18 Questions with Kevin Holloway

*This is an interview I did recently with Gurufocus.  It gives a pretty good idea of how I think about investing and my background

How and why did you get started investing? What is your background?

First off, let me say that I’m not quite sure I belong or deserve to be included with the other investors in this Q&A series. In fact, I’m quite certain I don’t. But when I was asked to do this I thought it could help me clarify my investment process and be somewhat interesting to a few people out there.

I work for a government contractor specializing in asset forfeiture investigations. In some ways it is quite similar to the process of investing. I investigate companies and look for financial crimes, transactions and large assets for seizure. I have a Bachelor of Science in economics and will be obtaining my master’s in financial management next semester. I’ve thought about going for a CFA, but have a two year old with another on the way and a wife who might kill me if I tried.

I became interested in investing while I was in college, but at the time thought I was more interested in running/owning a business. Once I graduated I had the opportunity to work with a family member in starting a franchisee business. This experience was invaluable to me in both life and investing. I was given immense responsibility right out of college and was basically at the ground floor of starting and operating a business. I was involved in store development/location plans, construction, hiring/firing, purchasing, labor and just about every aspect of the business. I was managing three stores and around 75 or so employees, which taught me a lot about leadership. I was lucky to be given the freedom to pursue my ideas for the business, which were generally focused on improving profitability and efficiency.

I learned a ton in that short two-year period. We opened three stores within almost a year, which is sort of insane when looking back. It was a whirlwind, but it taught me about hard work and what goes into running a successful operation. Our stores were extremely successful due to our combination of intense focus on customer service, cleanliness and efficiency. It was the perfect example of how management can make a huge difference in the success of a business. I say that in respect to my boss who hammered home the importance of customer service, which was hands down the biggest factor in our success.

When we opened our stores there were two other stores (no owned by us) in the same general area. Same franchise, same product, same marketing, similar buildings, equipment, location, just about everything was identical. Despite that, those two stores were struggling and we were thriving. The main difference was our customers loved us; our stores were cleaner, our product fresher and our employees better trained. It sounds easy, but these factors don’t really show any tangible return or benefit and cost more money on the front end. We had some pushback from others in the business about cutting more labor or reducing waste by keeping the product out longer. It’s hard to show the tangible benefit of a larger staff or fresher product, but if done right it can really make a difference.

I always go back to this when I’m researching companies. It’s made me much more aware of management and how easily they can improve or damage a business.

After two years of the 24/7 grind I realized that (like Buffett) I didn’t particularly enjoy the nitty gritty of operating a business. I preferred the strategy/capital allocation aspect, but it was obvious to me that I could never fully step back from the operations side.

Around this time is when I began investing in stocks. I actually bought my first stock (Dick’s Sporting Goods (NYSE:DKS) at ~$15) right in the midst of the financial crisis. I knew nothing about it except that I’ve been to the stores and liked them. A typical “buy what you know” Peter Lynch style investment with just about no research. The stock dropped 15% the day after I bought it. I bought more. I also bought Costco (NASDAQ:COST), American Express (NYSE:AXP), Nike (NYSE:NKE) and a few others. I knew next to nothing, but like Klarman says you either have the value gene or you don’t and I’ve been hooked ever since.

Describe your investing strategy and portfolio organization. Where do you get your investing ideas from?

My strategy is a concentrated value based approach. Typically I own around 10 to 15 companies, with a large concentration in the top 3 to 5 holdings. Currently I have only 8 holdings. That is probably the lowest number of stocks I’ve ever held, but that can change quickly. I can afford to do nothing for long periods of time since I’m not managing clients’ money and only my families (which thankfully can’t withdraw). There are times when I could own closer to 20-25 if I found a basket type investment or if there was just a ton of cheap ideas available. Generally I’d like to keep it in the 10-15 range.

Value is a very generic term. I’d put myself more on the Buffett side of the spectrum rather than the Graham side, but I find those descriptions sometimes too simplistic. I look for (like everyone else) great companies that can compound at high rates of return for a long time. Obviously these companies don’t grow on trees and/or don’t come cheap. I also like to find good maybe even just average companies at cheap prices. These tend to be contrarian type investments selling at double digit FCF yields where I think the market is overly punishing the company. I will occasionally look at a net-net type investment if there is something that appeals to me beyond cheapness. Also, I keep an eye out for special situations. It could be a spinoff, a company with underappreciated assets or maybe a profitable business obscured by a money losing one.

What ties these strategies together is my focus on simplicity and downside. I like to find companies no matter what type, that even in a bear case scenario I see very little downside. I also want situations where I can see just a few variables at play. If the situation is too complicated I generally pass. Simplicity doesn’t mean it’s easy or that I’ll be right, but having clarity into the factors and possible outcomes. That’s easier said than done. I also tend to be attracted to great management teams that I feel I can trust, which comes from what I talked to about earlier.

I get my ideas from everywhere and anywhere. Newspapers, internet articles, Twitter, Value Investors Club, newsletters, my wife, my kids, going out to eat, friends, the person that cuts my hair, wherever. I’m always thinking about investing and looking for new investment ideas.

What drew you to that specific strategy?

I think it’s just in my nature to look at downside risk first. And as I mentioned earlier, my previous job left an indelible impression on me regarding the importance of good management.

My process has been shaped by my circumstances too. I have a day job that doesn’t allow me to research companies all day, every day. It’s forced me to be selective in the number of companies I follow and focus on simple investments while avoiding complexity. I’m very quick to put something in the too hard pile, because I simply don’t have the time.

What books or other investors changed the way you think, inspired you or mentored you? What is the most important lesson learned from them? What investors do you follow today?

I don’t know where to even start. I can’t say what the most important lesson I’ve learned is, but Buffett and Munger have given so much back to the investment community that has been invaluable to my education. That’s obvious and probably even cliché. Margin of Safety and Mr.Market have to up there in terms of most important lessons/concepts.

I follow a bunch of investors but some of my favorites are Chuck Akre (Trades, Portfolio), Ted Weschler, Joel Greenblatt (Trades, Portfolio), Lou Simpson (Trades, Portfolio), Glenn Greenberg (Trades, Portfolio), Tom Gayner (Trades, Portfolio) and Allan Mecham. Some other investors worth following are Don Yachtman, Bill Nygren (Trades, Portfolio), Mark Massey, David Rolfe (Trades, Portfolio), Paul Lountzis, Jeff Ubben (Trades, Portfolio), Francois Rochon, Brian Bares, Wally Weitz, Tom Russo (Trades, Portfolio) and a bunch more I’m leaving out.

