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- Benjamin Graham
The following case study covers Peter Lynch's investment in La Quinta Motor Inns.
Case Study: Peter Lynch & La Quinta Motor Inns
Peter Lynch's investment in La Quinta Motor Inns is perhaps the most iconic case study that investors can use to understand his investment philosophy. It combines a high-growth business, a management team of spectacular quality, and a business that was generally unnoticed by institutional investors. Perhaps more importantly, La Quinta was an exceptionally profitable purchase for Lynch's Fidelity Magellan fund.
This chapter will discuss Peter Lynch's investment in La Quinta Motor Inns in detail.
Peter Lynch's La Quinta Motor Inns Investment
Lynch describes his investment in La Quinta Motor Inns with the following passage in One Up On Wall Street:
"At one point I’d decided the motel industry was due for a cyclical turnaround. I’d already invested in United Inns, the largest franchiser of Holiday Inns, and I was keeping my ears open for other opportunities. During a telephone interview with a vice president at United Inns, I asked which company was Holiday Inn’s most successful competitor.
Asking about the competition is one of my favorite techniques for finding promising new stocks. Muckamucks speak negatively about the competition ninety-five percent of the time, and it doesn’t mean much. But when an executive of one company admits he’s impressed by another company, you can bet that company is doing something right. Nothing could be more bullish than begrudging admiration from a rival.
“La Quinta Motor Inns,” the vice president of United Inns enthused. “They’re doing a great job. They’re killing us in Houston and in Dallas.” He sounded very impressed, and so was I.
That’s the first I’d ever heard of La Quinta, but as soon as I got off the phone with this exciting new tip, I got back on the phone with Walter Biegler at La Quinta headquarters in San Antonio to find out what the story was. Mr. Biegler told me that in two days he’d be coming to Boston for a business conference at Harvard, at which time he’d be glad to tell me the story in person.
Between the United Inns man’s dropping the hint and five minutes later the La Quinta man’s mentioning that he just happened to be traveling to Boston, the whole thing sounded like a set-up job to sucker me into buying millions of shares. But as soon as I heard Biegler’s presentation, I knew it wasn’t a set-up job, and the best way to have gotten suckered would have been not to have bought this wonderful stock.
The concept was simple. La Quinta offered rooms of Holiday Inn quality, but at a lower price. The room was the same size as a Holiday Inn room, the bed was just as firm (there are bed consultants to the motel industry who figure these things out), the bathrooms were just as nice, the pool was just as nice, yet the rates were 30 percent less. How was that possible? I wanted to know. Biegler went on to explain.
La Quinta had eliminated the wedding area, the conference rooms, the large reception area, the kitchen area, and the restaurant—all excess space that contributed nothing to the profits but added substantially to the costs. La Quinta’s idea was to install a Denny’s or some similar 24-hour place next door to every one of its motels. La Quinta didn’t even have to own the Denny’s. Somebody else could worry about the food. Holiday Inn isn’t famous for its cuisine, so it’s not as if La Quinta was giving up a major selling point. Right here, La Quinta avoided a big capital investment and sidestepped some big trouble. It turns out that most hotels and motels lose money on their restaurants, and the restaurants cause 95 percent of the complaints.
I always try to learn something new from every investment conversation I have. From Mr. Biegler I learned that hotel and motel customers routinely pay one one-thousandth of the value of a room for each night’s lodging. If the Plaza Hotel in New York is worth $400,000 a room, you’re probably going to pay $400 a night to stay there, and if the No-Tell Motel is built for $20,000 a room, then you’ll be paying $20 a night. Because it cost 30 percent less to build a La Quinta than it did to build a Holiday Inn, I could see how La Quinta could rent out rooms at a 30-percent discount and still make the same profit as a Holiday Inn.
Where was the niche? I wanted to know. There were hundreds of motel rooms at every fork in the road already. Mr. Biegler said they had a specific target: the small businessman who didn’t care for the budget motel, and if he had the choice, he’d rather pay less for the equivalent luxury of a Holiday Inn. La Quinta was there to provide the equivalent luxury, and at locations that were often more convenient to traveling businessmen.
Holiday Inn, which wanted to be all things to all travelers, frequently built its units just off the access ramps of major turnpikes. La Quinta built its units near the business districts, government offices, hospitals, and industrial complexes where its customers were most likely to do business. And because these were business travelers and not vacationers, a higher percentage of them booked their rooms in advance, giving La Quinta the advantage of a steadier and more predictable clientele.
Nobody else had captured this part of the market, the middle ground between the Hilton hotels above and the budget inn below. Also, there was no way that some newer competitor could sneak up on La Quinta without Wall Street’s knowing about it. That’s one reason I prefer hotel and restaurant stocks to technology stocks—the minute you invest in an exciting new technology, a more exciting and newer technology is brought out of somebody else’s lab. But the prototypes of would-be hotel and restaurant chains have to show up someplace—you simply can’t build 100 of them overnight, and if they are in a different part of the country, they wouldn’t affect you anyway.
