Forage Capital 4Q16 Letter To Investors – This trinity path to wealth

General ElectricBy General Electric Company (w:File:General_Electric_logo.svg) [Public domain], via Wikimedia Commons

Forage Capital letter to investors for the fourth quarter ended December 31, 2016.

Forage Capital 3Q16 Letter To Partners

2016 Hedge Fund Letters

“Prosperity knits a man to the World. He feels that he is ‘finding a place in it’, while really it is finding its place in him.” – The Screwtape Letters, C. S. Lewis

Dear Partner,

For the quarter ending December 31, 2016, Forage Capital (“the Fund”) returned +4.1%, net of all fees and expenses compared to +3.8% for the S&P 500 Total Return Index. The two largest contributors to performance this quarter were ODFL and MRC; the two largest detractors were OAK and SELF. From inception on July 14, 2016 to year-end, the Fund returned +3.4%, net compared to +4.8% for the S&P 500 TR Index. Around 54% of the fund’s assets were in cash at year-end. The other 46% was unevenly allocated across 11 stocks with a median market cap of $9bn. Lofty valuations and the absence of meaningful, sustained sell-offs within the universe of businesses I find investable, have confounded my efforts to put more capital to work during these first 6 months of the fund’s life. Considering our significant cash allocation, should the broader averages continue their quiescent ascent, the fund’s performance is highly unlikely to keep pace.

It appears I goofed in purchasing Global Self Storage (SELF) last quarter. I was enticed by the prospect of a responsibly capitalized REIT rolling up and applying easy operating aid to a fragmented landscape of mismanaged self-storage properties in 2nd tier markets that seemed relatively insulated from excess capacity, and was further encouraged by persistent open market stock purchases by Mark Winmill (the CEO) and Board Members. But then, in the Holiday Spirit of giving, on the day before Thanksgiving the Company stealthily announced an agreement to purchase, at an egregiously inflated valuation, a self-storage entity in which Mark had a substantial personal ownership stake. Investments in small cap companies like SELF (~$35mn market cap) are primarily jockey bets and I’ve learned through expensive mistakes that the slightest whiff of value-thwarting self-dealing is usually reason enough to punt. I sold all our shares at an 11% loss.

Something I’ve also learned in perusing the quarterly updates of other fund managers is that it’s helpful to occasionally probe investing tenets and frameworks, and so, wary of further amplifying the crusading screech that value investors have long pitch-perfected, I’ll start with some pedantry commonly applied to so-called “compounders.”

Forage Capital

This trinity illustrates the path to wealth everlasting: purchase, at a sane price, a company whose unique capabilities allow it to earn a return on capital that exceeds that capital’s cost against an opportunity set vast enough to consume meaningful reinvestment. The box labeled “moat” is the only one with three outbound arrows because absent a sustainable advantage that repels determined competitors, today’s profitability is ephemeral and tomorrow’s growth is destructive. And without understanding an enterprise’s excess returnenabling edge, we can’t confidently ascribe value, so it follows that price-to-value assessments are moot. That sounds droolingly obvious when articulated, I know. But in practice I’ve found that, rather than consider these three factors in balanced unison, many investors subordinate the foundational pillar of moat, casually corralling it as addendum to an alternative angle of attack….

Isolated faith in huge, dynamic markets provokes our basest instinct to blindly extrapolate yesterday’s growth rates under misguided enterprise value-to-potential market size symmetry intuitions with little consideration for why, besides some tenebrous sense that what it does tangents some buzz word nourished trend, the company is uniquely positioned to sustainably capture value. On the flip side, well-intentioned TAM estimates, tightly circumscribed by our limited imaginations, often underestimate the extent to which an enterprise with a capably managed moat can profitably carve innovative niches, redefine use cases, and bisect orthogonal markets: early in its corporate life, Google believed its primary revenue source of licensing its searc  engine to online portals could be supplemented by an advertising sideshow that might constitute 10%-15% of its revenue at some point; Dwight & Church’s baking soda (Arm & Hammer) was first marketed as a baking ingredient before it blessed laundry detergent, deodorant, toothpaste, and other consumables; that brick & mortar bookstores once represented Amazon’s primary competitive threat seems quaint in retrospect.

