Someone who reads my blog emailed me this question:
“As a private investor, I try to analyze those companies where I might find an informative advantage of any kind, and it is usually in micro, underfollowed companies where it is easier to find (while access to management is better). The problem with these companies is that information about their business model, their industry, their products, etc. is usually scarce, which makes talking to management quite necessary.
Even when within my circle of competence, my main concern is that, as more commonly management is heavily biased towards the company, I am afraid I will buy their “wonderful equity story.” Especially since I cannot contrast that information, as it is scarce in the first place.
How do you avoid getting lured by management? Maybe using checklists? What kind of questions do you want answered and how do you ask them? How much should you rely on their answers? How do you contrast the answers?”
Thanks for your question. I do not rely much on talking to management. In fact, I prefer not to talk to management. I know a lot of value investors feel differently. I can think of some situations where reading what management said in earnings call transcripts, etc. over a long period of time did help me understand the business. However, I cannot think of any cases where talking to a member of management myself was useful. So, I’m not as much at risk of falling for a “wonderful equity story” as many investors might be. I do, however, read investor presentations. I do get management’s take in shareholder letters, press releases, earnings call transcripts and investor day presentations.
There are a few ways to avoid being taken in by management’s enthusiasm. One very good way of doing this is to research stocks in peer groups. Say I’m interested in Southwest Airlines (LUV, Financial). I do not have any interest in buying another U.S. airline. How can I be more objective? I can research Southwest, American (AAL), United (UAL), Delta (DAL), Alaska (ALK) and JetBlue (JBLU) all at the same time. When Quan and I were writing "Singular Diligence," we always picked five peers to compare to the stock we were interested in. There are a few reasons for doing this. One, it lets you see if it’s just this stock that is cheap or if the whole group is cheap. Two, it gives you a better understanding of the industry. Three, it lets you see if there is a better business in the group than the one you are looking at.
Picking the right industry is very important to me. Sometimes, it can be more important to pick the right industry than the right business in that industry. You need to pick an industry where competition is not going to destroy even a good business with a rational, long-term oriented management team. We picked Car-Mart (CRMT, Financial) for the newsletter. That’s an example of a good business in a potentially not so good industry. When we researched that stock, we found no evidence that other competitors in the industry – especially those who extend more and more into subprime auto loans when credit is loose – are good, rational competitors. Our biggest worry with that stock is the damage that irrational competition can do when credit is too loose. Car-Mart is not insulated from competition. It will lose business if competitors make loans they should not. This is not true of something like the advertising industry. In the ad industry, as long as the management team of the company you are looking at is doing its best to grow intrinsic value – the stock will do okay. Competitors cannot do much harm to each other in the advertising business. They can do a lot of damage to each other in the subprime auto loan business.
Sometimes you cannot find a lot of peers. Sometimes you can. It was easier for Quan and I to find peers for banks, MRO distributors, watchmakers and ad agencies. We really could not find any peers for “hidden champion” type companies like Tandy (TLF) and Breeze-Eastern (no longer a public company). The more niche a company is – the harder it is to find peers. This is a problem because very niche businesses are often very good businesses. Even with a company like Car-Mart, it was not easy to find real peers. None of the other subprime auto loan companies we could find had as high charge-offs as Car-Mart. We could not find any businesses that lend to as uncreditworthy customers as Car-Mart. In fact, that was one of our reasons for liking the stock. Although you could easily securitize subprime auto loans – we did not think it would be a good idea to securitize the kinds of loans Car-Mart makes. Car-Mart’s loans have such different loss rates and require such hands-on collections that it is hard to imagine other holders of that debt having as good an outcome as Car-Mart gets. We did not think it was safe to securitize the kinds of loans Car-Mart makes, but we could not prove that was true. We could not find detailed information on any company that was enough of a true peer to Car-Mart to know a lot about this business other than what Car-Mart’s management told us.
In cases where competition is not very direct or very intense, peers can sometimes provide information about each other. For example, we learned a little reading about Prosperity (PB) and Frost (CFR, Financial). They are both big Texas banks. And, in fact, Prosperity’s management said that when there is a bank up for sale in Texas, the first bank to get a call is probably Frost. Then Prosperity. Frost gave some vague information that suggested it sees a lot of deals and makes very few. But Prosperity has done a lot of deals. Prosperity says that they think they are the second bank you call in Texas when you are looking to sell – and that maybe Frost is the first bank people call. Based on that, we know that Frost passes on a lot of deals. I am sure I could find a quote somewhere that has a Frost CEO saying something like “We pass on a lot of deals”. But it’s not as convincing as when Prosperity says that Frost probably sees as many deals as they do and does not acquire as much. Other industries like ad agencies, MRO distributors and direct auto insurers (Progressive and GEICO) fall into this category of peers that are willing to talk about each other honestly. We talked to some people at the different MROs. They all said they had the best business model. Grainger (GWW, Financial), MSC Industrial (MSM) and Fastenal (FAST) all have different business models. They have different levels of online and offline businesses. Some – like MSC – ship very directly without using stores at all. Others, like Fastenal, make small-format stores near the customer a big focus. They even want to grow them. These peers will talk in detail about why – at least for them – their system is more economical than if they adopted the competitor’s system.
