I wrote a post a few months ago on Fastenal’s quarterly results. As I mentioned then, it’s one of the few companies that puts out an earnings press release that is more like a quarterly investor letter than a typical corporate press release. As I did last quarter, I thought I’d basically share some of the notes I wrote down in my FAST file as I read through the press release. This isn’t comprehensive, but I’ll probably get into the habit of sharing more “stream of consciousness” type comments as I read about companies this year. Hopefully sharing some research scratch notes will be useful for readers…

To recap what I’ve said before, Fastenal is a well-managed business that has done a great job at executing a relative simple business model. They are a distributor of nuts and bolts, among other things, and they are good at it. The company has focused on keeping costs low while making effective investments in its sales force, product lines, and store footprint over the years. The company has produced excellent returns on capital over many decades, which has led to growth and a compounding stock price in excess of 20% per year. I also admire management for their willingness to be transparent and honest about their results.

The business currently is struggling. This is likely obvious at this point, but the energy sector has a long reach and problems are arising at other manufacturing firms and service providers that do business with energy companies. Fastenal is an example of a company impacted indirectly by the commodity rout, as many of its customers do business in the oil and gas industry.

Here is the snapshot of their year:

FAST-2015 Results

Here is the month by month growth numbers:

FAST-2015 Monthly

On the surface, it doesn’t look too bad. But Fastenal’s large customers are really struggling. The company breaks its national accounts (which represent about half of Fastenal’s revenue) into two groups: top 100 companies (large firms) and smaller national accounts (companies not in the top 100 in terms of size).

  • Net sales to top 100 customers were down -4.3%
  • Net sales to all other national account customers were up 8.1%
  • Both of these growth rates slowed from Q3 2015 (which were about 1% and 13% respectively)

Growth is slowing, and in the case of the large customers, growth has turned negative. Short of a miraculous rebound in energy prices, there is almost certain to be much more “pain” this year as the companies that Fastenal distributes to are slashing capex budgets, laying off workers, and reducing capacity. Revenue declines at these commodity-dependent businesses (i.e. many of Fastenal’s large customers) are very painful because these are low margin businesses that are forced to make spending cuts in order to prevent cash from drying up.

There isn’t a lot of room for error with these heavy manufacturers. Operating expenses have to be cut and investments have to be delayed. As companies tighten their belts, Fastenal can experience volume declines and price deflation in some of its large accounts (large customers have the negotiating leverage to renegotiate contracts or force Fastenal to cut prices).

This isn’t a terrible problem for FAST, and it’s one that they’ll certainly get through, but it adds an element of cyclicality to its own results.

Fastenal’s stock price has lagged for some time now, and since many investors are worried about Fastenal’s exposure to the energy sector downturn, I thought I’d look to see how the company did during previous manufacturing slowdowns/recessions.

2008-2009 Financial Crisis and Recession

I took a look back at 2008-2009 Fastenal results, and I was quite shocked at how quickly things deteriorated for Fastenal during the recession.

Recall that the financial crisis occurred in the fall of 2008 (most people point to the Lehman bankruptcy on 9/15/08 as the main trigger event that precipitated and accelerated the crisis). The financial crisis seized up the credit markets, causing a deep recession across the broader economy (as many firms that needed access to credit couldn’t get it, causing business to grind to a halt in many industries).

You can see this in Fastenal’s numbers. This is just a snap shot from the 3rd quarter press release on October 12th, 2009:

Company “same store” sales (Sales at stores opened more than 2 years):

FAST 2009

Growth went from 10.5% in September 2008 to -3.9% by the end of the year, and by the next month (January 2009) the business was contracting by double digits. Wow… I doubt things get anywhere close to this bad, but it gives you an idea of how quickly this business can be impacted by a shut down in customer spending.

2001-2002 Recession

In addition to 08-09, I also went back and glanced at some old filings from the 2001-02 recession. Fastenal was a much smaller company at this time and was expanding its store footprint at a much faster rate, so growth slowed but did not decline during this particular economic contraction.

I read through the 10-Q from October 2002 and noticed that sales increased 10.6% in the first 9 months of 2002 vs 2001, and earnings were up 1.9%. Growth slowed from previous years, but remained positive.

However, in the 2002 10-Q I noticed that although sales grew, it was largely due to volume increases (thanks in large part to growth in the number of stores).

“The increase came primarily from higher unit sales rather than increases in prices, as the Company experienced some deflationary impact to pricing.”

During this period, as during other periods of economic contraction, sales growth was offset somewhat by price deflation, meaning that they sold more units, but the price per unit decreased.

Lower prices is a sign that customers have some leverage to negotiate pricing with Fastenal during difficult periods. This wasn’t severe in 2002, but it is evident by looking at gross margins, which contracted from 50.6% in 2001 to 49.4% in 2002. Not a big decline, but evidence that Fastenal sees some pricing pressure during tough times. Since gross margins are so high at Fastenal, even a modest 1.2% decline in gross margin meant over $8 million to the bottom line, which is why sales grew by double digits in 2002 but earnings grew just 1.9% (operating expenses were flat at 36% of sales in both years).

FAST 2002

Store Growth Is/Was the High ROIC Growth Engine

Speaking of operating expenses, I also noticed a trend in Fastenal’s business relating to its operating leverage. Fastenal has talked in recent quarters about how it is expanding its capacity (i.e. it is preparing for future growth by aggressively hiring new employees and growing its store footprint). This “investing for the future” has paid off for Fastenal, as they’ve consistently achieved double digit returns on capital invested, which has led to growth over time. In 2002 their operating expenses grew by 10.4%, basically exactly the same as sales growth. So the 2002 recession didn’t impact Fastenal significantly. They continued growing sales and investing for future sales growth—employee count increased 16.5% between 12/31/01 and 9/30/02. Net store openings grew 11.1% over the same 9 month period. Other than a temporary decline in the price of their fasteners, Fastenal kept marching through the recession.

But again, the company was smaller in 2002, and was rapidly growing its store footprint. 2014 and 2015 saw a net shrinking in this store footprint, which makes it very difficult to grow sales, especially in the current environment. Even in the 2002 period, same store sales growth was very low single digits.

The growth engine, and the beauty of the Fastenal business model, is the fact that they could replicate their model over and over by opening new stores, which produced very high returns on the capital required to open them, leading to sales growth, earnings growth, and a steadily compounding share price.

Also, in 2002 the company didn’t break out “same store” sales by month, but by looking at the trend in the 2001-2002 daily sales growth numbers, it’s clear that the business was affected by the economic downturn that occurred in the industrial sector in 2001 as sales growth slowed from 20% at the beginning of the year to 1.4% by the end of the year. And if not for the 11.1% growth in new stores, overall sales growth would almost certainly have gone negative by year end.

To Sum It Up

I think Fastenal is a good business. However, it has a cyclical nature to its results because many of its customers operate in the commodity space and have very cyclical businesses.

The historical results were much smoother than they might have appeared because Fastenal was always growing its store footprint by double digit percentages. Now that the store base is not growing (or at least not growing as fast), I think we’ll likely see more frequent declines in sales/earnings during future recessions. In short, the overall growth rate will be much slower going forward over the course of the full business cycle.

Looking at the previous two recessions as a crucible for the next one, I come to the conclusion that Fastenal will likely see sales and earnings declines that while temporary, could be significant. In the last recession, sales declines reached over 20% and stayed there for many months, affecting Fastenal’s bottom line to an even greater degree as negative operating leverage (like financial leverage) works both ways and in this case worked against the company as sales declined 22% in the third quarter of 2009 while earnings declined 35%.

In the 2002 recession, sales growth declined to almost 0%, but stayed positive thanks to double digit growth in new store openings. This tailwind is no longer available to Fastenal.

On the positive side, despite sales and earnings declines, Fastenal did remain profitable during the recession (albeit at a lower level), and subsequently recovered and sales and earnings grew to new heights during the recent recovery of the past few years.

But I think the worst of the commodity downturn has not come close to getting priced into many companies who do business in the energy sector, and I think Fastenal is probably one of them.

