense ratio is a base measure of efficiency of an insurance company's administrative cost of doing business before factoring in insurance claims on its policies and investment gains or losses within its float investment portfolio. The base administrative expenses are advertising, employee wages, and commissions for the sales force. Specifically, the expense ratio in the insurance industry is a measure of profitability calculated by dividing the expenses associated with acquiring, underwriting, and servicing premiums by the net premiums earned by the insurance company.

Combined Ratio: The combined ratio is a comprehensive measure of profitability gauging how well an insurer performs its daily operations. The combined ratio is calculated by taking the sum of incurred losses and expenses and then dividing them by an insurance company's earned premium. A combined ratio of 100 basically means an insurance company breaks even. Any profits then must be generated by interest income, dividends, and capital gains from an insurance company's investment portfolio. Such investment portfolios of float are essentially premiums in excess of claims and expenses. The auto insurance industry, as most commodity-like insurance, is a brutal business, typically generating a combined ratio of 100-102 (2018 was an unusually good year).

A quick glance at the graphics below (though a couple are dated, the same trends persist today) and the latest available industry stats (2018) note the standout performance of Progress and GEICO (Berkshire Hathaway) in terms of expense ratio and combined ratio. In terms of expense ratio, GEICO (12.9%) and to a large extent Progressive (19.6%) too, possesses a critical competitive advantage in that GEICO does not employ a sales force; so, zero commissions. Progressive utilizes both direct and commissioned sales channels. As mentioned at the 2019 Berkshire Hathaway annual meeting, Progressive has been an outstanding underwriter, employing state-of-the-art tools and technology.

In the aforementioned Berkshire Hathaway Q&A on GEICO and Progressive, Warren Buffett (Trades, Portfolio) noted Progressive's "very sophisticated way of pricing business." Key to understanding Progressive's competitive advantage over the industry – and other direct insurers too – is understanding the Company's differentiated policy pricing algorithms and related pricing skill sets.

Given Progressive's multidecade experience of insuring higher-risk drivers, the Company has amassed an incomparable data set that sits at the core of its cutting-edge usage-based policy pricing. In 2004, the Company introduced the usage-based TripSense. In 2008 MyRate was introduced, and it allows frequent changes in pricing based on how its customers actually drive. MyRate was rebranded in 2011 as Snapshot. Snapshot collects driving information during the first policy term. The customer will see a new personalized rate when the policy renews. Driver information includes the time of day a person drives, sudden changes in speed (hard braking and rapid accelerations), the amount driven, and, for customers using the mobile app in some states, how the drivers use the mobile phone while driving. Smart Haul is similar to Snapshot, but it's for commercial trucking. September marked the largest monthly take rate (+24%) for Smart Haul. According to the Company, by 2014 it had collected over 10 billion miles of data. Just last month, the Company introduced Snapshot ProView, a usage-based, fleet management program for small business owners. Such initiatives should help to drive growth in the Company's commercial business, which grew +30% between 2017 and 2019.

More recent innovations include Snapshot Road Test, an app-based program that logs real-time driving data for 30 days to ascertain a quote while still with your current auto insurer. The net result of such ongoing, usage-based, data analytics innovations lead to unmatched speed in adjusting risks, which has been the foundation of the Company's industry-leading loss ratios.

Any discussion of Progressive (and GEICO) would not be complete without a few words on both Companies' spirited and aggressive marketing. Creative marketing works. Creative marketing really works in auto insurance. One can hardly watch any network or cable-based television programming (particularly live sporting events) without being flooded by comedic car insurance ads. GEICO's Gecko made his acting debut in 1998 – and its Caveman in 2004. Progressive's Flo made her debut in 2008.

The impetus behind all the major auto insurance companies getting on board with massive advertising campaigns was the early move by GEICO (later Progressive) to directly market to consumers rather than through commission-based insurance agents. In 1995, GEICO's marketing budget was a scant, but effective $35 million. The next year GEICO booked its best policy growth (+10%) in over 20 years. Policy growth in 1997 soared to +16%. Seeing a good thing, Buffett swung big in 1998 taking GEICO's marketing to $100 million (Gecko). GEICO's policy growth in 1999 was +23%. GEICO's marketing budget soared over the next decade: 2001: $219 million, 2003: $238 million, 2004: $502 million, (Caveman), 2006: $631 million, 2007: $751 million, 2010: $900 million, 2011: $994 million (industry record), 2012: $1.1 billion. GEICO's ad budget increased a minimum double-digit rate every year until 2019.