Now, I will be honest with you. Quan and I ran all the cost numbers we could on Grainger, MSC and Fastenal. The truth is we never could come to a conclusion about which model has lower costs. They have different types of customers. In each case, shifting somewhat away from their specific system and adopting aspects of their competitor’s system would probably increase costs. They developed along with their customers. And they tend to be especially good at efficiently serving their specific customer types. If they had a different mix of accounts, their efficiency levels would be different. So, I cannot offer a clear conclusion on whether Grainger, MSC or Fastenal has the most economical model. But I can tell you that people at all three companies are willing to talk about the way the other two are run and the way their company is run and why they think their company’s approach makes more sense. I should also point out that these companies are “peers” more than competitors. Direct competition between Grainger, MSC and Fastenal for the same accounts is much, much lower than investors believe. If you read what a lot of investors, analysts, etc. write about these three companies – you would think they were the only three competitors in the industry. The truth is that something like two-thirds of the industry is controlled by other companies. And while there may be quality differences between Grainger, MSC and Fastenal – the differences are compared to the quality gap between the kinds of returns on capital these companies generate versus the kinds of returns on capital the local or regional competitors produce. Normally, these companies are going up against smaller, more local competitors. Those companies are not public so we cannot see detailed financial information on them. However, we can find some information on them as a group. It’s obvious that although Grainger, Fastenal and MSC account for less than half the industry – they account for a big amount of the total reinvestment made in the industry each year. Smaller competitors just do not earn enough money to reinvest large amounts of earnings in websites, large-scale distribution centers, etc. They cannot invest in the same level of automation, new systems, etc. If you look at the figures of even how much gross profit they are producing – they just cannot be spending as much per client on investment in future growth. That is something we might not know if we did not look at all three of these public companies plus whatever other companies we could find information on.
So, my advice on how to avoid getting caught up in one management team’s view of a business, industry, etc. is to get the views of all the managements of all the public companies in that industry. If you’re interested in NVR (NVR), do not just read about NVR’s business model. Read about the business model of some other – more traditional – homebuilders. Or read about LGI Homes (LGIH). LGI is sort of a nontraditional homebuilder too. But it’s nontraditional in a way that is different from NVR.
There are some cases where this will not be possible. And I do not have a very good answer of how to look at these companies. But Quan and I did try to find peers for all companies – no matter how small and niche. One good example – which we never did an issue on – is Transcat (TRNS, Financial). Transact has a $70 million market cap, so it’s a small company. It’s a micro-cap in fact. It’s also in a niche business. Transcat distributes instruments used for measurement, testing, etc. It’s not a small industry, but it’s a fragmented industry. Many competitors are regional. There are some companies – like Electro-Rent (ELRC) – that will show up as “peers” when you search for Transcat online. However, the business model of Electro-Rent is not similar to the business model of Transcat. Furthermore, our research was complicated by the even “niche-er” nature of what we were interested in. Quan and I really did not care about Transcat’s instrument distribution business. What we were excited about was the calibration business. Calibration is a service. And we thought that the economies of scale in calibration for Transcat could be big. When the company first entered this business it would not be making any profit. Later, it would show a tiny operating margin. After that, profit growth in this segment would always be higher than sales growth as operating margins climbed higher and higher. That is the kind of thing that is very hard to learn about without relying on management. How much was Transcat really going to focus on the calibration business? How big are the economies of scale in calibration? How quickly could this business grow? What would Transcat look like in five years?
The “what will this business look like in five years” question is the big one for me. Sometimes, it’s worth listening to what management has to say. Usually, you can find some peers to compare a company to. But, yes, in the case of something like Transcat – you may have to rely a lot on what management says the company will look like in 2021. You have objective data on what Transcat looks like in 2016, but that does not matter. If I buy Transcat stock this year – I’m not going to be selling it till something like 2021. So, what matters is what Transcat will look like in 2021. How big will calibration be? What will the operating profits from calibration be in 2021? Transcat is such a small, niche business in such an underanalyzed industry – that you might have to either trust management or just ignore the stock. I’m not sure you can get a lot of information from peers. So, Transcat is the kind of stock where you might end up believing in a tale management is telling that turns out to be a pipe dream. That is one of the risks of being a longer-term micro-cap investor. I do not know how to avoid it entirely.
Disclosure: Long CFR.
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