I recently wrote a post discussing long-term thinking, and how investors should look out 3-5 years and not make investment decisions based on the next few quarters. In this case, I would still look out 3-5 years, and I believe Fastenal will likely have slightly better earning power then than they do now, but given the current valuation level of over 20 times last year’s earnings (and given earnings have shown a susceptibility for short term declines during recessions), I’ll continue to pass on the stock at this level. I think the price relative to normal earning power—even looking 3-5 years out—continues to not have the margin of safety that I’m looking for.

I’ll continue to keep the company on my watchlist, and I’ll continue to evaluate it if it gets cheaper. For now, I think there are much more interesting opportunities, given the current market conditions. We’ll discuss some of those as well at some point…

John

———

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com.

When markets are tumbling, it’s time to get excited about stocks. This is often talked about, but rarely practiced. J. Paul Getty once said the key to getting rich is simple: “Buy when everyone else is selling and hold when everyone else is buying”.

For the value investing community, Buffett’s famous “Be greedy when others are fearful” basically is the same gist. Commonly referenced and preached, but far less often practiced.

I am lucky to have a great client base at Saber Capital. It is very important to have an investor base who understands how you are trying to create long term results. For individual investors, or small fund managers like myself, it’s important to capitalize on what is in my opinion the best advantage we have—the ability to look out long term. The more sophisticated people call this long-term idea “time arbitrage”. The ability to have a longer term time horizon than the vast majority of market participants is a widely talked about attribute by most fund managers, but I think it is still underrated.

Many market participants willingly admit that over time, the business in question will be making more money and the stock price will likely be much higher years down the road, but yet they are selling or avoiding the stock now because of an expected poor quarter or some other short term problem, or worse yet—for reasons that have nothing to do with the company at all but for general market or macroeconomic worries.

Regarding one well-followed company I am currently looking at, I heard one analyst downgrade the company for fears about the current quarter while admitting that the company has an extremely bright long-term future—his recommendation is to sell now as near term “pressure” will likely create a “better entry point”. Possibly, but not sure I have any edge in picking “entry points” or being able to tell when “pressure” has alleviated (other than after it’s already too late and reflected in the stock price).

As Mohnish Pabrai said in his book:

The typical hammer-wielding Wall Street analyst is fixated on the next few quarters, not the next half century when trying to figure out any given company. No Wall Street analyst’s mental model of Coke in 1988 was comprised of the latticework that Munger and Buffett fixated upon.

I’ve always felt that this is one of the reasons why large cap stocks often get significantly mispriced. The average large cap stock’s 52 week high is around 50% higher than its 52 week low. The reason for these large fluctuations in huge well-followed companies is partly due to the changing moods of the market, but also partly due to the very short-term focused views that the majority of market participants have. Every analyst talks about Google’s next quarter and has a model for earnings and other quarterly metrics. Very few analysts consider that no 22-year old engineer would rather work at Yahoo or Microsoft over Google. These intangible things matter, but they don’t show up in quarterly results. It’s why a stock like Google can trade at $500 one year and nearly $800 the next, a difference of around $200 billion of market value.

This is the time to be getting more excited, and this is the time to be taking advantage of marked down prices. Good companies are much cheaper than they were just two weeks ago. It’s like a post-Christmas sale.

The key, as Rudyard Kipling said, is keeping your head when all about you are losing theirs.

So in response to a number of readers who asked me my opinion on the market (I have no opinion by the way), I’ll list some “back to basics” things that might be helpful to review. Think of it as weekend reading list to get your frame of mind focused on thinking about businesses and valuations next week, and not economic indicators or where the S&P will find “support”.

Long-Term Thinking

Great investors talk a lot about long-term thinking. So do some of the most successful businesses of all time. Jeff Bezos doesn’t care about quarterly results now, nor did he in 1997 when he wrote the first Amazon shareholder letter:

“We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.”

And my favorite bullet point from this letter:

“When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.”

By the way, Amazon did $148 million in sales in 1997. This year they’ll do $100 billion.

Google

Take a look at the Google IPO Prospectus from 2004. The original shareholder letter that Page and Brin wrote contain a few great concepts:

Google Long Term View

Many people will attribute things other than “long-term view” to Google’s and Amazon’s successes. Certainly a long-term mindset wasn’t a sufficient condition for their success, but I do think it was necessary. And I think it’s interesting that these two firms were the ones who—well before they were entrenched companies with huge moats that we now know from hindsight—actually talked about this from the very beginning, before they achieved the dominance that they did. There were other search engines and other ecommerce retailers, and certainly there were many reasons why these two firms squashed the competition, but focusing on long-term results certainly helped them get there.

It behooves investors—just like it behooves corporate managers—to think past the next few quarters.

Steve Jobs—Go For a Walk

Walking helps clarify thinking. It can produce good ideas. If you don’t like to walk, sit in a room and think for a while. It worked for Buffett. It worked for Archimedes. Great ideas don’t usually come from a schedule like this one.

Steve Jobs talked a lot about “zooming out”. He would go for walks around Apple’s campus and get deep into thought about an idea.

Buffett’s 2008 NY Times Op-Ed Piece

I remember when Buffett wrote this piece, and I remember how many people laughed at him then. I also remember all the ridicule he received as the market continued lower for the next few months. A year later it was 30% higher, and five years later (the time frame he mentioned in the article) the market had tripled. I no longer hear anyone laughing at him.

“A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

“Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”

“Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”

It’s such a simple concept, and the article was written for everyday Americans, yet the advice is really practical for all investors.

Buffett’s You Pay a Very High Price in the Stock Market for a Cheery Consensus

This piece was originally written by Buffett in Forbes in 1978.

“A second argument is made that there are just too many question marks about the near future; wouldn’t it be better to wait until things clear up a bit? You know the prose: “Maintain buying reserves until current uncertainties are resolved,” etc. Before reaching for that crutch, face up to two unpleasant facts: The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.”

Superinvestors of Graham & Doddsville

This is always an interesting piece to review once in a while. Check out the track records of some of Buffett’s friends. These guys primarily operating under the same philosophy of buying assets for less than their true value, but they used different tactics to implement their approaches (Schloss bought bargains and was diversified, Lou Simpson bought businesses that could compound over time, Munger did some of both, so did Buffett, etc…).

Here is a link to the piece.

I don’t think any of these guys paid much attention to the S&P. They didn’t beat the market every year, and they all had some bad years, but over time their focus on value and not markets paid off.

Zoom Out

Go for a walk. Turn off CNBC, stop watching “Markets in Turmoil” specials, stop reading twitter, and pick up a book or go for a walk. “Zoom out” as Jobs said. And remember that most of the great wealth was made not by using stop losses or trading in and out (granted-there are some great traders). But most of the real wealth was built by buying good assets, particularly when they are on sale.

Also, by “zooming out”, you’ll notice the market hasn’t fallen that much. 10% corrections throughout history have occurred every 18 months or so. This isn’t abnormal. 20% corrections occur about once every 4 or 5 years. Another 10% decline from here would also not be abnormal.

Regardless of what happens, low stock prices lead to opportunities, and opportunities are becoming more prevalent, which is a very exciting development.

John

———

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com.

 

“It is the basics. It is focusing on selection, low prices, and reliable, convenient, fast delivery. It’s the cumulative effect of having this approach for 14 years. I always tell people, if we have a good quarter it’s because of the work we did three, four, and five years ago. It’s not because we did a good job this quarter.”Jeff Bezos, 2009

The new year is always a good time to review your investment process. The other day, I read a post on Nate Tobik’s Oddball Stocks that makes a great point about “practicing”—basically stop trying to read everything under the sun and get out there and actually start investing—start valuing companies, make investments, learn, repeat, etc…

This post got me thinking because I am one who reads a lot. My favorite part of investing is the reading, thinking, and strategic aspects of portfolio management. I much prefer the strategic aspects (i.e. analysis, research, critical thinking) of the investment business over the executional aspects (i.e. making the actual trades and other administrative requirements). I prefer reading over just about any other investing activity, although I have more and more begun to appreciate the information and perspective you can get by talking to people—scuttlebutt. Anyhow, that’s a separate post. But I completely agree with Nate’s point—practice is the best way to get better.