Buffett learned that after the upfront costs to acquire a new customer, if you can retain such customers, as both GEICO and Progressive can, returns on marketing spend can approach 30%. Buffett channeled his inner-Ted Williams .400 batting average and changed the marketing game forever through an intense amount of fat-pitch television advertising, which forced other car insurance companies to pick up their own games in order to keep pace with GEICO and then soon after, Progressive.

Progressive stepped on the marketing gas pedal in 2018 (largely in nontraditional media), increasing its advertising spending by +41% in the midst of the most rapid growth in the Company's history as net premiums surged 39% from 2017 through 2019. Sensing opportunity again, the Company recently increased its ad budget (mostly in direct) by +29% and +20% year-over-year. In 2019 alone, the Company recorded premium growth of +14.7%, versus the industry's growth of just +2.8%. It was only auto insurer that gained more than +10%.

Progressive has also been quite successful in bundling its policies across their product set, particularly after the Company acquired part of American Strategic Insurance in 2015, thereby allowing independent agents the ability to offer a competitive auto-home bundled offering. The Company purchased the remaining share of American Strategic last May. Specifically, within the Platinum program – an invitation-only program for leading independent agents – these leading independents (top-10 in Company volume) earn higher commissions for home/auto bundles, as well asexclusive performance bonus opportunities and complimentary marketing tools and services to boost leads and make more sales. The success of these Platinum agents of late has been notable with agent-bundled sales up +75% during 2108 through 2019. Bundling for direct has been notable too as applications for bundled policies sold was up +250% in 2019.

Circa 2020, Progressive has about 23 million policies in force. About 20 million of those are auto policies (personal lines), split about 50/50 between direct and agency. These policies have grown around +8-10% in recent years. Commercial (trucking) policies in force are almost 800,000. Property policies in force are about 2.3 million. Before the upheaval of driving during the pandemic, the personal lines had been operating at a very profitable combined ratio of 90-91 due to price hikes. Commercial lines operated at 88 and property lines at 103. Most critically, customer retention over the past twelve months remained quite healthy +9%.

As would be expected, the auto insurance industry saw dramatic swings in all key industry metrics during the pandemic shutdown, including plunging miles driven (-40% at the trough), plunging premiums, and concomitant plunging loss ratios. The industry responded with a series of rebates, credits, and lowered premiums. For its part, Progressive credited 20% of April premiums in May and 20% of their May premiums in June. The sum of those two credits amounted to approximately $1 billion.

As of the Company's most recent monthly (November) earnings release, it looks like business is starting to return to normal. Companywide policies in force increased +11%, year-over-year. Total personal auto policies in force increased to 16.5 million, +11% - with direct policies up +13% and agency policies up +9%. November net premiums written of $2.96 billion increased a healthy +14% year-over-year, while net premiums earned of $3.2 billion increased +11%. Lastly, the Company's combined ratio snapped back to a smart 86.6 from 94.1 in October. The Company will likely exit 2020 with +$38 billion in net premiums written and +25 million policies in force.

Due to the relative consistency of the Company's business model, our expectations of future annual profitability and growth largely mirror that of the recent past. Specifically, we expect both policies in force and revenues to grow at a high single-digit rate and a combined ratio of 93-95. We expect more variability in returns on capital and earnings growth. The last few years have been exceptional with returns on equity ranging from 26% to 32%, above the more typical range in the high teens. We would be thrilled with sustainable ROE's from 20% to 25%. We also would be happy with earnings growth, lumpy as it typically is, between a high single-digit and low double-digit range.

At current valuations, the stock is far from a screaming bargain (what is these days?), hence our initial position size of just a 2.5% weighting. Future risks to consider that the Company must navigate are margin compression and/or if growth in policies in force decline due to heightened competitive pressures, including fluctuating fears of autonomous vehicles (AV). We look forward to building our position in Progressive as opportunity knocks.

S&P Global

S&P Global announced the acquisition of IHS Markit, a provider of financial indexes, fixed income data, and industrial market data. The Company offered about $40 billion in SPGI equity to IHS Markit at a modest premium to IHS' price at the time. We think the acquisition has compelling industrial logic, despite both companies exhibiting little revenue overlap.