How long will you hold a stock and why? How long does it take to know if you are right or wrong on a stock?

I will hold a stock as long as I think it still offers decent future returns. How long I hold has more to do with the underlying company and the stock price than any predetermined time frame.

I have a longer leash with great companies and a shorter leash with the mediocre/cheap ones. So if one of my compounder type investments gets to fair value or slightly above, I will be more inclined to hold versus with a net-net or special situation I will be more apt to pull the trigger and sell near fair value.

Can an investor know how long it takes to know if you’re right or wrong? You may not know if you were right or wrong even after selling the stock (regardless if you made money or lost it).

How has your investing approach changed over the years?

Like many value investors I started out with a more Ben Graham quantitative approach, buying cheap stocks, low P/B, low P/E, etc. So easy! I learned pretty quickly that cheap does not equal value. I don’t want to make it seem like the Buffett approach is superior, which value guys sometimes do. A quantitative approach with cheap multiples can be a great way to invest if you do your research.

Now I have a much deeper respect for the qualitative side of things. Many of the stocks I own do not screen well based on the typical cheap “value” multiples. I put more weight on management and the underlying business than when I started out. I focus much more on ROIC and FCF; where as, early on being cheap was the most important criteria. That said, I still have a tough time paying up for great companies. And it’s not false modesty; I genuinely have a hard time with paying 25-30x for great companies and am trying to get more comfortable in this area. The Brooklyn Investor did a great post (that I often reread) about Buffett paying 10x pre-tax earnings for some of his biggest investments. Reconciling this hasn’t been easy for me, but some companies are simply great buys at 25x earnings and some companies are terrible buys at 6x earnings.

Name some of the things that you do or believe that other investors do not

I’m not sure I believe anything different than other investors. Maybe I put more emphasis on certain things. I probably put a greater emphasis on simplicity than some. I want very few assumptions made in any investment for the base case. I seek investments where I’m paying virtually nothing for the bull case scenario. But who doesn’t?

What are some of your favorite companies, brands, or even CEOs? What do you think are some of the most well run companies?

Markel (NYSE:MKL) and Berkshire (NYSE:BRK.A) are two of my favorite companies. Obviously Buffett and Gayner are two of my favorite CEO’s. I’m from Baltimore so I’m a big Under Armour fan and I kick myself for not seeing that one early on. Sergio Marchionne is one of the most interesting and entertaining CEO’s out there. No interview or call with him is ever boring. John Malone is a legend, so I like to follow him and the Liberty complex.

Do you use any stock screeners? What are some efficient methods to find undervalued businesses apart from screeners?

Not really. Every once in a while I’ll screen something I’m interested in or look at the Magic Formula screener.

I don’t know about efficient, but if you keep your eyes open and constantly look for bargains you can find some great ideas. Twitter is an incredible resource if used correctly. I have a list of about 200 or so people that share interesting articles, videos, research, commentary, ideas, etc. These are some really smart people that you can follow and converse with daily. It does a great job of filtering through the garbage. I’ve definitely found potential investments or valuable information on an investment through Twitter.

Some great Twitter follows off the top of my head:

@bluegrasscap @BrattleStCap @basehitinvestor @Find_Me_Value @covenantlite @HurriCap

Name some of the traits that a company must have for you to invest in, such as dividends. What does a high quality company look like to you and what does a bad investment look like? Talk about what the ideal company to invest in would look like, even if it does not exist.

The ideal company to invest in would be Berkshire Hathaway in the early years. A young company with high ROIC, a long runway for growth, the ability to reallocate capital/reinvest at similar rates, a sustainable competitive advantage and if you can get that at a cheap valuation it’s a home run. Unfortunately that is incredibly rare/hard to find.

Before making an investment, what kind of research do you do and where do you go for the information? Do you talk to management?

Once I’m interested in a company, I read everything I can find on it. That includes 10K’s, 10Q’s, any article I can find, research reports, quarterly call transcripts… really anything. I don’t have the option of talking to management. I think you can get a feel for management from listening to calls and reading annual letters to shareholders. Over time it should be evident whether their words are backed up by action.

What kind of bargains are you finding in this market? Do you have any favorite sector or avoid certain areas, and why?

I’m not finding much at the moment. I do think some banks are undervalued. I know many will disagree with this, but I believe banks like Bank of America should do well even if rates remain lower over the next few years. At worst, they will grow book value at ~6% or so and payout most of that to shareholders. No you can’t know everything that is in the banks, but they have never been better capitalized or safer. Bank of America is trading less than TBV, around 11x earnings and they’re continuing to cut costs. Of course the upside is rates go up, expenses go down and valuation increases. If you believe the scandal won’t be detrimental to earnings power, than Wells Fargo might be worth a look too.

How do you feel about the market today? Do you see it as overvalued? What concerns you the most?

It’s definitely not cheap. I don’t get too deep into the market valuation discussion. Luckily I can be patient and wait for any pullbacks or opportunities that turn up. Nobody knows what’s going to happen or when it’s going to happen. I just continue to invest, have cash available and not fixate on where the market is.

What are some books that you are reading now? What is the most important lesson learned from your favorite one?

I’m reading “Titan” by Chernow, which is great so far. I don’t know that I can pick a most important lesson or a favorite book, but Galbraith’s “The Great Crash, 1929” is a book I highly recommend. It’s amazing how similar everything was to the most recent financial crisis. It really crystallized for me how human nature never really changes.

Any advice to a new value investor? What should they know and what habits should they develop before they start?

I recommend opening a brokerage account and just get started investing. Don’t get carried away with huge amounts of money, but put some skin in the game. Nothing can replicate having actual money on the line. Once you have a stock drop 10%, 15%, 20% in a short period of time you’ll know whether you have the temperament for this.

Describe some of the biggest mistakes you have made value investing. What are your three worst investments? What did you learn and how do you avoid those mistakes today?

I’ve made plenty of mistakes. Some of the more recent ones that I can think of are Colfax (NYSE:CFX), JC Penney (NYSE:JCP), Weight Watchers (NYSE:WTW) and Iconix Brand Group (NASDAQ:ICON). I was lucky that in each case they were small investments as a percentage of my portfolio. Also I believe I actually made money on Weight Watchers and broke even with JC Penney. But that was total luck and I still consider them huge mistakes. In every case (except Colfax), the management teams were less than stellar and that is being kind. Two of them were turn-around situations. They each had large amounts of debt and all of them, except Colfax, were cheap on a “normalized” earnings basis. As for my mindset, I think I deviated from my usual framework and got enamored with the possibilities on the upside versus focusing on the downside. The upside led me to excuse certain things that I normally wouldn’t, especially in the case of Weight Watchers and Iconix. Those management teams had big red flags. When I did a postmortem of these investments, I noticed that all were small allocations of around 2-3% each. I rarely invest such a small allocation and should of listened to my gut when I wasn’t confident enough to make it a more significant position.