Procedural Memory

A concert pianist gains proficiency at his or her craft by developing procedural memory—doing the same thing over and over again. You can’t learn to play Rachmaninoff by reading a book. For years, Phil Mickelson had the best short game in golf. His incredible talent was a necessary, but not a sufficient condition for his success—he got to be the best greenside player because his dad built him a green in his backyard as a kid, and Phil hit shot after shot after shot onto this green at a very young age. Mickelson’s chip shot on the 72nd hole that won him the 2005 PGA Championship was one that he said he had practiced “tens of thousands of times” as a kid.

Whether you’re playing the piano, hitting a sand wedge, shooting a jump shot, riding a bike, or even driving a car—the way you learned was through repetition. The same can be said for valuation. Reading books is fine, doing case studies is better, but actually valuing companies and making investments—practicing—is the best way to learn.

Developing a Process

As regular readers of my blog have probably gathered, I am very focused on developing processes. I’ve always felt that a process oriented approach to investing is one that will give you the best chance of being able to produce success over long periods of time. Investing is a long-term game. To produce superior results over long periods, you need a process that is replicable.

One of the centerpieces of my investment philosophy is to only invest in my very best ideas. I don’t find lots of great investment ideas on a frequent basis. Because I have a high hurdle rate and because what I am looking for is not available every day (quality businesses at cheap prices), I tend to make larger, more infrequent investments. There aren’t that many great ideas. So in order to find these good investment ideas, you need a system.

Focus on Process, Not Outcomes

I try to focus on implementing investment processes because I find it more productive to focus on processes than to focus on outcomes. I think this is especially true for investing. Your investment results in investing are due to work and effort that has been accumulating for years. Buffett was reading Bank of America reports for decades before ever buying a share. The work that I am doing today is not going to pay off tomorrow. It is going to pay off at some unknown time in the future.

Also, you rarely can attribute investment results to any one specific action. It’s usually a confluence of factors that come together over multiple investment events and multiple time periods that collectively produce results. Yesterday I read Disney’s 10-k and recorded some notes, I read the Wall Street Journal, and I talked to a few users of a product made by another company I’m researching. I have no idea if, how, or when any of these specific work activities will produce a result. I just know that if I continue to focus on my process, I give myself the best chance of achieving the long-term results I’m looking for.

Wells Fargo – Process Focused

My investment process has some similarities with the companies that I prefer investing in. My investment strategy puts an emphasis on durable companies that have predictable earning power. The stocks I buy come in all shapes and sizes, but one large well-known example is Wells Fargo. As I wrote about when I mentioned the bank warrants in a post a few weeks ago, there isn’t much more predictable than the deposit growth in the US banking system. Wells Fargo is extremely well positioned to continuously capitalize on that predictability.

They have a process—a relatively simple business strategy—that can be replicated over and over. They take in a consistent share of a steadily growing deposit base, lend out or invest these funds at higher rates, and spread operating costs over a large nationwide branch network. They try hard not to do dumb things (easier said than done in the land of big banking). Focusing on their process has led to very predictable results over the long-term for the company and its shareholders.

Get Better Each Day

As an investor, I am constantly trying to improve. One thing a cross country coach of mine used to often repeat is: “Try to get better today”. Running is a sport that I competed in at the high school and collegiate level. Long distance running has a lot of parallels with investing. You can’t wake up on race day and expect to force a great performance. The performance will depend on stringing together many months/years of daily runs—one mile after another. None of the miles will stand out much individually, but they collectively add up to produce a result.

I am using the new year as an excuse to refine and refocus my process, which I’m always trying to improve. I read the paper each day, but this year I am going to make it more routine and more deliberate. I’ll make notes and keep them in a file. I also will be focusing on writing more about individual ideas. I do a huge amount of research on companies that I end up either investing in or putting on a watchlist. I have found (and others have too I think) that writing improves comprehension and helps you retain more information. It clarifies your thinking. Basically, a short summary might help you wring more comprehension out of a given unit of effort. I keep a Word doc with hundreds of pages of notes per year on investment ideas, but they are mostly scratch notes. By organizing these notes, I hope to get a better understanding of the business and also have a file to look back on later.

Building a List of Great Businesses

Also, I am going to embark on a mini-project next week where I am going to go through all 3500 stocks in Value Line one by one to come up with a watchlist to study. I already have a watchlist of businesses I follow, but I am going to create a “best companies” file on a google sheet that will come from this project. I haven’t finalized exactly how I will do this yet, but my first idea is to go through the list and input all the companies that I think I can reasonably understand (which will narrow the list significantly). Then, I will refine it one more time by trying to pick out the best businesses from this list, as measured by the attractiveness of their economics and their historical financial results (consistent earning power, stable margins, high ROICs, growth, etc…)

My hope is to build a fresh list of maybe 50-75 durable companies that are compounding their intrinsic value at high rates. These are the horses you want to bet on over time. Some of these might be very small, others will be large. I think this will complement my current watchlist of businesses that I already follow closely. And I might even find a few bargains by turning the pages as well. I plan to report back on this effort here on the blog. Feel free to comment on your own ideas for processes…

These aren’t unique ideas. In fact, if I remember correctly, I got my the idea of building a “best companies” list by going through Value Line from something Stan Perlmeter (an original “Superinvestor”) did a long time ago. It doesn’t have to be Value Line. The point is I think that it’s a useful process to build a list of great companies. Then go through one by one and value them–determine if they are in fact great. Read about them, write down findings, and this will hopefully lay the foundation for a few great investments at some point. There is a lot of value in this process.

So none of this is original. Everyone talks about watchlists, processes, etc… And much of this I already do. I’m deliberately writing down my process this year, but I already am very process oriented. I’m just using the new year as a way to get refocused on taking these concepts and diligently implementing them in my day-to-day work.

Focusing on a process is much more important than focusing on a result. As Bezos said, a “good quarter” is the result of things they did 3-5 years ago. The same can be said for investing.

Happy New Year!

John

———

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com.

“I’ve never said, ‘If you go to a mall, see a Starbucks and say it’s good coffee, you should call Fidelity brokerage and buy the stock.'” – Peter Lynch

I saw an article in Monday’s Wall Street Journal on Peter Lynch. Basically, it was a very brief piece where Lynch basically says that people are misinterpreting his advice to “buy what you know”.

I like Peter Lynch and I like his writing. Although the first book I ever read on value investing was a book on Buffett that I picked up one day in the library many years ago, I began reading about Peter Lynch and his investment concepts before I really began studying Buffett. His common sense approach that has been so widely attributed to him resonated with me (as it did with so many others as well). I particularly gravitated toward the idea of compounders (or as Lynch called them, 10-baggers, or stocks that were growing and could go up 10-fold or more in value). I don’t tend to own stocks forever, but the concept of finding a great business that can do the heavy lifting for you while you passively let value compound is about as good as it gets. These are very rare birds, but it became interesting to me to study these businesses and begin to focus on identifying some common denominators.

I’ve talked in numerous posts about the value of finding a business that can retain and reinvest capital at high rates of return. The key ingredients to Lynch’s 10-baggers are attributes such as high returns on capital, ample reinvestment opportunities, and a long runway through either unit growth or price increases. A durable competitive position along with shareholder friendly management often provide tailwinds to these 10-baggers also.

This concept has always stuck with me and I have always placed a premium on the quality of a business and its ability to produce attractive returns over time. But although his common sense approach has a lot of merit, I’ve always thought that the most people misinterpreted Lynch’s advice in a way that became a desired short-cut of sorts to achieve investing success. I never really thought this was true. Maybe Lynch was a bit too simplistic and didn’t properly set expectations. But I think part (most) of the onus should be on the reader. There is no free lunch and beating the market is not easy. Investors should know and expect this if they decide to pick their own stocks.