Like S&P Global's equity indices, Markit has amassed some very unique index assets that define its product category. For example, Markit's iTraxx and CDX indexes are the most popular baskets of credit default swaps (CDS) on loans and regularly traded debt, with market activity north of $5 trillion a year that make up more than 90% of CDS market activity, according to the International Swaps and Derivatives Association. Markit also provides intraday pricing data on millions of corporate and sovereign bonds as well as consensus data to help independently verify valuation data on a wide array of derivatives.

Tangentially, S&P Global is one of the largest providers of credit ratings services and therefore data for both loans and traded bonds, so there should be ample revenue and/or expense synergies when the combined company approaches mutual customers of their data. The Company's Market Intelligence data platform will be particularly important as a distribution hub for the new data sets being acquired from IHS Markit. For example, mutual customers that already use S&P Credit Research will be able to easily access fixed income issuance data from Markit.

The other 60% of IHS Markit's revenues come from proprietary and public datasets as well as analytics for various industrial markets, including vehicle ownership records and production forecasts, oil and gas data for upstream, midstream and downstream applications, and maritime vessel data. The Company's Platt's segment should benefit from the analytic capabilities that IHS brings to the combined company.

On the face of it, having the same customer does not necessarily generate new revenue, but there should be ample overlapping expenses that can be harvested or reinvested for future growth at the combined company. The Company's management has done an excellent job over the years leveraging its "asset-light" model (fixed plant investment is low as percentage of total assets). With a methodical focus on low-risk cost savings and reinvestment, we expect this discipline can be effectively overlayed onto IHS Markit, which has a similarly asset-light model (gross plant running about 10% of total assets). S&P Global and IHS Markit should be able to reduce 5%-10% of their expense base, though we would expect them to reinvest some of this.

The combined Company should be able to generate mid-to-high single-digit revenue growth over the next several years, as both businesses expand their offerings commensurate with the massive expansion of capital markets thanks, in part, to perpetually profligate monetary policy. We also expect the new Company to be able to generate steady expense leverage and drive very attractive marginal returns on invested capital while leading to healthy double-digit earnings growth, once the dust from the acquisition has settled.

Clearly IHS Markit management were motivated sellers, as S&P Global offered just a single-digit percentage premium to IHS' previous close. That's not to say this deal came cheap, but both Companies exhibit nearly the same multiples that are at the upper end of their historical ranges. We would have preferred the Company issue more debt to finance the deal, however it will have plenty of capacity to repurchase shares in the future. We continue to carry S&P Global at a half-weighting and will wait for the market to serve up its nearly annual offering of the stock at cheaper multiples.

Tractor Supply Company

While the entire market rallied in 2020, despite overwhelmingly negative real-life fundamental performance, our long-term holding Tractor Supply Company had an excellent year both in terms of company fundamentals and stock price performance, with events clearly elucidating why we have been avid supporters of this company for many years. The unique events of 2020 demonstrated two very important attributes of the company: first, and perhaps most importantly, the essential nature of this business to its customer base; and second, the skill of this Company's management team.

First of all, 2020 showed, quite literally, what we have said all along: Tractor Supply provides an essential service to its rural and semi-rural customer base. The nature of the business, and the physical locations of its stores – which have been placed in physical proximity to its customers, and in areas that are not served by other large retail competitors – allow the Company to meet crucial customer needs not being provided by anyone else, which includes physical retail and online retail competitors.

If, as Tractor Supply retail-bears have been arguing for the best part of 20 years now, Tractor is going to be supplanted by Amazon or by any other online retailer, 2020 would have been the year for this to happen. For a start, if the Company truly was not an "Essential Retailer"– actually certified as such by governments this year – stores would have closed for significant periods. This did not happen, although Tractor Supply did adapt its hours in response to the pandemic. Second, with much of the country hit with stay-at-home orders early in 2020, combined with the public's very sensible aversion to mingling with strangers in the middle of a pandemic, one would expect everyone to be forced into the arms of Amazon and other online retailers...unless, it turns out, Amazon and other online retailers are unable to meet those customers' needs. We have always believed this, and 2020 proved it.

We have argued for years that there actually isn't much magic in selling something online. 2020 demonstrated, however, that there definitely is some skill involved in being able to handle sales growth – online or otherwise – profitably and in a capital-efficient manner. While Tractor saw a more than doubling of online sales penetration (still very low as a percentage of total sales) in response to the pandemic in 2020, and while it invested heavily in multiple areas in order to meet this shift in customer demand, it managed to handle the flood of sales that unexpectedly arrived. It also significantly improved profit margins, prudently managed working capital, and thus delivered a massive improvement in cash flows. We present the following table to compare how Tractor Supply managed this year's unexpected windfall in relation to Amazon, for example.

