Maximum Financial Risk: Ask The Right Questions by CSInvesting
[cfa-society-of-chicago-june-2015-final Note pages 16 through 18 on Grainger and Fastenal. GWW_VL Jul 2014 and Fast VL. Since the prices are high and their gross margins are way above the competition, what can change that? Ask the right questions.
Length of S&P 500 Bull Markets
Add it all up – low rates, increasing P/Es, high margins and tremendous corporate profitability – it’s no wonder that’s left us with a bull market that has entered its seventh year, the longest in at least 70 years.
As the British journalist and businessman Walter Bagehot once wrote, “at particular times, a great deal of stupid people have a great deal of stupid money.”17 We try not to be among them but that doesn’t mean their actions won’t have an impact on the markets and therefore our portfolio.
It’s not just what you do that can make you money over time, it’s what you don’t do. You might be able to make money by buying a 30-year Treasury bond. We don’t know that rates won’t drop another 1%, causing your bond value to jump more than 20%, assuming it happened immediately. With rates at all-time lows, we’d prefer not to make that bet because just a 1% increase will cause a price decline of around 18%. The risk/reward’s not there. The same thought applies to stocks. Buying a company at 20x earnings, hoping for growth in earnings and a future P/E of 22x is not a recipe for good risk-adjusted returns.
It might be helpful to show some outtakes, that is, those companies that haven’t made it into the portfolio to help you climb inside our heads. Understanding why we don’t do something highlights process as well as what we do own. I’ll describe why we’ve stayed away from a couple of companies and a sector in which we have invested in in the past but whose valuation we believe does not take into account a worst case scenario that could reasonably develop. The following is not meant to be interpreted as a short thesis but will hopefully illustrate how challenging this environment is for value investors.
Grainger and Fastenal are two well-run industrial distributors that have historically delivered fantastic returns on capital. Their customers depend on them to offer product breadth, good prices and speedy delivery. Mr. Market has rewarded their shareholders with great stock performance and a projected Price/Earnings ratio of ~20x. These companies are middlemen distributing products made by others. Distribution can be a great business and both of these companies have been well-run, satisfying both customers and shareholders alike. But as we studied their businesses, we questioned if that would be the case in the future.
Distributor Gross Margins
They both already earn incredibly high gross margins: Fastenal ~50% and Grainger in excess of 40%. That’s unusual for a distributor as you can see in this table that shows ten distributors serving different end markets. The average gross margin ex-Grainger and Fastenal is 19.2%, dramatically lower than both of them.
One significant difference today is that efficient and ruthless competition in the form of Amazon.com is coming after them. What began as Amazon Supply with more than two million SKUs has morphed into Amazon Business with hundreds of millions of products for sale. Commercial customers have been asking why can’t shopping for their business be as easy as shopping on Amazon – and now it is. Amazon.com doesn’t care about short-term profits, willingly sacrificing price in an effort to gain market share. We’ve already seen how they’ve successfully attacked other entrenched and once successful enterprises. In the book business, for example, Borders went bankrupt and Barnes & Noble’s operating income remains roughly down by half from its peak a decade ago.
Amazon Business is still relatively nascent but has a broad product line, lower prices and free shipping on orders over $49. Asking if Grainger and Fastenal can sustain their unusually high margins becomes too difficult a question for us to answer. Despite being very well-managed, they may not be able to deal with the inevitable reality that strong competition could cause margins to decline. Amazon also likely has better buying power and more leverage with UPS.
The market therefore poses the following questions: Do you believe that these companies will be bigger and stronger down the road? Will they earn more? Will they spend their cash wisely? Is their high valuation therefore justified? Even though Grainger and Fastenal combined have less than 10% market share and other competitors will probably cease to exist, we still find it tough to bet on margin stability.
Fastenal/Grainger Margin Scenario Analysis
Although we don’t know what will happen, we can see that for every 1% change in gross margin, earnings would decline 7% and 4% for Grainger and Fastenal, respectively. Assuming a constant P/E, then the stock price change would be commensurate. This is an admittedly oversimplified view that doesn’t take into account any change in revenues or share count, but it’s enough for us to want to stay away. It’s not that we wouldn’t buy these businesses. It’s that at these prices, with these questions, we can’t purchase them and have our desired margin of safety.
You may reach a different conclusion but at least ask yourself this: Amazon.com trades at an even higher valuation – a $200 billion market cap and it’s losing money yet its future may well justify that price. If Amazon.com wins, won’t it be at the expense of companies like Fastenal and Grainger? Most likely, either Amazon.com has a great future or these two distributors do. That’s the kind of market in which we find ourselves. Some good questions with one side or the other likely to be surprised at the answer.
I’ll briefly touch on another example but keep it at even a higher level. The aircraft leasing industry is the lessor of planes to airlines around the world. The industry has been around for about 40 years and there have been many different points in time when one could invest in the sector at discounted valuations through public equities, distressed debt and equipment trust certificates. I have been involved in all three including International Lease Finance equity in the 1980s, equipment trust certificates in the 1990s and International Lease Finance debt in the 2000s. In each case, the securities were trading at a price that justified the risk that one must assume in owning a leveraged business that is effectively a financing arm of the cyclical airline industry.
Global Airline Industry Profits
At prior points, these companies have traded more inexpensively on mid-cycle earnings than they do today. This has been when their airline customer has suffered due to recession, overleverage, price wars or excess capacity.
The industry is in fine shape today. Lessors are able to extract higher than normal lease rates while having a lower than average debt cost. This is contributing to historically high spreads and net interest margins (NIM).
Aircraft Lessors – Net Interest Margin (NIM)
As you’d expect, the look through value of the planes in a lessor’s fleet trade at a premium in good times and at a discount in bad times.
See full PDF below.