How do you manage the mental aspect of investing when it comes to the ups, downs, crashes, corrections, and fluctuations?

One of my biggest strengths is the ability to stay even keel while the market or stocks that I own fluctuate. I try to focus on the fundamentals and underlying drivers of each one of my investments. I ask myself if anything has changed. I look at what the fundamentals are over the course of time and that helps me focus on what matters. Of course that’s easy for me to say having started investing in 08/09 and seeing nothing but a rising market since. Generally though, I’m wired in a way that I get excited when the market is down and anxious when it goes up.

If you’d like to share, how have the last five to ten years been for you investing wise?

I started keeping detailed records of my returns over the last few years and have beaten the market by a decent margin. However, as I mentioned earlier I picked a great time to start investing and haven’t been through a full investment cycle. This year I’m trailing the S&P by quite a bit. I’m really looking forward to finishing school and focusing on my investments.

Paul DePodesta and Investing

Last week I saw on ESPN that the Cleveland Browns signed Paul DePodesta—of “Moneyball” fame—to be their Chief Strategy Officer. Whatever that means. As a Baltimore Ravens fan I’m a little worried and you’ll probably see why after reading this. If the Brown’s owner actually lets DePodesta implement his ideas (and that is a BIG if) the AFC North teams will no longer be able to count on two easy wins each year.

History

For those not familiar with DePodesta he’s best known for being Billy Beane’s (Oakland A’s GM) sidekick, which is chronicled in the book “Moneyball” by Michael Lewis. In the movie he is portrayed by Jonah Hill, albeit by a different name because DePodesta didn’t want his name used. Moneyball showed how the use of analytics (sabermetrics) was radically changing player scouting/evaluation in baseball.

**Sidenote: DePodesta started with the Cleveland Indians, moved to the A’s, Dodgers and then Met’s before getting the Brown’s job. He’s dabbled in Finance and Health Care as well.

DePodesta played wide receiver at Harvard, but didn’t get on the field much. While at Harvard he was an intern for Jim Pinkerton (deputy assistant to President George H.W. Bush), where he was told by Pinkerton to go read Thomas Kuhn’s “The Structure of Scientific Revolutions” and not come back until he was done. This led to what became DePodesta’s quasi motto/philosophy: “If we weren’t already doing it this way, do you think this is the way we would do it?.”

What really caught my attention though, was an open letter DePodesta wrote called, “The Genesis, Implementation, and Management of New Systems”.  I was amazed at how many quotes could have just as easily been applied to investing. In fact I wouldn’t be surprised if DePodesta tried his hand at investing and became fairly successful. He is very analytical, focused on long term results, has the right temperament and looks to take advantage of inefficiencies.  Sounds like a value investor to me.  Anyway, below are some quotes from the letter (and some from articles) that I thought were informative.

Quotes

In the letter DePodesta leads off with a quote from Common Sense:

“As an introduction to the second edition of his pamphlet, Common Sense, Thomas Paine wrote, “perhaps the sentiments contained in the following pages, are not yet sufficiently fashionable to procure them general favor; a long habit of not thinking a thing wrong, gives it a superficial appearance of being right and raises at first a formidable outcry in the defense of custom.” Well, welcome to the world of baseball. “

He might of well said “Well, welcome to the world of investing.”

 

On Moneyball:

“Michael Lewis in Money Ball referred to us as crazed K-mart shoppers who would take anything we could fit in our cart in under 15 minutes. I prefer an analogy with Warren Buffett or Charlie Munger. [laughter] Either way it became clear to us that the inefficiency in decision-making in baseball was vast.” 

Basically this guy is a value investor looking for undervalued athletes.  How many sports executives know who Charlie Munger is?  Let alone what his and Buffett’s philosophy is.

Reading and Continuous Learning

 “I always felt those other things [jobs] were informing me and making me a better executive,” DePodesta told VICE Sports this week in his first interview since joining the Browns. “I think a big part of it was being this continuous learning. It’s not necessarily conscious. It’s just the way I am. For 20 years it was, ‘What can I take from this and how can I maybe apply it to baseball and make us better?’  

“In the last 10 days I’ve learned so much and I know how much more I have to learn,” he said. “That’s sort of my mindset, more than anything else, whenever I get into anything new. I’m in this constant pursuit for new knowledge. I think I sometimes focus more on all the things that I don’t know and what I’m trying to figure out.”

“In Oakland, DePodesta and Beane often found ideas outside of baseball. Beane, like DePodesta, is a voracious reader, he said. They would read very little about their own sport and look to outside sources for information and, hopefully, guidance. Sometimes, something would click.”

Reading and continous learning are the backbone of great investors. I read these quotes and felt like I was reading a letter by Buffett, Munger, or Klarman. Don’t get caught up in the analogy though, focus more so on the content of what he said. It’s just good advice.

Bias/Subjectivity

“To the untrained ear, these scouts were unbelievably convincing. Some of their subjective opinions almost sounded like they were objective. If you had worn a major league uniform at some point in your life, you were somehow qualified to make these judgments despite a complete lack of empirical evidence to support your claims. Don’t get me wrong, subjectivity by itself isn’t really a sin, and complete objectivity isn’t perfect either. In our industry we make a lot of educated guesses on the future performance of people under very stressful situations. Subjectivity will be an element in any decision we make.”

“The response to all this questioning was somewhat expected. There were opinions layered on top of opinions. A lot of people were saying, “I think it’s because,” or “maybe it’s this,” or even “that’s the way we’ve always done it.” My industry is comprised of human capital—the players are our assets. So subjectivity plays some role. But the enormity of the subjectivity was staggering. Our scouts even started making up vocabulary like “pitchability” to describe players.”

“The incredible thing is that in subjectivity there are a lot of biases that come into play—emotional opinions or focusing just on outcomes, or even worse, focusing on the most recent outcomes.”

“Opinions are great—don’t get me wrong. They’re great for starting research projects. Then you go study and see if you can prove the opinion or not. But when placing multi—million dollar bets on future outcomes, opinions are wholly unsatisfactory. Opinions as conversation starters are fine. Opinions as conclusions are very bad. I started research projects to discern the objective “why.” I wanted to know why certain teams won and why other teams lost; why certain drafts produced big stars and others didn’t. This was the naïve question at work.” 