Whether assessing value-accretive market share gains in an established market or potential surplus capture in an embryonic adjacency, we’re usually better off starting from the inside and working our way out (understanding the moat that enables profitable participation in an expansive market), rather than the other way around (holding a high conviction view on an industry trend and buying stocks that “play” on that trend). It’s the difference between, say, owning Netflix because you think its flywheel of [subscriber growth/engagement, recommendation engine relevancy, and intelligently bid/created content] offers an insuperable competitive advantage over alternative entertainment providers, and doing so primarily because you’re confident that streaming video will continue taking viewership share from linear TV (we don’t own NFLX). But given that a stock cares not why you own it, do the reasons matter?

Here’s a fictitious, half-way credible stock pitch I whipped up:

“Company X is a small, branded snacks company based out of California with a long but unremarkable history. Unremarkable, that is, until now. Its newly branded additive-free energy bars are capitalizing on the erumpent appeal of healthy organic snacks, which are rapidly stealing share within the perennially stodgy, low growth convenience goods category. Following two years of 18% compounded growth, revenue during the most recent year catapulted 80% higher, but even so, the Company’s total sales make up just 1.5% of a $16bn organic foods market that I expect will grow by low-to-mid teens percent for the foreseeable future. Although the stock price has quintupled over the last year, a 5% market share in five years equates to 7x today’s revenue and, assuming the company holds its margins and the stock holds its current low-30s multiple, a 7-bagger in the stock.”

You’ve likely heard many versions of this cheesy pitch, whose extrapolative allure anesthetizes the pressing discomfort of not knowing why this enterprise, in particular, is well positioned to compete in what seems a crowded, barbarously competitive landscape with few entry barriers. To me, it looks like a “pass.”

But so, Company A is actually Monster Beverage, the addressable market is alternative beverages, and all the facts of that pitch were true when I passed on the stock in 2005 (back when it was called Hansen Natural), grimacing from the sidelines as it zig-zagged a route from ~$2/share to its current price of $45.

Passing on this stock was clearly wrong. But was it unreasonable? To me, Monster was a middling juice company that hit pay dirt capitalizing on a feverish but likely transient fad in a congested field of undifferentiated competitors, including one dominant energy drink brand and two traditional soft drink incumbents with the marketing heft and privileged retail shelf space to capture whatever surplus materialized. This narrative held more sway with me than another, more hopeful one about a talented management team steering luridly fluorescentgreen shambolic lettering on elongated can (or whatever) from frontal consciousness to limbic sentience. While I could have speculated on Monster’s growth rate’s persistence, unable to discern the Company’s edge, let alone the sustainability of its end market, I almost certainly would have mistaken innocuous hiccups for death-impending gasps and fumbled during inevitable bouts of weakness, like when the stock sold off by nearly 70% as it did between ~September 2007 and ~June 2008 on decelerating revenue growth and margin contraction, and even assuming I’d held to June ’08 through gritted teeth, I’d probably have been relieved to exit the stock when it recovered 30% two months later or nearly doubled from its lows 6 months after that. In my shaky hands, this >20- bagger was always an illusion.

[Aside: To be clear, this isn’t about incidentally right decisions with dazzling outcomes whose obviousness is, always in retrospect, applauded with knowing flourish. We’ve all politely marveled at the tale told by the guy who knew a guy who plowed half his life savings into Amazon stock in the early 2000s and forgot he owned it for next 20 years, and have been bludgeoned by the adjoining advice it’s spawned about securing today’s “winners” in a lockbox, barred from further reassessment that for reasons related to behavioral biases concerning overconfidence and anchoring and compulsion-to-action, etc. can only foil the lasting wisdom of a single judgment call, which wisdom shall moreover passively become more valid over time as the appreciating position consumes a growing proportion of investable assets.

Against the protean tapestry of fierce competition, it makes little sense to conceive of moats as perpetual rights. The key strength of both Moody’s Investor Services (MIS) and Nielsen’s Watch segment has long been anchored by a dynamic in which debt issuers/investors re: Moody’s and media companies /advertisers re: Nielsen, coalesced around these companies’ eponymous ratings, which ratings’ mounting industry adoption fomented veritable trade currency status used to peg relative value across fixed income securities and media content for MIS and NLSN, respectively, reflexively reinforcing ratings reliance by ecosystem constituents.