What about the costs? When small and new companies undertake expensive projects like hotel construction, the burden of debt can weigh them down for years. Biegler reassured me on this point as well. He said that La Quinta had kept costs low by building 120-room inns instead of 250-room inns, by supervising the construction in-house, and by following a cookie-cutter blueprint. Furthermore, a 120-room operation could be managed by a live-in retired couple, which saved on overhead. And most impressive, La Quinta had struck a deal with major insurance companies who were providing all the financing at favorable terms, in exchange for a small share in the profits.
As partners in La Quinta’s success or failure, insurance companies weren’t likely to make loan demands that would drive the company into bankruptcy if a shortfall ever occurred. In fact, this access to insurance-company money is what enabled La Quinta to grow rapidly in a capital-intensive business without incurring the dreaded bank debt (see Chapter 13).
Soon enough, I was satisfied that Biegler and his employers had thought of everything. La Quinta was a great story, and not one of those would-be, could-be, might-be, soon-to-be tales. If they aren’t already doing it, then don’t invest in it.
La Quinta had already been operating for four or five years at the time Biegler visited my office. The original La Quinta had been duplicated several times and in several different locations. The company was growing at an astounding 50 percent a year, and the stock was selling at ten times earnings, which made it an incredible bargain. I knew how many new units La Quinta was proposing to build, so I could keep track of progress in the future.
To top it all off, I was delighted to discover that only three brokerage firms covered La Quinta in 1978, and that less than 20 percent of the stock was held by the big institutions. The only thing wrong with La Quinta that I could see was it wasn’t boring enough.
I followed up on this conversation by spending three nights in three different La Quintas while I was on the road talking to other companies. I bounced on the beds, stuck my toe into the shallow end of the swimming pools (I never learned to swim), tugged at the curtains, squeezed the towels, and satisfied myself that La Quinta was the equal of Holiday Inn.
The La Quinta story checked out in every detail, and even then I almost talked myself out of buying any shares. That the stock had doubled in the previous year wasn’t bothersome—the p/e ratio relative to the growth rate still made it a bargain. What bothered me was that one of the important insiders had sold his shares at half the price I was staring at in the newspaper. (I found out later that this insider, a member of the founding family of La Quinta, was simply diversifying his portfolio.)
Fortunately I reminded myself that insider selling is a terrible reason to dislike a stock, and then I bought as much La Quinta as possible for Magellan fund. I made elevenfold [sic] on it over a ten-year period before it suffered a downturn due to declining fortunes in the energy-producing states. Recently the company has become an exciting combination of asset play and turnaround."
The La Quinta Motor Inns investment illustrates a number of important investing principles, perhaps more than any other example provided by Lynch in One Up On Wall Street. The fundamental principles are discussed below.
What Investors Can Learn From Peter Lynch's Investment in La Quinta Motor Inns
There are a number of actionable investing lessons that you can learn by studying Peter Lynch's investment in La Quinta Motor Inns.
The first is that you shouldn't be afraid to talk to corporate managers. I know from personal experience that dialing the phone number of a company's investor relations representatives can be a surefire way to find the answers to questions you have. Just tell them you're a prospective shareholder (or a true shareholder, if that's the case) and they'll be happy to speak with you.
The second lesson is the importance of cost management in the businesses you invest in. La Quinta was essentially duplicating the business model of Holiday Inn, but with reduced costs thanks to the elimination of the wedding center, conference rooms, kitchen, and restaurants. Importantly, these costs did not contribute to La Quinta's revenues, which means that their elimination had the potential to do one of two things:
- Boost profit margins.
- Reduce the prices paid by consumers.
La Quinta chose to reduce prices, which presented a tangible competitive advantage over its competitor Holiday Inn.
La Quinta was also a notable example of the powerful benefit of ingenious financing. The company's partnership with a large insurance company allowed it to obtain capital on favorable terms through a counterparty that had a vested interest in the motel's success. While complicated financing structures can sometimes be toxic for even the most well-run companies, La Quinta is an example of innovative financing done right.
The last observation that investors should take away from Lynch's investment in La Quinta is his first-hand experience with the company as a consumer. Lynch made a point to stay in 3 different La Quinta Motor Inns before buying the stock, which allowed him to be certain that the company actually had the competitive advantages that its representative alluded to. We recommend gathering a similar first-hand experience of a company's products before making investments, when possible.
Peter Lynch's investment in La Quinta Motor Inns is one of the defining investments discussed in One Up On Wall Street. To follow up this important case study, we present two other classic Lynch investments in the subsequent chapters.
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