“Evaluation is really at the core of decision—making whether the field of endeavor is baseball or picking stocks. It was clear to me that using clearly subjective evaluation was shoddy at best.”

Subjectivity is a necessary part of the investment process, but evaluation and thorough analysis should be first and foremost.  Basically, don’t let ones opinion/subjectivity lead the analysis.  I think we’re all guilty of this one to some degree (myself included).  I see it all the time on CNBC, FinTwit, research reports, etc.  People have a subjective opinion on a stock and make it seem as if it’s objective.  Either they let their opinion shape the analysis or they don’t do any real analysis at all.  And man some of them are really damn convincing.

Even more evident in investing is the intense focus on recent outcomes.  This is Mr.Market at his best and why a longer time horizon paired with good analysis can be a huge advantage.  In my opinion this is my greatest advantage as an investor.

“Evaluation is really at the core of decision-making.” 

I might put that on my wall.  So simple.

Preconceived Notions

“In retrospect, I had a distinct advantage over everybody else in the industry at the time in that I knew absolutely nothing. I’d played baseball in college but that was about it. Because I knew nothing I observed everything critically and took nothing for granted. I spent my first few years with the Indians analyzing all of their systems, from contracts to player development and scouting. Because I had no preconceived notions over how an organization ought to be run, this was an education for me.”

This quote made me think of Buffett’s thoughts on EMH and how students are being taught EMH at universities.  I believe Munger has had similar thoughts/comments as well.  I remember the first time I learned about EMH in school and just shook my head. (thought the same thing with Economics)  It made no sense to me, but to many it was just “this is how I was taught, this is how it’s done.”  Coming into something fresh can be a huge advantage especially if you ask questions and observe critically.

“The problem itself wasn’t the people. Our scouts were very loyal, passionate, industrious people. The problem was the operating system. The industrial inertia was leading them further and further away from the truth.”

This too is true of many analysts, investors, hedge fund managers, etc.  For the most part these guys/girls are all trying to do their job, but various incentives keep them from doing what they are truly supposed to do.  Sell-side analysts are highly capable analytical people that work hard and I’m sure mean well.  As long term investors we often shake our heads when we hear some ridiculously short term focused question asked during a conference call or see a downgrade on a stock because of an issue that has no bearing on the long term success of the company.  Analysts do this not because they’re idiots, but because they’re incentivized to do so (or dis-incentivized to think long term) in their respective system.

Maintaining Success

“How was I supposed to innovate a supposedly smooth running machine? There was, however, a crisis underlying our success. Our lofty expectations had stifled our innovative spirit. Everything we had done to be successful, we stopped doing. We were hanging on instead of trying to move forward. We signed veteran, big name players who everybody knew. Our team got a lot more expensive and started growing older. Though I was seeing all this, I didn’t have much of an audience in Cleveland.” 

Not much to add here.  It reminded me of funds with massive AUM that are no longer able to invest the way that originally made them successful. (style drift?)  Also, when funds are successful many tend to be more conservative in order to keep clients (generate fees), rather than focus on compounding returns.  A successful fund like this might be less likely to give an analyst leeway for creativity and/or have much influence on the portfolio.

Straight Up Graham and Dodd

“What did I decide to do? I moved to the Bay area. This was the perfect opportunity because losing had become the expectation in Oakland. If we tried something really innovative and it didn’t work, all we’d be doing is fulfilling expectations. To use a scout’s term, there was a lot of upside. If somehow we figured out how to put a playoff caliber team on the field for pennies on the dollar, the baseball world would have to take notice.” 

Going to Oakland was basically a cigar butt investment that had virtually no downside and all upside.  It allowed DePodesta to experiment freely; whereas, with the Indians he couldn’t due to their previous success.  He’s doing the exact same again with the Browns.  Where’s the downside?  The Brown’s are one of the worst organizations in football.  Dhando in action.

Information Overload

“Then I encountered another problem in baseball—information overkill. Between stats, scouting reports and ESPN, there’s too much information and it’s difficult to decipher what was important and what didn’t matter. Naturally, our brains go searching for cause and effect relationships, but there was too much noise. The problem was that baseball people would draw conclusions from baseball stats that just didn’t matter. It was difficult to distill what was important. We started making up relationships and people bought into them and the myth was perpetuated.” 

That is right on the bullseye for investing in today’s world.  We have a ton of information at our fingertips which we can access in seconds.  We have access to information from companies, Google, investment websites, newspapers, Twitter, Bloomberg and tons of other sources that were unavailable not that long ago.  With so much information it’s hard to remember what matters.  As DePodesta points out, figure out what’s really important and forget the rest.

Differentiation/Edge

“We didn’t have the resources to keep up with everybody else and the idea of following best practices within our industry, we knew that wasn’t a great strategy for us,” DePodesta said. “In fact, it was probably a losing strategy for us because we didn’t have the resources to keep pace. So our challenge was to try to create new best practices and ones that would actually provide us some sort of competitive advantage. The only way for us to do that was to look outside of baseball for inspiration.”

To beat the market, you must be different than the market.

“I was on a quest to find relevant relationships. Usually it wasn’t as simple as “if X then Y.” I was looking for probabilistic relationships. I christened the new model in the front office: “be the house.””

“We may not always be right but we’d be right a lot more often than we’d be wrong. In baseball, if you win about 60% of your games, you’re probably in the playoffs.”   

This guy was born to be an investor.  Peter Lynch likes to say, “In this business, if your good, you’re right 6 times out of 10.”  DePodesta’s approach of being the house is basically him saying what’s our edge?  If we can get an edge and be right more times than we’re wrong, we’ll do pretty good.  This approach definitely works in investing, but I’m curious whether it works at the highest level of sports?  Making the playoffs is good, but the ultimate goal and prize is to win it all.  In investing being first doesn’t matter.  If you are above average for a long time you are basically a god (and rich).  If you make the playoffs 4 years in a row, but lose every time you’re considered a failure (well to some fans).  Does winning on average lead to winning championships?  I guess you could argue that it increases you odds of winning a championship by simply making the playoffs.  Anyway, I’m getting off subject.

Keeping Your Emotions in Check

“Dealing with our own decision-making was relatively easy. As long as we maintained some kind of emotional detachment that comes with running a casino and knowing that in the end it’s going to work out, we would be able to maintain a high level of confidence and discipline. We would avoid making lazy decisions.”

