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Geoff Gannon
Geoff Gannon

Buying a Good Business in a Bad Industry

Only buy if the stock occupies a market niche or is the clear market leader

Someone emailed me this question:

“How do you feel about good businesses in poor industries? Are there any industries that you just won’t even consider?”

No. In theory, I do not think there is any industry where I would not consider a good business worthy of investment just because it was part of that industry. But, this question is not that simple to answer. Let me start by giving some examples of businesses I like in industries I do not.

I wrote a newsletter about Progressive Corp. (NYSE:PGR). I do not mind direct insurers, so I am fine with companies like Progressive and GEICO in the U.S. and Admiral in the U.K. There are differences between these three companies, but they are different from auto insurers that get all their policies through agents.

Most insurance that covers general risks is not very interesting to me. I have invested in insurers before, but it would be pretty hard for me to ever imagine investing in a life insurer or something like that. If the insurer markets directly (online, through direct mail, etc.) and covers non-standard risks or operates in some specific niche, I would be more likely to consider those kinds of insurers. Progressive does both. It got started in non-standard auto and also has a direct business. At the opposite extreme would be something like life insurance sold through an agent. Like I said, I cannot imagine ever investing in a company like that. It is the commodity nature of that kind of business that turns me off.

I picked America’s Car-Mart Inc. (NASDAQ:CRMT) for the newsletter. The company sells used cars. However, it really sells those used cars in order to lend money at high rates to finance the purchase of said cars. So, it is really a deep, deep subprime lender. I do not like the car loan industry. I made that clear in the report I wrote about Car-Mart. I felt then – and feel even more so now – that lending for the purchase of cars in the U.S. is way too loose. This is a cyclical problem for Car-Mart. I also felt the kind of loans it makes are difficult to securitize. You do not need to know anything to make car loans to prime borrowers. It is like letting prime borrowers carry a balance on their credit card. There just is not much risk because of who the borrower is and how they are likely to treat their debt. They tend to do what they can to pay it off. They are not going to walk away from the loan and are unlikely to declare personal bankruptcy.

The kinds of loans Car-Mart makes are very different. For one, I think borrowers often buy the car to get to a job. So, if the car breaks down (Car-Mart’s cars are usually quite old) and needs repairs, or if the borrower loses their job, ends up in the hospital or gets divorced – I think any of those events could trigger a default. The borrower certainly did not have good credit to start with – and often really had no credit. If they no longer want the car, they really are not worried about failing to make payments on the loan. This makes quickly contacting borrowers who have missed payments, aggressively collecting loans and also modifying loans (no one at Car-Mart wanted to talk to us about modifications, but I am sure they do them) really important.

Therefore, I thought Car-Mart could be a good business in a bad industry, but it is really niche and it needs to stay really niche for this to work. First of all, Car-Mart is really for borrowers with no credit at all. Credit checks would not provide meaningful information for their customer base. So you are lending blind compared to what some other lenders do. Second, Car-Mart is basically just in the Southern U.S. And third, even within the South, Car-Mart has been far more successful outside of major cities. For example, the company is in Texas, but there is too much competition for car loans in the major cities. Parts of Texas are very rural, but the biggest cities in Texas are some of the biggest in the U.S. You have to avoid those if you want to stick to your niche.

I am not sure how good of a stock pick Car-Mart has been. In some ways, we were completely right. In other ways, it did not matter that we were right about the things we were right about. We were right about both the company and the industry. However, the damage that excessive competition in this loose credit part of the cycle has done is really serious. The behavior of Car-Mart's competitors and the likelihood of the Federal Reserve keeping rates low for a long time were both things we considered when we picked Car-Mart.

Even if Car-Mart works out well as an investment, it will still have been riskier than I intended the investment to be. The only way Car-Mart can perform well is if management demonstrates willpower and restraint beyond what a normal management team would. There has always been a risk that Car-Mart will eventually give in to making loans in ways I think are unacceptable for the long-term health of the company and the industry.

Car-Mart has relaxed its standards in certain ways – for example, it has made longer loans. I do not blame them for doing that. Competitive pressure really forces its hand. Some of Car-Mart’s safer borrowers can actually be poached by more mainstream lenders. I personally think it is a little crazy that there are lenders, who have never experienced the kind of loss rates Car-Mart deals with routinely, making loans to its ex-customers. When I picked the stock, I knew that kind of competition was possible if the Fed kept rates low for a long time. Car loans are pretty short term.