Where metrics were available, we compared Tractor to Amazon's most comparable segment, its North America business, which includes its retail business as well as Prime and other subscription revenue. Unfortunately, cash flow data is not available for this segment, so we used Amazon's total company cash flows in the table. We would note that Tractor Supply managed to convert their windfall in sales into more than 4X better profit growth than Amazon's comparable North America business, while also more than doubling operating cash flows and nearly quadrupling free cash flow. Over at Amazon, in a model that is supposed to be geared for scalability, and where it theoretically is supposed to be more capital efficient, considering that it does not have to throw up all of these dinosaur-era physical retail stores in order to generate sales growth, we find the lack of profit and cash flow generation to be fairly astounding, particularly in a period during which customers were driven to them in droves.

For those who somehow believe there is something disruptive in Amazon's much-trumpeted move to next-day shipping – only for Prime members, on some stuff, sometimes, but not actually during the time of year you really need it, and not very often at other times, either, in our experience – we would point to Tractor Supply's exceptional execution in meeting customer's needs; over a period of only three weeks during the early chaos during the pandemic, from just 20% of stores offering same-day shipping to ALL stores offering same-day shipping. This, along with similar services offered by large retailers such as Wal-Mart and Target, demonstrates another of our long-held beliefs; Amazon isn't getting ahead of these retailers, who all have inventory and people on the ground today in physical proximity to their customer base. By trying (with mixed success) to provide next-day shipping, Amazon is still scrambling to catch up with these retailers' capabilities, all the while sacrificing profits and capital in order to do so.

All in all, throughout 2020, we were truly impressed with the execution of Tractor Supply's management team, which smoothly handled all of the pandemic-related challenges, including, conditions in physical stores, managing through a variety of government decrees, adapting store hours, ramping up hiring, significant cleaning/sanitation expense, managing a supply chain that suddenly had to deal with considerably higher demand, and with a different sales mix than usual, plus handling a sudden change in demand for omni-channel services. On top of dealing with these unexpected changes in the short term, management continued (in fact, accelerated) investment for the future, including store expansion, increasing staff hiring and wages, distribution footprint expansion, and technological/online/omnichannel investment, and never missing a beat as they stayed on top of the typical day-to-day quest for operational improvement that has been a hallmark of this company for the past fifteen years.

Tractor Supply's stock rallied +50% in 2020, but, considering the entire market rallied in 2020 on a pandemic and a massive recession, we believe a rally in the stock of this company, which actually benefited from the pandemic in 2020 and will continue to benefit into the future, is fully justified. It's also worth pointing out that a significant portion of the market was beating up the stock in late '19/early '20 for somehow being an "oil stock," which was overblown on a variety of fronts. This had left the stock trading at an attractive valuation going into the pandemic, so, even with its eventual rally, the stock still trades at a very favorable valuation, both on an absolute basis and, particularly, in relation to the rest of the market. While the stock took a bit of a break toward the end of last year, as investors began to take profits (as we did, to a small degree, ourselves) and to look for more beaten-up businesses which might have stronger rebounds as the economy hopefully recovers, we expect Tractor Supply to remain a long-term winner.

Trampoline or Tightrope

"I worry that bond buying has some distorting impact on price discovery, that they encourage excessive risk taking, & excessive risk taking can create excesses and imbalances that can be difficult to deal with in the future."

Robert Kaplan, President Dallas Federal Reserve Bank

2020 was, what? Too many adjectives come to mind. Surreal, sobering, maddening, astonishing? One wants to comment on matters beyond the economy and the markets, as seemingly everything from the pandemic to the political magnified thoughts and expectations on the economy and markets. We left our last Letter worried about the spiking force of the pandemic and the inevitable political playbook of a second round of shutdowns. That happened. Then the vaccine happened. The markets, in their usual draconian manner, cut through the fear, latched on to a post-vaccinated world, looked long into 2021, and began to price in a strong, rebounding economy post-COVID.

The stock market ended 2020 at all-time highs. Most major stock market indices ended the year at all-time highs, including the S&P 500 Index, the S&P 500 Equal-Weighted Index, the Dow Jones Industrial Average, the S&P 400 MidCap Index, the S&P 600 SmallCap Index, the NASDAQ Composite, the NASDAQ 100 Index, and the Russell 2000 Index.