Emotional detachment in investing is a must.  Focus on the process rather than the outcome.  This is incredibly hard to do as we’ve seen so far this year.  Stocks have been in the red and invariably this leads to emotions running high, which leads to irrational decision making.  Focus on the fundamentals of the underlying company, not the price movements of the stock.

Good Outcomes vs. Good Decisions

“I was in Las Vegas for a weekend playing blackjack. A person at the table to my right had 17 and said they wanted a hit. The whole table stopped and even the dealer asked if he was sure he wanted a hit. Finally he said he wanted a hit. The dealer deals the card and of course it was a four. What did the dealer say? “Nice hit.” But I’m thinking, you’re kidding me. It was a terrible hit. Even though it ended up working out, it wasn’t a good decision.” 

Just because a stock is up doesn’t mean it was a good decision.  And conversely, just because a stock is down doesn’t mean it was a bad decision.  This to me is one of the toughest things to explain to people.  You either get it or you don’t.  (if you’re reading this blog post you probably get it)

Random Stuff:

“It is not the first time DePodesta has stepped out of the sports world to work on something else. He has sat on the Sears board of directors for the past three years. When Sears chairman Edward Lampert announced his addition, he noted that DePodesta’s “ability to scrutinize data and use it to assess talent and drive execution makes him ideally suited to join our board.”

ESL!  Well maybe the AFC North will be safe after all.  Jokes aside, I was surprised by this.  I’m not too familiar with the Sears story, but I’d be interested to know DePodesta’s involvement and level of influence on Sears/ESL.

“DePodesta has also branched out into financial services and done advisory work for venture capital companies. After Moneyball came out, Michael Mauboussin, currently a managing director at Credit Suisse, reached out to him, and it led to time spent with Bill Miller, the former chairman of Legg Mason Capital Management. DePodesta now jokingly calls Mauboussin a “partner in crime.”

Mauboussin his PIC, makes perfect sense.

Conclusion

I would recommend reading the whole letter.  There is a ton of great detail regarding management, implementation of new systems, how to deal with changing perception and some other gems.  He’s obviously a very smart guy and one that I have a feeling might do some good outside of the sports world in the future.  He alludes to this in some of his interviews.  As for football, it’ll be interesting to see what he does with the Browns.  The value investor in me wants to see him succeed, the Ravens fan in me wants him to get fired by the owner after 1 year.  We’ll see.

DePodesta closes with this quote:

Thomas Kuhn wrote, “the proliferation of competing articulations, the willingness to try anything, the expression of explicit discontent, the recourse to philosophy and to debate over fundamentals, all these are symptoms of a transition from normal to extraordinary research.”

 

 

Links:

The Genesis, Implementation, and Management of New Systems

PAUL DEPODESTA EXPLAINS HIS PATH TO THE CLEVELAND BROWNS

Can a Moneyball Maven Fix the Browns?

Cleveland should be optimistic after Browns’ innovative DePodesta hire

The Structure of Scientific Revolutions: by Thomas Kuhn

Valuing Markel

In my previous post I valued Berkshire Hathaway using Tom Gayner’s valuation method, which he described in a Value Investor Insight interview from 2012.  So I figured  I might as well put Markel’s numbers into the spreadsheet and see what we get.  Before I get to that here’s a quick summary on Gayner’s valuation method for those who didn’t read the last post.


 

Valuation Method Summary

Gayner breaks down the business valuation into three parts:

  • underwriting profits
  • investment returns
  • non-insurance normalized earnings  

He then applies a range of returns to insurance premiums earned, the investment portfolio and also estimates normalized earnings for the operating businesses.  Finally he takes the sum of all three parts and applies a multiple of 10x, 14x and 18x.  I changed things up a bit, but most of it is self explanatory.


 

Markel’s Investment Returns

I decided to adjust the investment portfolio returns down (vs what I used in the Berkshire model) to a base case of 5% with a low of 3% and high of 7%. Historically Markel has achieved higher investment returns (see below):

  • 5-yr annual return:  7.4% 
  • 10-yr annual return:  6.2% 

I’m being conservative with Markel for a few reasons.

1. Markel has an unusually large fixed income allocation due to the acquisition of Alterra  

When the investment portfolio from Alterra was inherited by Markel the total investment portfolio went from $9.3B in 2012 to $17.6B in 2013.  It almost doubled!  Alterra’s $7.9B investment portfolio consisted mostly of fixed income securities and a hedge fund portfolio that was subsequently liquidated.  This diluted Markel’s equity allocation, which currently sits at roughly 55% of shareholder equity.  Obviously having less invested in equities and more in bonds will lead to lower returns.  Historically Markel’s equity returns have outperformed fixed income returns by a wide margin.

  • 5-yr annual return: Equities, 20.4%   Fixed Income: 4.7%
  • 10-yr annual return: Equities, 13.4%   Fixed Income: 4.6%

2. Markel doesn’t use float to invest in equities like Berkshire 

Markel invests in equities with shareholder equity only; whereas, Berkshire uses both shareholder equity AND float.  Markel’s float is mostly invested in fixed income securities that match Markel’s insurance liability durations.  In a Gurufocus interview from 2011 Gayner explained why Markel does this vs. investing in float like Berkshire:

TG: “Berkshire has a much bigger balance sheet than Markel and a much bigger base of equity compared to its insurance liabilities than we do. As such, they can allocate more of the investment portfolio towards equities. Over time, if we continue to grow and build up our equity capital we should be able to move in the same direction as Berkshire.  Furthermore with a rising interest rate headwind and potentially lower forward returns from stocks I’m lowering expectations for conservatisms sake.”

I thought that last part was very interesting.  I’ve seen Gayner state that his preference is for equities to be 80% of shareholder equity, but I’ve never heard him say they would like to eventually invest the float.  This strikes me as another under appreciated benefit to the upside that could juice returns further as Markel grows in scale.  For now though, returns have and will most likely be lower than Berkshire’s.

3.  Rising interest rates

With such a large fixed income portfolio the obvious drawback is as interest rates rise the existing fixed income values will fall.  And theoretically equity returns should be lower in the future.  This combination would put a drag on investment returns going forward.  On the other hand as rates rise (assuming it continues) Markel’s investment income will rise too. But for the sake of conservatism I’m lowering return expectations.

Markel is being proactive by keeping durations lower than normal and waiting.

From the 2014 Annual Letter:

“We continue to own a portfolio of fixed income securities which mature faster than what we expect from incoming insurance claims. We will continue to maintain this modest override from our normal design until such time as interest rates are higher than current levels. We just don’t think we are being paid appropriately to take the risks of owning long-term bonds so we won’t do it.”