Lower quality car loans have nice yields compared to other assets with shorter maturities. If investors want yield but do not want to go out very far in terms of how long dated the bonds they buy are – because they know interest rates will be higher in the future than they are now – then assets like subprime car loans are going to get overvalued. If those assets get overvalued, some people are going to create subprime car loans when they really should not. So, here we can see the industry problems we know are damaging Car-Mart, even though I said it is the most niche auto lender you can find in the U.S. That is the danger you run into.

I do not like the car loan industry, but I do like Car-Mart. So far, I would say the results have been mixed. I was not wrong about anything, but I might have been better off taking my concerns about the industry more seriously and just ignoring any business related to car loans.

Village Super Market Inc. (NASDAQ:VLGEA) is another example of a business I considered to be good in an industry I considered to be bad. I do not like generalist supermarkets because I think the store level economics of these stores are poor. They are not necessarily dismal, but they are still not good.

The way competition in generalist supermarkets works is that households generally shop at one supermarket. If there is a family with two kids, a mom and a dad, and the mom makes 70% of the grocery shopping trips – then she probably makes those trips to the same local place week after week. Sure, some groceries are purchased in smaller batches during the week by other people in the household or as part of trips to discount chains like Target (NYSE:TGT) or Wal-Mart (NYSE:WMT), but those trips are not competitively meaningful. There is a circle of convenience around a household that probably extends for more than about five minutes of driving time and almost certainly does not extend beyond 15 minutes of driving time. Grocers within that circle of convenience can compete to be the primary grocery shopping destination for that household.

Village – which operates Shop-Rite stores in the state of New Jersey – is generally competing with stores like Kings and Stop and Shop. They could also compete with big format stores like Wegman’s that are regional to that part of the country (but extend far beyond the state). They also compete with some supermarkets that have different business models. Those “supermarkets” include Whole Foods (NASDAQ:WFM) and The Fresh Market. The Fresh Market – which had been public – was officially classified as a supermarket for industry purposes. However, even in its own 10-K, The Fresh Market said it was not a supermarket, which I agree with completely. They do, however, present a problem for stores like Village because they can put a smaller format store that generates enough free cash flow to provide a shorter payback period on the investment. This is critical because it means The Fresh Market could enter markets where no one would put an additional Shop-Rite, Kings, Stop and Shop or Wegman’s location.

So, why did I like Village? As I just laid out, the economics of the supermarket industry are very, very local. What matters most is the population within your circle of convenience. If you have a supermarket with very few and very poor households within the store’s radius of convenience – that store will have a low return on equity. If you have a supermarket with very many and very rich households within the store’s radius of convenience however – that store will have a high return on equity. This factor is huge. I would estimate that equally well-run supermarkets in a poor, rural area and a rich, dense suburban area (think Northern New Jersey or Southern California) could have pre-tax returns on equity of as low as 10% and as high as 30% respectively.

In other words, a supermarket in a poor, rural area is a below-average business. A supermarket in a rich, suburban area, however, is an above-average business. The advantage here is location. I even pointed out in the newsletter that although Village Super Market has much higher unlevered returns on tangible equity than Kroger (NYSE:KR) does – I do not think it is better run. In fact, I suspect Kroger is – in some respects – better run than Village. Frankly, I think Kroger is really well run, and I know Village’s top executives are a bit overcompensated. So, there is even a little bloat to the SG&A line that is the result of being a family controlled company.

Kroger has a good store format and is well run, but its store base is spread over a lot of the U.S. that is not particularly rich or particularly suburban. Village’s stores are almost entirely located in the state of New Jersey.

New Jersey is the best state in the U.S. for running a supermarket. On top of that, a lot of those stores are in Northern New Jersey. Northern New Jersey is the best part of the best state for running a supermarket. The volume of business that an incumbent supermarket does in a Northern New Jersey town is just much higher than what supermarkets in the rest of the country can do. So, it is not fair. It is just a historical accident. Some companies happen to have been founded in the New Jersey area and some companies happen to have been founded in the Midwest. The supermarkets in New Jersey got to sign their leases, build their parking lots and so on at a time when it was possible to put in a new supermarket. They then expanded those stores in size. To now put in a new supermarket of 60,000 to 80,000 square feet in a densely populated suburban region like Northern New Jersey is just unrealistic.