Lynch’s Early Magellan Years

You don’t hear much from Peter Lynch these days. I think he has lived a relatively quiet life (or at least a life out of the limelight) since retiring from Fidelity in 1990. Of course, his fund is probably the most famous mutual fund of all time with probably the best 13 year track record during the time he was running it. Lynch compounded capital at 29% annually during this incredible run, and his fund grew from $18 million to $14 billion by the time he signed off. It’s an impressive run, but even more impressive were his returns in the early years of Magellan when it could still maneuver like a speed boat (it turned into to a supertanker by the end of Lynch’s tenure). Here are the results of Lynch (as mentioned in Beating the Street) when he was just getting the snowball rolling:

  • 1978: 20.0%
  • 1979: 69.9%
  • 1980: 94.7%
  • 1981: 16.5%

I wrote a post earlier this year referencing Lynch and how he was able to achieve these results. He was a very active investor, constantly moving in and out of stocks. I prefer more concentration and less activity in my own investing. That said, turnover is neither good nor bad in and of itself. The benefits/drawbacks are misunderstood. As I mentioned in my post, portfolio turnover (like asset turnover when evaluating a business’s efficiency) is just one part of the equation that determines returns on investment. Some businesses achieve high returns through high profit margins and low asset turns. Other companies can achieve attractive returns despite very low margins by turning over their inventory very rapidly. The same is true for a portfolio of securities… some achieve great returns by owning relatively few stocks that return huge profits over multiple years, others are more active traders who make many different investments and have shorter holding periods and smaller average profits per investment.

Despite being famous for 10-baggers, in the early years Lynch was like a productive grocery store-he got very high returns by achieving relatively small margins on many different items (stocks) but turning over his capital multiple times per year. His turnover exceeded 300% per year during the early years of Magellan. He frantically would buy stocks that were dirt cheap, sell them as they appreciated, and then rotate his funds into other stocks that were cheaper.

You have to put this in context though, as the early years of Magellan were very good years for value investing. Walter Schloss also had the best stretch of his career from 1977-1982, a period where the overall market averages didn’t do much, but bargains were everywhere. The US economy entered a recession in the late 1970’s, and then again (the now often-applied phrase “double-dip recession”) in the early 1980’s. The stock market hadn’t budged in 17 years (it was flat between 1965 and 1982). But for value investors like Lynch (yes, he was a value investor), it was heaven.

Lynch mentioned at the end of chapter four in Beating the Street how good of a market it was in the early 1980’s. What happened according to Lynch?

“The stock market fell apart. As is so often the case, just when people began to feel it was safe to return to stocks, stocks suffered a correction. But Magellan managed to post a 16.5% gain for the year (1981) in spite of it. No wonder Magellan had a good beginning. My top 10 stocks in 1978 had P/E ratios of between 4 and 6, and in 1979, of between 3 and 5. When stocks in good companies are selling at 3-6 times earnings, the stockpicker can hardly lose.”

So Lynch in the early years was buying bargains. He remarked in Beating the Street: “I doubt that I was ever more than 50% invested in the growth stocks to which Magellan’s success is so often attributed.” Similar to Buffett in the early years, I think Lynch had more ideas than capital, and the stock market was filled with bargains so there was a constant recycling of capital–buy something cheap, let it appreciate some, notice something even cheaper, swap the capital from the cheap idea to the even cheaper idea. This lasted for a period of years.

Now, Lynch preferred the growth stocks. It’s just that he wanted to buy them at a fair price. But he was always on the lookout for the potential 10-bagger. Some of the stocks that made the most returns for Magellan shareholders were these big winners that played out over multiple years. And Lynch is right in that 2 or 3 of these huge winners (the Walmarts, the Cracker Barrels, the Suburus, the Wells Fargos, etc…) can make a career. So for good reason, Lynch trumpets the merits of looking for these home runs. But while he himself was always on the lookout for them, he also was buying bargains and special situations when they were available.

One strategy is not necessarily better than the other. A lot depends on the investment opportunities available. Right now, there are a lot of great businesses on my watchlist but very few of them seem attractively priced. I think Lynch paid much more attention to value than most people think, but it still pays to heed his common sense advice of buying a good business that you understand (one with good economics that can grow).

Generally, that’s all I’m trying to do. I am always interested in value, bargains, or special situations, but I spend most of my time reading about businesses and building my watchlist of quality companies. The key is waiting for the fat pitch–i.e. the rare opportunity when a large gap between price and value appears. They are rare, but they appear often enough.

Have a great weekend,

John

———

My name is John Huber. I am the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com.

In general, I find reading short reports to be a very valuable exercise. I don’t do much shorting in my partnership, but I find that for the most part, short sellers provide a useful service to the capital markets and I think that the good short sellers (who are few and far between) often do more thorough investigative analysis than the vast majority of long-only investors.

For a good book on shorting, I recommend reading Scott Fearon’s book called Dead Companies Walking. Even if you don’t short, I think it’s useful to read and listen to short sellers—if you can identify the good ones.

I don’t like shorting because I think it’s a difficult task. The best short sellers often are 100% correct in their analysis, but if they are “early” (meaning the stock keeps climbing for months or even years before their thesis comes to fruition), they can lose all (or more) of their money that they allocated to that short trade. So it’s generally an uphill battle when you are betting against stocks.

But special situation shorting can be very productive, and with mass media outlets and platforms such as Seeking Alpha where a short seller can now publish his or her own research, a good short seller can create his own catalyst. That’s what Andrew Left at Citron does, along with numerous other short sellers. There are a lot of people that cry foul or talk about manipulation when it comes to published short write-ups, but the good news is that the market generally is a pretty good judge of what is good work and what isn’t. Shorts can often successfully knock a stock down 10% or more simply because of fear generated from an article (some investors will always “sell first, ask questions later”), but if the short thesis isn’t based on sound fundamental analysis, the market will quickly correct itself.

Where short sellers really do good work is when they put the effort in and summarize their research on companies that turn out to be engaging in destructive business practices, fraudulent accounting, or operating a business model that isn’t sustainable. Often the market doesn’t understand these situations immediately, but the market always will get these situations right in the end. Short sellers simply expedite the timeframe. They speed up the time it takes for the market to discover these frauds on its own. But short sellers—the good ones—don’t create frauds. They simply discover them and tell the market about them.

So although short sellers often get a bad rap, the good ones provide a valuable service. The bad ones are the ones that deserve bad raps—the ones that simply try to drive stock prices lower by spreading rumors or fear mongering. But in my experience, these types of short sellers a) don’t ever make any money over time, and b) although they might successfully manipulate a stock price lower temporarily, the market will always quickly correct itself. Innocent companies might see their stock prices fluctuate, but won’t permanently be damaged by short sellers if they truly aren’t doing anything wrong. I know there might be occasional exceptions to this, but by and large I believe this is true.

One of the things Ted Weschler once mentioned—he said when looking at health care companies, one of the checklist items he asked himself is whether or not the company adds value to or takes value from the health care system. If the company doesn’t add value to the health care system, then it probably will eventually run into problems.

The Valeant Saga

Last month, Valeant Pharmaceuticals (VRX) was all over the front pages. Short sellers questioned many aspects of the business such as its accounting (which has been in question for years now), its controversial practice of significantly hiking prices of newly acquired drugs, its relationship with a specialty pharmacy and the volume of drugs that Valeant sold through that channel—not to mention broader questions regarding the sustainability of its business model (there are legitimate questions regarding the company’s ability to grow “organically” through volume increases as opposed to price increases and acquisitions).

In other words, one general argument is that if Valeant has a legitimate growth model it should be able to increase revenues and cash flows by selling more drugs over time, not by using more and more debt to buy drugs and then jacking up their prices.

Valeant is used to being attacked by short sellers who for years have questioned its accounting. Andrew Left is probably the most well-known short seller in this case, although his work to me is much more sensational than it is useful (I’m not saying Left is wrong—often times he does good investigative work and is correct, but to call Valeant the next Enron is probably a bit sensational).