But the competitive backdrop for each company has evolved quite differently, with material consequences on their shared legacy advantage. Synchronized mass consumption of uniformly delivered, media monolith-curated content has entropically atomized across time, audience, and platform, forcing ontological concerns that impugn the continued relevance of traditional panel methodology for measuring audiences and offering new entry points for competitors who – unburdened by the yoke of linear TV incumbency – have built direct, multi-faceted measurement capabilities off digital scaffolds. 1 In contrast, MIS’ persistent incumbency strength reflects staid patterns of debt placement, asset manager work flows, and just an overall institutional and regulatory lassitude so intractable that even after badly failing investors during the last financial crisis, when its grossly conflicted issuer-pay revenue model was laid plainly bare, its ratings – and those of other rating agency oligopoly’s constituents – continue to play a central role in the proper functioning of global debt capital markets.]

As I compare Monster’s current trailing 12 month financials to those of 2005, it’s now glaringly clear that the company has created tremendous value – pre-tax unlevered profits have increased by $1bn on $4.2bn in incremental assets, the Monster-branded beverage line has multiplied, and distribution has flourished, and while I still, a decade+ and 2,000% later, cannot profess much greater confidence in the forward sustainability of whatever advantages enabled these results, my befuddlement reflects more the limits of my own understanding than some stubborn indignancy that this perceivedly moatless company could thrive for so long.

I don’t want to hide behind “value lies in the beholder’s eye” but I largely will, because although treating stock ownership as a vigilant journey requires trendline-transcending conviction in some enduring fundamental musculature, the stuff that resonates – I mean, really seeps into one’s marrow – as value-sustaining, is colored by personal biases and experiences that elude systemization, and what seems limpidly obvious to one rational investor is often received by another with a skeptical squint.2 This hippy dippy bluster is not to say that frameworks don’t matter; they yield few answers but evince necessary questions and are certainly more useful than the low-cal, incantatory value investing sciolisms so often fecklessly wielded like plastic swords.3 I’m just saying that, within those frameworks, the plausible story arcs we invent and negotiate, the degree of credibility we assign to each, and the resulting confidence needed to carry a position over time, is a personal endeavor. To the extent investment skill exists at all, this must be so: too much systematization (a formulaic approach from start to finish) yields performance that is easily replicated; too little of it (trading on gut) yields no assurance of replicability at all.

  1. A company’s equity value is the PV’ed sum of cash flows available to shareholders. But how does a company maximize this value?
  2. By investing lots of cash at really high returns for a really long time. But how?
  3. By fostering unique advantages that competitors find difficult to replicate. Like what?
  4. Those advantages typically fall into a few general buckets – supply side scale economies that enable a low-cost advantage, customer captivity (switching costs, search costs, habit), and network effects (which borrow some elements of both).

How does one build a differentiated brand that translates into a sustainable edge and under what conditions will that brand’s extension into other product lines succeed? Why are some brands more successful at nurturing habitual consumption than others? Will Harley Davidson’s brand remain just as relevant 10 years from now amid shifting demographic patterns? Can and will Google disintermediate OTAs the same way OTAs disintermediated offline travel agencies? Can commercial insurance carriers disintermediate traditionally sticky broker relationships as personal lines underwriters have? How do the scale advantages of an integrated PBM model compare to an independent one in the context of a consolidating value chain? Which content providers, if any, will capture equivalent economics across a comparably large audience outside the traditional MVPD bundle and why? How does an enterprise cloud provider foster user lock-in in an increasingly modularized computing environment?

Et cetera. We might curtail such concentricized involution at the early stages of investigation by, for instance, at least starting with a high degree of conviction that the end market a company serves (or hopes to serve) will exist in meaningful form 10 years hence, which lack of conviction, as mentioned earlier, was a key reason for passing on Monster.4 My anti-Monster is PPG, a soundly capitalized century+ old global5 coatings manufacturer that has averaged low-teens unlevered after-tax return on capital over the last two decades6 and whose stock I toe-holed at 15x trailing earnings after the Company pre-announced disappointing 3Q earnings on volume weakness in Europe, where it had previously witnessed relatively strong growth.