Once in a while, you can get lucky and get the site you want. But even then, you would have no local scale. Your brand would be new in the region. You just cannot put in enough new supermarkets from outside the state to compete away the superior returns the existing supermarkets have. Now, the downside to this is that Village cannot really grow, but that was not the problem I had to consider when I picked the stock.

When I picked Village for the newsletter, it was actually trading at a lower price-sales ratio than most of its peers. Village has better locations than those peers. If auctioned off separately, each of its stores would fetch a higher price relative to sales than a competitor’s store. A company like Kroger would pay a lot to control the locations Village already does. That is what attracted me to Village.

So, what gave me confidence investing in a supermarket? It was the knowledge that land that could be developed for use as a big format supermarket was very rare in all of Village’s local markets. Supermarkets do not compete across state lines. To compete in New Jersey, you need to build a store in New Jersey. To compete well with a 60,000-square foot store, you need a 60,000-square foot store of your own. I knew that no matter how eager competitors were to put such stores in New Jersey – it just was not going to happen. Very few development projects along those lines would ever be approved. Even if they were eventually approved, they would take forever to actually get done. It did not make sense for a nationwide supermarket chain to spend a lot of time and attention on trying to crack into the New Jersey market. It would be a lot of work that would not move the needle for the corporation as a whole.

All three of these examples kind of focus on niches. I am willing to buy into almost any industry as long as there is some “moat,” as Warren Buffett (Trades, Portfolio) calls it, that would insulate the company from irrational competitive actions taken by competitors. I would buy Progressive even though I do not like the insurance industry in general. I might buy Car-Mart even though I do not like the car loan industry – although that idea has really been tested by the actions I have seen competitors taking. And I would – in fact, I did in the past – buy Village even though I do not like the supermarket industry. At the right price, I would even consider a supermarket operator like Kroger, but it would have to be the right price.

I am really not going to invest in a company that I think is going to make less than 10% a year after tax on its tangible equity. If a stock is really, really cheap – I would buy it even if the ROE was as low as 10%. There is a catch though. The lower a company’s ROE, the more certain I have to be it will achieve that return on equity. So yes, I would buy a very, very cheap supermarket stock or a very, very cheap insurer or something like that if the return on equity was in the 10% to 15% range. I would, however, still need to see some sort of insulation from competition that proved to me the company would never end up with an ROE in the 5% range.

Obviously, a big structural advantage over competitors could do that. For example, I have looked at Southwest Airlines (NYSE:LUV) in the airline industry, Carnival (NYSE:CCL) in the cruise industry, Western Union (NYSE:WU) in the cross-border money transfer industry and Progressive in the auto insurance industry. Among major competitors, all of these companies have the ability to survive a price war longer than the other players in the industry. It would be difficult for Southwest to earn a 9% return on equity year after year for very long without other airlines earning closer to nothing. So, having a structurally supported profit advantage – it is usually due to scale and lower costs– over the competition would make me a lot more likely to invest in a business in a bad industry.

Generally speaking, a good business in a bad industry needs to either be the clear market leader or inhabit a niche others cannot invade. I would say the best niche is usually a local one. It does not matter to the big four U.S. airlines how rational or irrational competition among European, Middle Eastern or Asian airlines are. Southwest does not fly to those places, so it is possible to invest in the market “niche” of major U.S. airlines even though I would be worried about investing in airlines in parts of the world where passenger traffic is growing rapidly.

You will notice that in all these examples, I have focused on more “settled” industries. My biggest rule as far as industry selection goes is to always avoid bad, immature industries. If you have to invest in a bad industry, at least make sure it is a mature industry. The easiest way to go broke is to invest in a business that is growing quickly and unprofitably. Airlines today might be viable investments, but they were not in their fast growth phase. Likewise, I would never buy a supermarket anywhere there is plenty of land to build a new one. I would only buy a supermarket in a town where land is scarce.

So yes, you can invest in good businesses in bad industries. Always avoid young, bad industries however. If you do invest in a good business in a bad industry, make sure the business is either the clear market leader or occupies a niche that protects it from the bad behavior of its competitors.

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Geoff Gannon

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