However, one blog that in my opinion has done the best work on Valeant is AZ Value Investing Blog. His write-ups are much longer and use far less BOLD FACED CAPS, exclamation points and multi-colored fonts than Left uses, but I think his work is very substantive and worth reading. In fact, pharma is a business that I’ve never really considered for investment, but I learned a lot just reading his analysis of Valeant.

Valeant Sits in My Too-Hard Pile

Let me say that (luckily), I’ve kept Valeant in the too hard pile. I don’t know the pharma industry well, and although I’ve learned a lot reading about it recently, I just couldn’t quite understand the relationship between Valeant and its distribution channel, and how that relationship (or lack thereof) will impact revenue going forward. There are some questions I have a hard time answering.

I understand Valeant’s general model: Buy drugs that have inelastic demand and raise prices. Don’t use a “shotgun” approach to R&D. Instead, focus R&D dollars on drugs that have a much better chance of approvals and future sales, and thus higher returns on capital. So buy drugs that are undervalued, raise prices, slash spending on R&D, and try to grow organically through more focused spending on drugs with a higher probability of success.

But how is it that Valeant is able to raise prices so significantly for these drugs without any pushback from the parties who are paying these prices? Are the insurance companies really just too bureaucratic to notice? Or are these drugs really worth the prices Valeant is charging in a fair and transparent market? If the latter is the case, then I think Valeant has a legitimate model. If the former is the case, then Valeant’s model might be profitable in the near term, but is doomed at some point. This is because insurance companies—for all of their faults—aren’t stupid. They understand that a toenail fungus cream that costs 50x the price of a generic that is just as effective is not worth paying for. Eventually, the insurance companies (or other large payers) will have the largest say in the matter and the cheaper drug will get dispensed. Most health care providers will prescribe the cheaper drug if they understand the price disparity, and most pharmacies are incentivized to dispense the generic brand as well (they generally have much lower margins on the branded drugs and will fill generics unless the script is marked “dispense as written”).

So although there is a lot of bureaucracy among government payers and insurance companies, eventually they will correct these problems by not paying for overpriced drugs that aren’t adding any value. Companies like Valeant might be able to take advantage of this bureaucracy in the short-term, but it’s not a way to produce lasting value for shareholders.

If you’re not adding value to customers, you’re probably eventually going to destroy value for shareholders.

That’s a principal that I try to keep in mind when evaluating investment opportunities, and I’ve learned this through the school of hard knocks. But I find that it is almost always a rule that should not be disobeyed.

Similarly, if a health care company is taking value from (rather than adding value to) the overall health care system, it likely is not going to reward shareholders in the long term either. There might be exceptions to this “rule” as well, but I generally wouldn’t want to bet against this concept.

Whether Valeant is breaking this rule, I don’t know for sure. But the fact that I can’t answer it will keep me on the sidelines. Michael Lewis is probably working on a book right now about Valeant and he will feature the next Michael Burry who either “knew” Valeant was a fraud and shorted it to $0, or “knew” Valeant was the buy of a lifetime and loaded up as he tripled his money. The story of the Valeant saga has already has seen a very interesting plot unfold and it has included some big name characters such as hedge fund titans, government regulators, and even presidential candidates. I will read the book with great interest, but unfortunately will not be a subject in it.

Regardless, it will be fun to watch unfold.

Over the weekend I was reading David Einhorn’s book Fooling Some of the People All of the Time. I’ve had it on my bookshelf for some time, and it has always taken a back seat to other books until I decided to pick it up recently.

It’s an entertaining read, basically recounting his short thesis on Allied Capital in great detail. It is a good book because it provides a glimpse into the significant amount of research and due diligence that a great investor like Einhorn performs in his investment approach.

Don’t Count Einhorn Out

Einhorn—like many well-known value investors—has had a very tough year. But we have not seen the end of Einhorn’s run as a top quality investor.

To borrow an analogy I used in a post last year—just as so many were so quick to write off Tom Brady after an early season loss to Kansas City last year that left the struggling Patriots at 2-2 and looking like a shell of their former dominant selves, I think far too many people are writing off Einhorn (as well as others) who have had a bad year. As I said last year, if the Patriots were a publicly traded equity, the stock would have been beaten down after the Chiefs blowout and it would have been one of those rare opportunities to load up. Lo and behold (and as painful as it is for me to say as a Bills fan), the Pats rattled off a long string of consecutive wins on their way to their 4th Super Bowl title, and continued that winning streak until a surprising upset loss last night to the Denver Broncos (coincidentally led by a young QB who is temporarily replacing another legend that many are also writing off—perhaps prematurely).

Back to the book—there is one chapter where Einhorn describes a meeting he had with a well-known mutual fund manager. To put this meeting in context: Einhorn was in the midst of doing significant due diligence on a company called Allied Capital, a business development company (BDC) that used aggressive accounting practices, questionable reporting of their financial results, and very liberal valuations of the illiquid equity and debt securities that they held for investment. Einhorn had been short the stock for some time, and although it slowly was becoming apparent that Einhorn’s thesis was largely correct, the stock hadn’t fallen much and continued to trade in the same general range that it had prior to Einhorn’s famous speech where he announced his short thesis.

So Einhorn was introduced to this fund manager through his broker, who thought that it would be good for both sides to hear each other’s thesis on the stock (Einhorn was short and this mutual fund manager had a large long position).

Einhorn showed up to the meeting fully prepared with a briefcase full of his research, and the mutual fund manager came in with nothing but a notepad and a pen.

As it turned out, this fund manager hadn’t even read Einhorn’s research—this is despite being long a stock that was very publicly criticized by Einhorn and others who had published significant and detailed research laying out their thesis for everyone to see.

Einhorn couldn’t believe that this fund manager owned a large block of stock and not only did he not do his own primary research, but he didn’t even read the secondary research that was easily and freely available for him to read regarding the potential problems at Allied.

What’s the point here?

I’ve always thought that there are two main reasons that stocks generally get mispriced:

  • Disgust
  • Neglect

Disgust

Large caps stocks that get mispriced are almost always due to disgust. These stocks are large companies that are widely followed by investors and analysts. There is very little information that is not widely known by all market participants. However, sometimes these large companies run into a temporary problem and investors sell the stock because the outlook for the next next quarter or the next year is poor. Investors can take advantage of this situation by a) accurately analyzing the situation and determining that the nature of the problem is in fact temporary and fixable, and b) be willing to hold the stock for 2 or 3 years—a timeframe that most individual and institutional investors are not willing to participate in.

Some investors refer to this concept as “time arbitrage”. It just means that you’re willing to look out further than most investors and willing to deal with near term volatility and negative (but temporary) short-term business results.

In addition to a company specific “disgust”, these large caps can also get beaten down when the general market environment is pessimistic. In bear markets, companies with no problems at all often see their stock prices get beaten down because of macroeconomic worries or general market pessimism.

So although many value investors look at small caps because they feel this is where they can gain an informational advantage, I think taking advantage of this “disgust” factor is just as effective and is an important arrow to have in the quiver.

Neglect

Often times the most mispriced stocks in the market are small cap stocks that are underfollowed and neglected. The obvious advantage here is to locate a situation that no one else has discovered by looking under a lot of rocks and in the nooks and crannies of the market. Sometimes things slip through the cracks. I would also put special situations in this category. Sometimes companies are misunderstood as well—but this is usually because they are neglected to a certain extent. The market has collectively not been willing to put the effort into understanding these situations sufficiently, and this creates potential mispricings.

Einhorn’s Experience

Einhorn talks a lot about “the guy on the other side of his trade”. In other words, each stock trade has a  buyer and a seller and both think that they are getting the better deal (or they wouldn’t be engaged in the transaction).

I don’t really spend a lot of time thinking about this angle, but it is interesting to consider who might be selling you shares that you are buying, and the reasons why. In this case, Einhorn thought he might be selling (shorting) shares to sophisticated institutional investors who disagreed with Einhorn and believed Allied was undervalued.

However, as Einhorn learned, this wasn’t the case. The institutional investor was “too lazy or too busy” as Einhorn put it, to put the time and effort into understanding what he owned.