The increscent abstractions of our daily experiences are still mostly framed by a tangible backdrop that’s remained invariant for generations. The building honey-combed with apartments like the one you woke up in, the twin-aisle you boarded and the car you reluctantly drove across the cast-iron bridge segueing to your childhood home for the holidays – all that infrastructure and its attendant complex weave of subcomponents are coated with complex concoctions of resins, additives, pigments, and powders that extend their useful lives and offer various functional and aesthetic benefits. Salient among PPG’s stable of products: infrared-reflecting / solar-energy deflecting pigments applied to metal siding, roofing, and other architectural components that reduce a building’s air conditioning costs; single-component coatings that delay corrosion on metal substrates, cutting labor and inventory carrying costs for heavy-duty OEMs who have traditionally relied on a 2-coat system; “strippable” coatings systems that allow airlines to repaint aircraft with the original base primer intact, reducing downtime by up to 40%; and light weight fuel tank and fuselage sealant with nearly half the prior generation’s density that can shave up to 2,200lbs off the weight of a wide-body, yielding considerable fuel savings.

The Company’s competitors and industry structures vary by vertical, with architectural (where PPG is #2 by revenue behind Sherwin-Williams in the US and Akzo Nobel in Europe), general industrial (#2 behind AkzoNobel), and auto refinish (leading player along with Axalta) relatively more fragmented than automotive OEM, aerospace, and packaging. Over at least the last several decades, large coatings companies have competed rationally, realizing consistent pricing gains. PPG pushed through low-single digit price increases even as raw material feedstock costs (70%-80% of the Company’s cost of goods sold) and volumes declined dramatically during 2008-2009, and has mostly maintained pricing over the last 2 years even as petroleum-based input costs faded once again.7 But this is almost beside the point. Price is a deeply subordinate consideration for customers given the nominal cost of coatings relative to the total bill of materials and labor – an OEM might spend $100 per vehicle on coatings and 4x-5x that amount on application, while a collision shop will spend less than $50 of paint on a $2,000 job. Replacing an incumbent e-coat supplier can shut down OEM plant production for a week, the lost variable profits and reduced fixed cost absorption dwarfing any incremental cost savings from a cheaper coat.

For aerospace, auto OEM, and large auto refinish customers, technology and a reputation for quality and service are among the most important competitive stress points and represent formidable entry barriers. Market share continues to shift towards large, sophisticated coatings producers who can meet the intensifying technical requirements of OEM customers at global scale, benefitting PPG, which has typically led the industry in coatings innovation, spending more on R&D than Valspar/Sherwin Williams, RPM, and Axalta combined and leveraging that investment across multiple industry verticals. Manufacturing coatings that consistently cohere to increasingly diverse substrates of exterior vehicle components, enable compact processing systems – with 2 enhanced basecoat layers obviating the need for a primer layer on a 5-layer job and “wet-on-wet” application eliminating a baking cycle – and ensure consistency in outcomes across plants in different regions, is a complex chemistry challenge inscrutable to smaller players with constrained R&D budgets and limited experience, but increasingly demanded by customers looking to maximize throughput while limiting operating costs and capital investment. As compact processing expands its current 15% penetration within global auto OEM builds, and continues breaching aerospace and increasingly, more fragmented general industrial markets, incumbents with demonstrated technical leadership should continue gaining share.

Whereas technology and global scale are critical attributes in aerospace and auto, local economies of scale and regional brand strength are more significant drivers of competitive advantage in architectural coatings, which constitute around 40% of the Company’s sales. As you might expect, the global architectural coatings market is also relatively fragmented, with the top 4 players accounting for 40% of a ~$55bn global market. 8 PPG has been one of the industry’s most active acquirers, and even after having directed nearly half of its free cash flow towards acquisitions over the last decade, mostly within the architectural coatings market, PPG’s #2 global position and 10% market share still offers a long runway for accretive consolidation as procurement cost reductions, back office rationalization, leverage on distribution costs from geographic densification, and supply chain consolidation drive low double digit returns on deployed capital. Through its most recent acquisition of Comex, an architectural coatings manufacturer with 4,000 stores in Mexico and Central America,9 PPG is successfully cross-selling legacy products and extending and densifying Comex’s presence in adjacent territories in Southern and Northern Mexico, where Comex is underrepresented. In its second largest recent acquisition after Comex, PPG acquired AzkoNobel’s unprofitable North American architectural coatings business and delivered mid-teens margins and return on capital within a few years by leveraging transportation, reducing procurement costs, and eliminating duplicative overhead.