On rates rising over the long term:

“We normally don’t try to predict interest rates but we can use common sense to say that we believed they were too low during the last few years, and now they are trending back to a more normal level. Consequently, we too will trend back towards a more normal bond portfolio over time. This should increase our investment income substantially in the years to come.”

Again, a little off subject, but Gayner and co. are aware of the rate environment and as with insurance underwriting they are being disciplined by waiting for a price that warrants the risk taken.


 

Markel Valuation

Markel’s historical combined ratio is 96%, they had a 95% combined ratio in 2014 and so far in 2015 (through Q3) have an 89% combined ratio.  Due to fairly consistent underwriting profits I kept underwriting returns at 4%, the same as Berkshire’s.  I used 2014 net cash earnings for Markel Ventures opposed to Gayner’s use of EBITDA; and as previously discussed, I lowered investment returns to 5% for the base case.

Screen Shot 2015-12-23 at 8.35.31 PM

 

The base case shows a FV of $1,215 per share with 38% upside from Tuesdays close of $879.85.  Fair value here would imply 2.2x book value, which is at the upper end of Markel’s historical range.  Seems a little rich, but the assumptions aren’t overly ambitious.  If you play around with the assumptions you’ll see (especially when compared to Berkshire) just how much investment return drives the overall intrinsic value for Markel.

At base case $81 EPS Markel trades at:

  • 10.9x comprehensive earnings
  • 14.7% ROE

If we take the base case assumption down to 4% investment returns we get a FV of $1,014 (15.3% upside).  If we take it down to 3% we get a FV of $814 (-7.5% downside).  Of course you can also play with the multiples.  If Markel is only getting 3% returns on investments does it deserve a 15x multiple?  So for me this one is a bit tougher than Berkshire.  The range of outcomes are greater no doubt.


 

A few other thoughts on Markel’s bright future:

1. Markel Ventures growth

I didn’t forecast any growth for Ventures in the model because a) disclosure is minimal and b) it’s still a fairly small part of Markel. EBITDA for 2014 was $95m which comes out to just 8% of the estimated total net profit.  Also, it’s just too hard to forecast (at least for me).  But we can still look at what has happened so far.  Ventures has grown significantly over the years with 30% annual revenue growth since 2005.  Adjusted Ebitda has grown significantly as well.

Screen Shot 2015-12-23 at 9.06.33 PM

(BTW if you’re questioning Gayner’s use of EBITDA I recommend you check out The Brooklyn Investor post I linked to at the bottom)  

Again, this is off a pretty small base and at the moment is still a small part of the business, but I think Ventures could play a large part in Markel’s growth over the next decade.  Gayner said at a recent Markel brunch that if Ventures was outside of Markel they would earn greater than 20% ROIC.  Ventures gives Gayner yet another avenue he can allocate capital to and should provide consistent cash flows.  

2. The Leverage Ratio

The leverage ratio is currently 2.45x, which is at Markel’s low end historically.  If leverage increases to the historical average of 3.5x (or up at all), returns will be magnified.

3.  Increased portfolio mix towards equities

This one ties into the previous bullet.  Gayner has said in the past that their target goal for equities is 80% of shareholder equity (currently at around 55%).  This could be viewed as a nice tailwind for future returns as the investment portfolio mix moves toward equities, but that also depends on your view of the market and Gayner’s ability to beat it.  Additionally, as I quoted earlier, Gayner believes at some point Markel will be able to invest the float in equities a la Berkshire.  Currently Berkshire has about 65% of it’s investment portfolio in equities (rough estimate); whereas Markel has only 23%.  Bottom line, an increase in equity allocation could be a significant tail wind for returns in the future.


 

Conclusion

I do think that Markel’s stock could take a breather and pull back some.  Berkshire did just that in 2015.  It peaked around $150 after a pretty impressive multi-year run up and then receded back down to the $127 range (now ~$131).  If Markel is a large percentage of your portfolio than maybe trimming wouldn’t be a bad idea.  I did this with Berkshire when it was around $150.  I sold 20% of my shares as it was encroaching on 13% of my portfolio, then Berkshire stock dropped down to $127-128 where I bought the shares back.  A rare and lucky “trade” for myself.  This approach allows you to take a little off the table in the short term, but still participate in the long term compounding of a great business.  That said sitting on your hands might be the best bet.

In my original post on Markel I had a FV range of $800 to $1200 using a few different valuation methods.  I’m pretty comfortable saying that at today’s price Markel is at least fairly valued.  I know that opinion is not very popular lately, especially on twitter.  Some people are worried that Markel is getting expensive after the rather quick run up in the last year or two (65% return in 2 yrs).  This strikes me as shortsighted if you believe Markel is truly a great company that can compound overtime.  How many times in Berkshire’s history did people get burned by selling when they thought the stock was slightly overvalued.  Of course Markel is not Berkshire, but I tend to believe the business model is one built to compound overtime in the same vein as Berkshire.  In my opinion there is quite a bit of optionality in Markel’s future.

So that’s my two cents.  I’ll leave you with some interesting quotes from Chuck Akre’s 2011 VII interview:

On rising interest rates

“Just as TD Ameritrade is a coiled spring levered to rising interest rates, so too is Markel when there’s an upturn in the insurance pricing cycle.”

On the Leverage Ratio:

“As part of that model, they constructed a holding company balance sheet which typically had $4 of investments for every $1 of book value, so that when they earned 5% after-tax on their investments, that was magnified four times and the change in book value was 20%. When pricing is soft and the business isn’t growing, that gearing ratio shrinks because they can’t add enough to the investment portfolio to maintain the 4:1 ratio. Today the gearing is more like 2.5:1.”

On valuations:

“So you’re paying around 125% of book. That is hardly expensive for a high-quality, well-run and transparent insurance company that I believe can compound book value at 15% annually. As I mentioned earlier, 200% to 300% of book is not at all out of line for this type of company in a different part of the cycle.”

 


 

Additional Info/Links:

MKL IV Spreadsheet

Markel Corp (MKL): A Conservative Compounder

Valuing Berkshire with Help From Tom Gayner

Value Investor Insight 2012- Tom Gayner

The Brooklyn Investor- Markel Ventures

Tom Gayner Gurufocus Interview 2012

Value Investor Insight 2011- Chuck Akre

Markel (MKL): A Compounding Machine- John Huber

 

Valuing Berkshire with Help From Tom Gayner

I recently came across a post by Greg Speicher from 2011 that described Tom Gayner’s method for valuing Berkshire Hathaway (h/t Value Seeker @Find_Me_Value for the link). The post referenced a 2011 Value Investor Insight interview in which Gayner discusses his valuation method for Berkshire.  It’s really a great interview with a ton of insight from Gayner.  He’s always fairly open with his thinking, but I found this interview particularly informative.  I might have to do another quick post on it.