In terms of the markets, specifically the stock market, 2020 was beyond astonishing. Astonishingly binary. Lock-down stocks vs. vaccine stocks. For the first three-quarters in the year, lock-down insensitive stocks (nearly exclusively technology stocks) flourished as they once flourished during the late 1990's. Most of these growthier companies saw their respective corporate fortunes notably improve during the lockdowns.

The vaccine stocks, those of economically sensitive businesses that were forced to close were clobbered and stayed clobbered until the vaccine arrived. Indeed, until Pfizer announced the success of its COVID vaccine (November 9th) the Russell 1000 Growth Index gained +30.8% versus the Russell 1000 Value Index drop of -8.4%, a differential of +39%. Since November

9th, The Russell 1000 Value Index gained +12.3%, while the unstoppable Russell 1000 Growth Index gained +6.1%. (Note: As this Letter is being written the Democrats have swept the Senate run-off in Georgia. With the Democrats now controlling all three branches of the federal government, value stocks may now have a trillion-dollar "stimulus" kicker to boot.)

In other related "all-time" highs, stock market valuations joined the party too in 2020. Stock market valuation "Cassandras" have become nearly a laughingstock over the past few years (we admit to being a "fully-invested" social member of this club). "Don't Fight the Fed" has been a massively winning, fully-invested, long-only strategy for all but the most dancing on the-head-of-a-pin angels.

The Federal Reserve's extraordinary response to the pandemic recession was a +77% increase in the Fed's balance sheet – a cumulative 10X-fold increase over the past 20 years. The $3.2 trillion expansion in just three months beginning in late June wasn't, in our view, just a safety net, but a trampoline for nearly every asset class – stocks, bonds, real estate, IPOs, SPACs, speculative margin debt, Tesla stock, Bitcoin, Rolex watches – you name it!

Assuming the risk of COVID fades materially early this year, global economies, riding a tidal wave of central bank liquidity, are set to continue recovering throughout 2021. The stock market has aggressively priced in such an event – even to the extent that current expectations of a robust 2021 are still too conservative. Critically, the Treasury market has repriced inflation expectations back to more recent highs (while most corporate and mortgage yields remain at or near all-time lows).

More critically still, 10-year Treasury yields have risen sharply too from just 0.50% in early August to 1.19% as of this writing. That might not seem like a big move, but make no mistake, if such yields continue to climb, then the question of when, not if, the Fed needs to change course and begin "tapering" back the size of their massive balance sheet. This emerging tightrope act for the Fed would turn The Flying Wallendas acrophobic. Add into this melodrama extremes in valuation in most parts of the stock market, and it's an easy call to expect heightened risks for asset prices as the economy roars back in 2021. We hope Powell & Co. are already fitted for parachutes.

We wish to once again thank those clients who have been steadfast in their support of Wedgewood Partners.

January 2021

David A. Rolfe, CFA Chief Investment Officer

Michael X. Quigley, CFA Senior Portfolio Manager

Christopher T. Jersan, CFA Portfolio Manager

  1. Portfolio contribution calculated gross of fees. The holdings identified do not represent all of the securities purchased, sold, or recommended. Returns are presented net of fees and include the reinvestment of all income. "Net (actual)" returns are calculated using actual management fees and are reduced by all fees and transaction costs incurred. Past performance does not guarantee future results. Additional calculation information is available upon request.

The information and statistical data contained herein have been obtained from sources, which we believe to be reliable, but in no way are warranted by us to accuracy or completeness. We do not undertake to advise you as to any change in figures or our views. This is not a solicitation of any order to buy or sell. We, our affiliates and any officer, director or stockholder or any member of their families, may have a position in and may from time to time purchase or sell any of the above mentioned or related securities. Past results are no guarantee of future results.

This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be correct. These comments may also include the expression of opinions that are speculative in nature and should not be relied on as statements of fact. Wedgewood Partners is committed to communicating with our investment partners as candidly as possible because we believe our investors benefit from understanding our investment philosophy, investment process, stock selection methodology and investor temperament. Our views and opinions include "forward-looking statements" which may or may not be accurate over the long term. Forward-looking statements can be identified by words like "believe," "think," "expect," "anticipate," or similar expressions. You should not place undue reliance on forward-looking statements, which are current as of the date of this report. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events or otherwise. While we believe we have a reasonable basis for our appraisals and we have confidence in our opinions, actual results may differ materially from those we anticipate.

The information provided in this material should not be considered a recommendation to buy, sell or hold any particular security.

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