So I’m not sure which category this type of situation would fall into, or maybe ignorance deserves its own category. But the experience with the mutual fund manager that Einhorn describes is certainly evidence of how sometimes even widely followed stocks get mispriced. If an investor is buying millions of shares for reasons that don’t have anything to do with the intrinsic value of the company, then there is the potential for a mispricing to occur.

To Sum It Up

I think most investors intuitively understand that it’s occasionally possible to find a bargain in an underfollowed stock, but I think just as often, large caps (or more widely followed) companies get mispriced for these reasons (disgust, ignorance, short-term thinking, or irrational behavior).

Here is the passage of the book I referenced above where Einhorn met the mutual fund manager:

“…so James Lin and I walked over with a briefcase full of our research. We met with Painter and Stewart in the conference room. Stewart brought nothing but a legal pad and pen. “Okay,” he said, “go ahead.”

I thought this was supposed to be a two-way dialogue. “First, what did you think of our analysis?” I asked him. “Do you see anything wrong with it?” He said he hadn’t read it.

While I could believe that Allied’s shareholders might generally be too busy to have read the lengthy analysis we put on our website, it was hard to imagine a professional, who was the second largest Allied holder, would come to a meeting with us and acknowledge such lack of preparation.

So I asked him why he held the stock. Stewart said that in the tough market he felt it was a good time to own a lot of high-yielding stocks and his Allied holding was really part of a “basket approach”…

Einhorn concludes:

“I left with a new understanding of what we were up against. It wasn’t an issue of investors understanding our views and disagreeing. In addition to the small investors, Allied’s other investors were big funds managing lots of other people’s money—too busy or too lazy to worry about the details, other than the tax distribution.”

Thanks for reading,

John

———

My name is John Huber. I am the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. I established Saber as a personal investment vehicle that would allow me to manage outside investor capital alongside my own. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term. I also write about investing at the blog Base Hit Investing.

I can be reached at john@sabercapitalmgt.com

I came across this video that I’ve never seen before. It’s a video of a young 31-year old Warren Buffett giving an interview to a journalist about the stock market decline that occurred in the first half of 1962:

Buffett’s comment at the very beginning of the video regarding President Kennedy’s “actions on steel” referred to this press conference on April 16, 1962.

Basically, JFK announced that the Department of Justice was opening an investigation into the pricing strategies of the major steel companies. Steel prices and steel company profit margins had been rising despite excess capacity, lower input prices (steel scrap and coal), stable labor costs (according to the BLS). Steel company dividends exceeded $600 million in each year between 1957 and 1961. These facts, along with the 100,000 steel workers that lost their jobs in the three years leading up to 1962 was too much for the populist president to take.

I haven’t investigated this, but I wouldn’t be surprised if the steel industry made more money in 1961 than it did in most years of the recent decade or two.

The Difficulties of Investing in Highly Regulated Businesses

Buffett just referenced the steel industry, and although he has made investments in cyclical businesses at times, he has often talked about the headwinds an investor faces when doing so. JFK’s 1962 press conference is an example of one such headwind that recurs over and over again in highly regulated industries.

I heard someone talking about the cyclicality of the airline business and how regulators and lawmakers are constantly trying to balance the opposing desires of customers (who desire low prices) and airline companies (who desire high profitability). Throw in a third party with a third desire (labor unions who desire higher wages) and you have a never ending tug-of-war.

Regulators and lawmakers generally desire to pass legislation designed to keep prices low for consumers, which has the side affect of curbing airline revenue–often to the point at which airlines collectively lose money. Inevitably, it dawns on the bureaucrats that it’s good to have airlines around, and so mergers are allowed and airlines are once again allowed to make profits. For a time the airlines are allowed to make money, but inevitably the profits once again attract the attention of the lawmakers and regulators (not to mention labor unions), who begin looking for ways to tilt the scales back in favor of customers, and the cycle repeats.

The same cyclical battle between lawmakers (who supposedly have a proxy for consumers) and corporations (who supposedly want to make money for their owners) have existed since the days of John Sherman and more specifically, since 1909 when the Justice Department sued John D. Rockefeller’s Standard Oil Company for running an illegal monopoly.

Halfway in between that time and now, JFK was griping about the excess profits and dividends that the US steel industry was making, and he vowed that the Justice Department and Congress would do something about that.

1962 Stock Market Decline

According to Buffett, the JFK press conference precipated the stock market decline (which was presumably top-heavy with steel companies at the time).

However, Buffett seemed a) like he couldn’t care less, and b) like he had no idea where the market would go next.

His apathetic attitude toward general stock market prices should be put into context. Interestingly, in 1962 the Dow dropped from a high of 731 to a yearly low of 535 (a decline of 27% in the span of a few months)! And everyone was panicky over the 12% decline we just had over the summer…

I went back and looked at the history books, and it appears that the Dow had dropped 15% or so when Buffett gave this interview and then went on to drop another 10% for a total top to bottom drawdown of more than 25%. The 1962 Dow rallied strong to close the year down 7.6%. Buffett meanwhile finished the year up 13.9% after being down 7% at the halfway point, a result he was quite pleased with given the sizable margin he achieved over the market.

Although the interview is very brief, it provides a glimpse into how Buffett thought about stock price movements even in his early days. I don’t think much has changed for him, as 53 years later he again is talking about how macroeconomic and geopolitical events (like the horrific terrorist attack this weekend in Paris) do not influence his investment decisions.

But, I started the post with a point about the difficulties of investing in highly regulated businesses. I would say that it helps to think independently, and I would never say never (after all, one could argue that airlines have provided some of the greatest returns over the past four years), but I think as a rule of thumb, it’s helpful to consider why Buffett has often guided investors away from investing in these cyclical businesses.

There are probably easier places to make money.

“In the end, banking is a very good business unless you do dumb things.” – Warren Buffett

Buffett has been investing in bank stocks since the 1950’s, and I think one of the things he probably likes most about banking is the predictability of deposit growth. As he says, if you don’t do dumb things—if you stick to taking in deposits and lending them out, you’ll mint money.

All the money center banks reported earnings a couple weeks ago. In the process of reviewing their filings, I also spent some time doing some research on the FDIC website and I found a table that the FDIC updates on industry-wide total deposits at all US commercial banks. At the end of 2014, US commercial banks held $10.9 trillion in deposits.

High and Predictable Deposit Growth

Here is the incredible statistic: US commercial bank total deposit growth has grown every single year (not a single down year) since 1948! There have only been 3 years where industry-wide deposits shrank from the year before (1937, 1946, and 1948, and these three years were all very modest declines).

So deposits across the industry have grown for 66 consecutive years.

Even more incredible is the rate of growth in deposits over the past 80 years. Since 1934, deposits held by US commercial banks have grown 7.3% per year. In the past 50 years, they’ve grown at 7.4%. In the past 25 years, they’ve grown at 6.0%. In the past 10 years, they’ve grown at 7.0%.

Bank Deposits

So incredibly, the growth rate doesn’t seem to be slowing down much. I’ve always thought of deposits as something that would grow at maybe just a very slight premium to whatever GDP does over time (2-4%). But at least over the past 80 years, they’ve basically doubled the growth rate of GDP.

I remember Buffett saying something about servings of Coca-Cola sold has risen every single year for 100 years or so. I bet he feels the same about the predictability of deposit growth.

He probably feels the same way about loan growth as well as bank earnings for that matter (which have also risen steadily and unlike airlines, the US banking industry has been profitable in 78 of the past 80 years).

And unlike Coke, since deposit gathering is a commodity type business, the lowest cost business will have the biggest advantage.

Unfortunately for the small community banks which have decreased in number by 2/3rds in the past few decades, the big regionals and the really big guys have these cost advantages. Wells Fargo is currently paying 0.08% (8 basis points) for its $1.2 trillion in deposits. WFC largely funds its asset base with these low cost deposits (the total cost of their funding sources is just 25 basis points), meaning that even in this low yielding environment, it makes a healthy return on assets. Other big money center banks also gather deposits very cheaply, but because deposits make up most of WFC’s liabilities (which also fund a more traditional higher yielding asset base—loans and securities), the bank achieves better returns on capital than the majority of its competitors.