Discerning PPG’s cyclical exposure and positioning is tricky given the Company’s diffuse end-markets, 10 not to mention the more general difficulty of calling the top or bottom of any single end market’s cycle and all the noisome rancor that topic provokes; but, I don’t think the Company’s exposures are as uniformly peak-cycle as one might perceive. I estimate that more readily-apparent cyclically peak ones like US auto OEM production and commercial construction together make up around 15%-20% of total revenue; below mid-cycle or secular growth pockets like Asia-Pac auto OEM, US residential construction, Latam architectural, automotive refinish,11 packaging,12 and aerospace constitute another 40%-45%; and I humbly chuck the remaining end markets somewhere in between. Within the 40% of PPG’s revenue that are represented by architectural coatings, around 70% is tied to repaints, which should be relatively more stable than coating demand driven by new construction builds. But, I don’t want to overstate the case. One need only glance at 2008 and 2009, when performance coatings and industrial coatings volumes declined 15% and 26%, respectively, to see that a deep, globally coordinated industrial recession will leave a bruise. Still, PPG has the balance sheet to withstand a severe downturn and if 2008 and 2009 are any guide, the Company should remain solidly EBIT profitable and churn prodigious free cash flow during troubled times as its earnings trend peristaltically higher by ~high-single/low double-digits per annum over several business cycles.

[Aside: I’ve read countless investment pitches in which the author offers phrases like “capital light,” “non-cyclical,” and/or “recurring revenue” to answer the question “why is this a good business?”, which I think conflates the concept of business quality, which addresses the extent to which a company can sustain and grow long-term economic profits, with that of business model, which relates to how and when a company generates profits in the literal sense. As discussed, Moody’s Investor Services is a good business, not because it is capital light per se, but rather because its ratings are so widely accepted among investors and deeply embedded in the regulatory framework of banks and the work processes of fixed income investors, that a) issuers are compelled to pay Moody’s for ratings to cost-effectively place their debt and b) potential competitors cannot achieve the same ratings liquidity and are effectively locked out of the market, thus c) further reinforcing system-wide reliance on Moody’s (we don’t own MCO as of year-end). The mostly non-recurring nature of MIS’ revenue, 60% of which is transactional, does not enfeeble this advantage. Likewise, NVR’s moat as a homebuilder, to the extent one exists, derives not from its land optioning business model (just as investing in derivatives is not inherently superior to owning the underlying), which is easily replicated, but rather from leveraging the local economies of scale that stem from regional density. Alternatively, all the preceding adjectives typically associated with high quality businesses apply to my subscription-based blog (www.scuttleblurb.com). This does not make scuttleblurb a good business. No, what makes scuttleblurb a great business is the high-quality, relevant content consistently offered to an engaged subscriber base, so sign up NOW for the incredibly low price of $50/year while the offer still stands (I’m shameless like that!)]

Perpending competitive positioning can seem about as exciting as watching paint dry (zing!) and certainly lacks the aureate appeal of “Y% x $TAM” conjurations. But doing so cements a firmer perch on which to plot a company’s probable value capture path and for me, it’s far saner than white-knuckling it this earnings season because, although the specialty retailer that was supposed to comp 8% instead comp’ed 5% on slowing inventory turns, management assuasively promised that this unseasonably warm winter – not structurally waning demand for its game-changing moisture-absorbing thermal collection or a busted athleisure trend – was no doubt the true culprit behind mounting fleece supply, and after these margin-crushing clearance sales abate we’re set up for really easy comparisons next year, and so this multiple-compressing sell-off is actually a chance, nay, an opportunity to advantageously add exposure. This way lies madness.

Finally, BIG news at House Kim…it’s a girl! 23 weeks old, our first.

We’re beyond pumped for this exciting new year and wish you all the best,

David Kim

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