Anyway, Greg did a great job summing up Gayner’s method by creating a corresponding valuation spreadsheet including Gayner’s assumptions.  I thought it might be interesting to update the spreadsheet and see how Gayner’s valuation method looks today with shares at seemingly cheap levels. (quick note: Greg’s original post was in July 2011; a very good time to buy BRK shares, which were around $75 per B share, 1.1x -1.2x book value and have since produced 12.4% annualized.  The price actually dropped to $65 per B share later that September, producing 15% annualized.)  


 

Gayner’s method for valuing Berkshire:

TG: “I break the business into three parts, insurance, investments and the other operating companies. For the insurance business, which is currently relatively soft but is well-positioned and well-run, I look at the level of insurance premiums running through the business and assume at the low end that it breaks even on an underwriting basis, in the middle range makes 4-5 points of underwriting profit and at the high end makes 8-9 points. For the investment portfolio, I assume it earns from 3% at the low end up to 10-12% at the high end. For the operating businesses, I look at the actual cash flow produced over the past three years and overlay my expectations over the next few years to get a range of possible normalized earnings. On all of that, I apply 10x, 14x and 18x earnings multiples to arrive at a fair-value range for the company overall.”

The TL;DR version:

  • underwriting profits
  • investment returns
  • normalized operating cash flow

Gayner then takes the sum of all three and applies a multiple of 10x, 14x and 18x.

It’s pretty simple.  What’s interesting about this method (to me) is that Gayner’s not just some hedge fund investor valuing a business.  He is essentially valuing his business, which is as close to Berkshire as it gets.


 

Valuation

 

Screen Shot 2015-12-21 at 8.53.04 PM.png

I adjusted the spreadsheet a bit from Greg’s by doing five scenarios instead of three, and used slightly different multiples.  For insurance premiums I used Q3 ttm and assumed a range of zero to 8% underwriting profits with 4% as the base case.  I estimated the investment portfolio at $196.7B, which includes all investments as of Q3: equity portfolio, fixed income, “other”, the Kraft-Heinz investment and $25B cash.  I don’t recall how much cash the PCP deal involves, but you can adjust the cash level as you see fit.  I used Gayner’s range of 3% investment returns on the low end, to 10% on the high end, with a 7% base case.  For operating earnings base case I estimated future growth of 10% annually for three years off of $12.47B ttm, and took the average earnings.  Then I took the total net profit and applied multiples of 10, 14, 15, 16 and 18.

The base case has a FV of $181 per B share or 39.8% upside from Friday’s close of $129.53 per B share  (1.79x book value).  Not to shabby.  Yes, it’s very simplistic but I think this gives a good idea of what possible.  Can Berkshire achieve 4% underwriting profit?  I think so.  7% investment returns?  Probably.  And a 15x multiple  on that is not unreasonable.

At $12.08 EPS Berkshire trades at ($129.53 per B share):

  • 10.7x comprehensive earnings
  • 12% ROE

Conclusion

The main thing I took from Gayner’s method was the visual of just how big the operating businesses are becoming for Berkshire and its intrinsic value.  Growth here should lead to a declining importance of book value multiples, which we sometimes tend to anchor to.  Gayner alluded to this in the Markel 2014 Annual Letter stating that growth in book value CAGR is the best way to measure growth in intrinsic value opposed to using absolute book value multiples.

Anyway, this is just one method of many for valuing Berkshire, but one I’ll probably continue to use if for no other reason than to model various return scenarios from the three segments.

For a good discussion on BRK valuation take a look at Value Seeker’s (@Find_Me_Value) recent tweets.  Some great detail, and interestingly a similar FV despite the very different approach.

I attached the spreadsheet below so you can adjust/play with the assumptions yourself. I’d love to hear what people think about this so feel free to comment.


Additional Info:

Tom Gayner’s approach to valuing Berkshire Hathaway

Value Investor Insight: June 2011

BRK IV Excel Spreadsheet

Morningstar BRK Report

 

 

 

Todd and Ted Portfolio Update (9.30.15)

I updated the T&T portfolio as of Q3.  Let me know if anything is missing or should be added.

Todd & Ted Combined Portfolio (updated as of 9.30.15)
Stock Shares Held Market Value % of Portfolio
DVA 38,565,570 $2,789,448,000 14.97%
T 59,320,756 $1,932,670,000 10.37%
CHTR 10,281,603 $1,808,020,000 9.70%
GM 50,000,000 $1,501,000,000 8.05%
DE 17,052,110 $1,261,857,000 6.77%
PCP 4,200,792 $964,963,000 5.18%
VRSN 12,985,000 $916,222,000 4.92%
SU 30,000,000 $801,600,000 4.30%
BK 20,112,212 $787,393,000 4.23%
V 9,885,160 $688,600,000 3.70%
VZ 15,000,928 $652,691,000 3.50%
AXTA 23,199,474 $587,875,000 3.15%
LMCK 15,386,257 $530,210,000 2.85%
LBTYA 11,957,285 $513,446,000 2.76%
MA 5,229,756 $471,306,000 2.53%
WBC 3,559,189 $373,110,000 2.00%
TMK 6,353,727 $358,350,000 1.92%
LBTYK 7,346,968 $301,373,000 1.62%
LMCA 7,800,000 $278,617,000 1.50%
GE 10,585,502 $266,966,000 1.43%
FOXA 8,951,869 $241,522,000 1.30%
SNY 3,905,875 $185,412,000 0.99%
VRSK 1,563,434 $115,553,000 0.62%
CBI 1,983,190 $78,653,000 0.42%
GHC 107,575 $62,071,000 0.33%
MEG 3,471,309 $48,564,000 0.26%
JNJ 327,100 $30,535,000 0.16%
DNOW 1,825,569 $27,018,000 0.14%
MDLZ 578,000 $24,201,000 0.13%
LILA 517,139 $17,422,000 0.09%
LILAK 367,348 $12,578,000 0.07%
UPS 59,400 $5,862,000 0.03%
LEE 88,863 $185,000 0.00%
Total: $18,635,293,000

Ferrari: Notes from the Form F-1 (RACE)

I recently read the Form F-1 (which you can find here) and thought I would share some of the more interesting parts… at least to me.