Throughout its history, WFC has always taken market share. I took a look at the 1974 WFC annual report. In 1974, WFC had deposits of $10 billion, today they have $1,202 billion. So in the last 40 years, WFC has a 12.7% deposit CAGR. They’ve grown overall deposit market share from 1.3% in 1974 to 10.9% today:

WFC Deposit Share

(By the way, www.wellsfargohistory.com is one of the best company investor sites: 50 years of annual reports and other info).

So WFC has grown deposit market share, and grown share almost every year—especially in the past 3 decades. Given certain banking regulations and WFC’s size, you could argue that they’ll stop taking share, but as long as they just maintain their share (a pretty good bet given their track record), it seems pretty predictable to rely on steady mid-single digit deposit growth year in and year out. These deposits are the raw material that is used to create loans, which also have grown steadily over the past 80 years (loans have grown at a CAGR of 8.1% since 1934).

If you look at WFC’s ROE, it’s been a consistently profitable bank throughout history:

WFC 40 Year ROE

For the past few decades, the bank has consistently produced better than 1.5% ROA. At 10x leverage, this is about 15% ROE. Recently in this zero interest rate world the ROA has slipped to around 1.3%, so maybe you would say 13% is a better estimate of what shareholders can expect the bank to earn on their capital, but I doubt that a) interest rates remain this low forever and b) ROA doesn’t begin rising once ZIRP comes to an end.

With the deposit numbers and the low-cost moat of WFC, it’s hard to see value per share not compounding at 8-10% (at least) over time through a combination on asset and book value growth, steady returns on assets, and capital returns via buybacks and dividends.

The Investment Case for the Warrants

I have owned Wells Fargo through the warrants in the past, and bought them back during the August swoon when Wells traded down to 50 and the warrants got down to 17. What are the warrants? They are unique securities that were created by the government as part of the TARP Capital Purchase Program, where the government injected $205 billion of capital into the US banking system in exchange for debt securities, preferred stock, and in some cases, warrants to buy common stock.

The warrants are similar to deep in-the-money options, only with a very long time period before expiration as well as a few other small benefits. Originally held by the Treasury, these warrants were eventually sold at auction to the public and now trade on the NYSE. The warrants give the holder the right to buy a share of common stock between now and late 2018 for around $34 per share. The warrants have an anti-dilution clause which means dividends will reduce this strike price to around $33 by expiration.

I bought a decent amount when they traded down in August, but wish now that I would have really loaded up. I was somewhat reluctant to really back up the truck as I have sizable positions in a couple other banks. But I should have swung harder, and actually am considering buying more. With the warrant price around 21, the strike price around 34, and the current stock price around 55, it’s nearly free leverage so it allows me to keep a sizable cash position in the portfolio for other investments.

Buying the warrant is like putting a 30% “downpayment” (cost of warrant) on a share of WFC, but without having to pay any interest while I own the warrant and I’m not even required to pay back the “loan” (the value of the rest of the stock) if I decide to sell. I think the warrants of the big banks are some of the best investment opportunities in this market because of the quality of the underlying businesses, the value of the underlying common stocks, and the long-dated nature of the security itself.

Valuation

WFC had a book value of $33.69 as the end of the quarter, up 7% from the previous year. At low-teen returns on equity and factoring in the dividend payout, I think it’s a safe bet that WFC compounds book at 7-8% annually. This puts book value around $42 per share in 3 years when we will have to convert our warrants into common stock (or sell them). If Wells can do 13% ROE (historically low, but what it has been doing this year), the bank will earn around $5.50 per share. At 12-14 times earnings, this equates to a price of around 32 to 44 for the warrants, which are currently priced around 21.

I think that’s a pretty good return over the next 3 years—especially given that I think the downside chance of losing any money is extremely remote. Banks are much safer, much better capitalized, more streamlined, and their stocks are much more cheaply valued than the pre-crisis days. Short of an environment that leads to either severe financial stress and/or single digit P/E ratios (which is possible but not probable), it is unlikely these stocks will be lower in 3 years than they are now—in which case the warrants don’t lose. If ROE begins to rise a bit when rates rise, the returns for the warrants start to get extreme, but that doesn’t need to happen for the investment to work out very well.

I think Wells is the best bank among the big money center or regional banks—it’s not the cheapest and I think some other banks might offer more interesting returns, but I think it’s the highest quality bank of the group. I find these warrants to be attractively priced.

Disclosure: John Huber owns warrants to buy Wells Fargo common stock for his own account and accounts he manages for clients. This is not a recommendation. Please conduct your own research.

Fastenal (FAST) reported earnings yesterday. I love reading Fastenal’s press releases. They are more like investor letters than they are press releases. I didn’t even see one “Adjusted EBITDA” reference in the entire release—which is written in layman’s terms more than corporate jargon. Management’s candidness and depth of discussion regarding the company’s operating results is a breath of fresh air.

So I thought I’d jot down a few notes and put it into a post. This is not really an analysis of the company, but more or less just a clipping of portions of the letter I thought were worth commenting on. It’s mostly a summary of the press release, but I’d definitely recommend getting in the habit of reading these once a quarter. If nothing else, it’s a respite from the typical corporate-speak that permeates most of what I find in the company filings I read.

To briefly summarize, the company has an outstanding history of growth, but that growth has been challenged lately—in small part due to Fastenal’s increasing size, but much more likely due to the significant difficulties in the heavy manufacturing and commodity-based businesses (who represent a sizable portion of Fastenal’s customer base).

Fastenal has always been able to grow throughout the business cycle, but this cyclical downturn is proving to be one of the more difficult periods that they’ve had to navigate so far.

That said, to this point they are still squeaking out some growth:

FAST-Growth

They think that revenue has been hit because their customers have felt the effects of a strong dollar, and of course the slowdown in the oil and gas business.

Making Their Own Luck

Interestingly, they have been aggressively adding employees during this downturn. Fastenal has always felt that they employees are one of the largest competitive advantages they have. A knowledgeable, well-trained sales force that understands how to effectively engage with the customer base is an advantage that often doesn’t show up directly in the numbers, but like the left tackle that is diligently and thanklessly protecting the quarterback all game, it’s an invaluable part of the team.

Fastenal has ramped up hiring:

FAST-Hiring

In addition to expanding the headcount, they plan to open an additional 60-75 stores (around a 2-3% increase in store count) in the next year.

Fastenal management describes the company as two businesses:

  • Fastener distributor (40% of business)
  • Non-fastener distributor (60% of business)

Fastener Business

This is the business Fastenal started with 50 years ago. Fastenal is a distributor. They supply their customers with a variety of basic fasteners such as nuts, bolts, screws, washers, etc… The company sources these products from many different suppliers, and then sells to their more than 100,000 customers at a healthy markup (Fastenal’s gross margins generally are around 50%). Fastenal’s customers are usually the manufacturers at the end of the supply chain (farm manufacturers, oil producers, truckers, railroads, miners, etc…). The company also sells to non-residential construction contractors (plumbers, electricians, general contractors, etc…).

Roughly half of this business is production/construction and the other half is maintenance. The production portion of this business is very cyclical, with 75% of the customers engaged in some type of heavy manufacturing. This business is struggling right now. Fastenal mentioned that although they are steadily adding new national accounts (large customers), 44 of its largest 100 customers are reducing their spending on Fastenal products, many because they are seeing significant revenue declines in their respective businesses and thus tightening the spending belt is a necessary result. This hurts Fastenal in the near term, although the company expects this cyclical capital spending to work in their favor once the recessionary conditions in the energy and mining businesses subside.

But the downturn in commodities and the heavy manufacturing sector has caused growth in Fastenal’s industrial production business to go negative:

FAST-Industrial Business

Non-Fastener Business

Fortunately for Fastenal, the sale of fasteners is a sticky business because it’s difficult (expensive and time consuming) for customers to change their supplier relationships. This stickiness has probably even improved as Fastenal grows its vending machine business which primarily focuses on distributing non-fastener products (instead of candy bars, FAST is popping out tools, equipment, and other non-fastener products through vending machines at their customers’ own facilities):

So with a Fastenal vending machine onsite at the customer’s location (along with knowledgeable Fastenal employees providing service and product replenishment), this creates a resilient line of business for FAST. In fact, they now have around 53,000 machines onsite at their customers’ facilities—all doing an average of around $1000 per month of business (that’s a $600 million business that grew 17% in the last year).

So strong results from the industrial vending business is helping the non-fastener segment of Fastenal’s business, but the overall segment has seen growth slow from 18% in the last half of 2014 to 6% growth in Q3:

FAST-Non-Fastener

So this non-fastener business is still growing, albeit at a much slower rate. And management says that they are still taking market share.

Macro Winds Impacting Fastenal’s Business

Fastenal believes growth is impacted generally by three categories:

  • Execution
  • Currency Fluctuations
  • Economic Fluctuations

My take is Fastenal is executing very well–as best as they can in this environment. So the latter two are the culprits. Currency fluctuations only impacted Fastenal’s growth by 1.1%, so not a significant decline due to the weak Canadian dollar. However, Fastenal’s US customers represent 89% of sales, and many of those customers are impacted by the strong US dollar. So I think that Fastenal is probably impacted much more indirectly by the strong US dollar than they are directly as a result of their Canadian operations.

Economic Conditions

Sales to customers engaged in heavy manufacturing are estimated to be about 20% of overall FAST net sales. These businesses include the mining, agrictultural, and construction end markets, and all of these sectors have been hit hard by the bear market in oil and other commodity prices and a slowdown in construction and weak Chinese demand for heavy equipment.

PMI Index

The Institute for Supply Management conducts monthly surveys of private sector companies to gauge the health of the manufacturing sector. The oft-cited Purchasing Managers’ Index (PMI) oscillates between 0 and 100 (spending most of its time between 40 and 60) and basically measures manufacturing expansion when readings are over 50 and contraction when the index drops below 50. The PMI can be thought of as a general barometer of the current strength or weakness in the buying power of Fastenal’s customers that do business in the heavy manufacturing sector (again, approximately 20% of Fastenal’s revenue is impacted here). The PMI has spent most of its time since the recession in the mid-high 50’s but dropped to 50.2 in September, the lowest reading in 3 years:

FAST-PMI

So who knows what economic conditions will look like in a year (I certainly don’t), but the slowdown in the manufacturing sector has, for the first time, really affected Fastenal’s top line growth.

Valuation and Some Commentary

I think FAST is an outstanding business with moderate growth potential over the long run. They operate in a large and fragmented business and their scale, employee expertise (these sales guys know their products well), the sticky nature of their customer relationships, the thriftiness that management has toward expenses, the small ticket price of most of their products, the vending machine program (getting a spot on the customer’s location is huge)—these are all attractive features to me about Fastenal’s business.

By the way, any Harvard MBA who claims that expense management and frugality is not a competitive advantage should read this: The Cheapest CEO in America. They should also pull up a long term chart of Fastenal stock price, and see how a company that sells nuts and bolts and keeps costs low somehow has been able to eat their competitor’s lunch for decades.

By keeping operating costs very low, Fastenal is able to pay their employees incrementally higher wages and thus more effectively develop and retain talented salespeople. The quality of service and depth of knowledge that the employees have eventually brings in more revenue, which grows the business and allows it to further lower operating expenses as a percentage of revenue, thus allowing for more hiring of top quality employees, which brings in more revenue, etc… Maybe an overlooked virtuous circle of sorts.

I think that the business will continue to grind out steady profits and steady growth for a while to come. I think that the business might struggle to grow in the near term given the horrendous state of affairs in certain portions of the commodity-based industries and heavy machinery businesses. But I think over time these are normal aspects of just about every business cycle and this isn’t Fastenal’s first rodeo. They are a very well-managed firm and will no doubt see this through.

What is it worth? The company produced $401 million of operating cash flow in the last 9 months. I’m not sure that the stock is a bargain at 20 times cash flow since

  1. the company has stated that there are still sizable capital investments needed to continue to grow its vending machine business (although those investments have been attractive so far), and
  2. it seems unlikely that the company will be able to achieve the sizable mid-teen rates of growth it has in years past.

Should I be wrong on the latter, the stock is probably cheap. I’m not worried about the capital investments because those seem to be producing solid returns. But I would be concerned about the future growth of the overall company. They claim to operate in a $160 billion market, which implies a long runway ahead, but the larger they grow the more bumps in the road there are (as a friend said, Fastenal used to be a meaningless portion of many of its customers’ expense budgets, but if Caterpillar or some other struggling large heavy manufacturer now sees that it’s paying $30 million to Fastenal, they may become more motivated to spend the time renegotiating that contract).

Eventually, the recessionary conditions many of its customers are facing will subside, and Fastenal will get the benefit of a cyclical upswing. And Fastenal will certainly continue to execute well and grow revenue over a long period of time. I’m just uncertain how fast that growth rate will be, and so at this valuation I’m not sure there is a big margin of safety.

That said, Fastenal has always exceeded expectations to this point (as evidenced by the fact that throughout history the stock has been too “cheap” most of the time—compounding at 23% per year since 1987):

FAST-Stock Chart

Quite the wealth creator over time. Since the IPO in the mid-80’s, the stock has done better than BRK, MKL, WFC, WMT, AAPL, MTB and just about every other long term compounder out there.

If anyone has comments on the business, valuation, future prospects, or anything else, feel free to engage.

Thanks for reading.

I was glancing through the Berkshire letters from the late 1990’s because I recall Buffett briefly mentioning his large silver position he acquired and I was trying to see if Buffett referenced the specific cash cost of production. He didn’t in the letter—only mentioning that Berkshire acquired 111 million ounces. He has mentioned in other interviews that silver was in fact below the cost of production—a supply/demand imbalance that can persist for a while, but not forever.

Buffett felt comfortable loading up on silver (he took down roughly 25% of the world’s available inventory), and then just storing it in the vault until this supply/demand dynamic normalized. He didn’t have to wait long, as silver appreciated modestly back above the cost of production later that year, and Berkshire booked a nearly $100 million gain on Buffett’s unconventional investment.

Today, the cost of production of silver has fallen to around $8 per oz, and the price is around $14, so for anyone hoping that silver might be a bargain after a 3 year bear market, it is still nearly 100% above the relative level where it was when Buffett backed up the truck to load up… (note: this is the so-called “cash cost” of production, which excludes company overhead expenses, exploration costs, and capex–it’s just the actual cost to pull the metal out of the ground, which is the metric I believe Buffett used in his decision to buy it in the late 90’s).

Speaking of unconventional investments—these are ideas that I think Buffett really loves, although he talks far more in the recent letters about the great businesses (and for good reason, those are the businesses that provide the “sure” money).

Of course, in his partnership years, Buffett talks a lot about both “generals” (stocks that are purchased simply because they are undervalued) and “workouts” (stocks with some corporate catalyst or event that will help realize the valuation gap). The workouts tend to be more “unconventional”, but can provide profits that are often uncorrelated to what the general stock market is doing. In Buffett’s early days, this involved things like oil company mergers, cocoa bean arbitrage, closed end fund liquidations, special dividends, spinoffs, activist positions, and many others. These situations provided significant profits to Buffett personally in the early years, and then later for his partners.

Buffett even bought silver in the late 1960’s—although he wasn’t a gold (silver) bug, like so many today.

Anyhow, here is Buffett in the 1997 letter discussing a few unconventional investments that Berkshire participated in. These are quite small relative to Berkshire’s equity, but it still describes his affinity for making profits out of unconventional special situations:

Unconventional Investments 1 Unconventional Investments 2 Unconventional Investments 3

The other interesting takeaway from this clip is that Buffett said he followed the fundamentals of silver for 3 decades without investing in it. Reminds me of how he talked about reading Bank of America annual reports and IBM annual reports for 50 years before ever buying a single share.

Patience—all knowledge is cumulative…