A little background first. In October, 10% of Ferrari will be sold to the public via IPO, then the remaining 80% will be spun off to Fiat Chrysler shareholders early next year (the other 10% is owned by Piero Ferrari). Many Fiat shareholders (including myself) bought shares before Fiat and Chrysler merged in large part due to the value of Ferrari. You could of bought Fiat (which at the time owned less than half of Chrysler, Alfa, Maserati and 90% of Ferrari) for less than the value of Ferrari. Having Ferrari as backing put a nice basement on the downside and gave me confidence investing in a small Italian auto manufacturer with a ton of debt. It also helped that CEO Sergio Marchionne was focused on creating shareholder value and understood the value of Fiat’s assets. Anyway, here we are.

Structure post IPO:

Screen Shot 2015-08-20 at 8.58.01 PM

Intro from the F-1:

Screen Shot 2015-08-18 at 9.23.46 PM-2

2014 Financial Summary
Revenue: €2,762
Net Profit: €265
Adj EBITDA: €693
EBIT: €389
Cars Produced: 7,255

Net Revenues by Segment:

Screen Shot 2015-08-18 at 9.32.29 PM

Shipments

One of the most discussed issues regarding Ferrari has been the number of cars produced and whether going above the 7,000 car cap limit is dilutive to the brand. It’s officially the limit is no longer…

“Our strategic business plan reflects a continuation of the low volume strategy, while gradually increasing shipments to approximately 9,000 units per year by 2019.”

Shipments from 2010-2014:

Screen Shot 2015-08-18 at 9.42.34 PM

I’ve seen some argue that increasing production to 9,000 or 10,000 cars would dilute the brand and it’s exclusivity. In the whole world there will only be 9,000 cars sold in 2019…. 9,000! In the world! That’s pretty damn exclusive IMO. A move to 9,000 cars would be a 24% increase over 2014 or a 4.5% annual growth rate through 2019. That’s pretty reasonable. Of course beyond 2019 I’m not sure how they’ll proceed. They also mention that Ferrari’s market share in the luxury performance car market has declined due to the rise of wealthy individuals in conjunction with the static 7,000 car cap limit. They don’t focus on market share or consider it relevant, but it does illustrate how Ferrari could be better aligned with its growing wealthy customer base.

Sergio has mentioned 10,000 cars is possible. He’s also stated that Ferrari should sell one less car than demanded. His argument is essentially that there is a greater growth of wealthy individuals and Ferrari should grow with that demand. He also mentioned that exclusivity can be so extreme that it becomes absurd, referring to the 3+ year waiting lists and 7,000 cap limit.

I agree that maintaining exclusivity of the brand is paramount. One of the biggest mistakes luxury companies make is becoming greedy in the pursuit of short term profits. Inevitably it bites them in the butt by cheapening the brand over time. This happens quite a bit in fashion (Tommy Hilfiger, KORS, Coach). They try to sell more clothes, bags or whatever to more people and all of the sudden everyone and their mom has one of these things. It’s no longer cool or exclusive. Not everyone will own a Ferrari (obviously), but it could become less desirable if it doesn’t maintain ultra-luxury status.

I don’t know how turning Ferrari into a luxury brand opposed to just a luxury car company will affect the long term brand value. Will Ferrari theme parks, clothes, key chains or whatever they think up cheapen the brand? They already have many of these things, but it’s worth keeping an eye on. As far as car production goes IMO, 7,255 to 9,000 cars will not damage exclusivity.

John Elkann, the head of the Agnelli family and CEO of Exor Spa (holding company that controls Fiat), will own a majority voting stake in Ferrari. His prescence gives me comfort in the long term future of Ferrari. I think Elkann will show the same patience he has for Fiat by allowing and encouraging a long term approach that upholds the brands ultra-luxury status.

Formula 1 Racing Team

I have to admit I had no idea how big Formula 1 racing is. In 2014 their were 424 million television viewers, which is the most watched annual sport series in the world.

“More generally, Formula 1 Racing allows us to promote and market our brand and technology to a global audience without resorting to traditional advertising activities, therefore preserving the aura of exclusivity around our brand and limited the marketing costs that we, as a company operating in the luxury space, would otherwise incur.”

Screen Shot 2015-08-20 at 8.53.50 PM

Ferrari takes a share of annual profits from the FOWC (Formula One World Championship Limited), which includes television broadcasting royalties and other commercial activities. 60% of the profits are distributed to the teams based on the ranking of each team. So the first place team gets the most money and last place the least. There is sponsorship money from the likes of Phillip Morris, Shell, Santander and others. Ferrari is also the only team that gets paid a fee for just being a part of the race. All of this money is used to offset the cost of the racing team.

The racing team is kind of a marketing, client schmoozing and R&D department all in one. Many of the racing teams designs, technological advancements and enhancements make their way onto later production models.

Engines

What I found most interesting was the engine segment. Revenues are up 300% since 2011 and went from 3.5% to 11.3% of revenue. This is mostly due to the ramp up of Maserati, which uses engines built by Ferrari. This quarter’s revenues were lower due to a decrease in Maserati sales, but longer term this could be a nice area for growth. It’s a double edge sword that depends on the success of Maserati. Sergio is planning to introduce multiple new models over the next few years including the Levante SUV next year.

“Net revenues generated from engines were €311 million for 2014, an increase of €123 million, or 65.4 percent, from €188 million for 2013. The €123 million increase was mainly attributable to an increase in the volume of engines sold to Maserati, and to a lesser extent, driven by an increase in net revenues generated by the rental of engines to other Formula 1 racing teams.”

Here’s the deal with Maserati:

“Our arrangement with Maserati is currently governed by a framework agreement entered into in December 2014. Pursuant to this agreement, the initial production run of up to 160,000 engines in aggregate through 2020 is expected to increase to up to 275,000 engines in aggregate through 2023 to cater to Maserati’s planned expanded model range and sales. Volumes and pricing are adjusted from time to time to reflect Maserati’s changing requirement.”

“In order to meet our obligations under our agreement with Maserati, we constructed a new production line dedicated to the Maserati V6 engine, which was funded by Maserati.”

I believe Alfa is using Ferrari engines as well, which is not referenced at all in the F-1. I found that kind of curious. Anyway, it could be a huge boon for engine growth since Alfa is being positioned for a bigger/broader market than Maserati. The stated goal of 400k Alfa’s is a ridiculously lofty goal, but for Ferrari’s purposes anything at all will be good for business.

UPDATE: From what I’ve read Ferrari isn’t building Alfa engines.  Alfa is using the term “Ferrari Developed” or “Ferrari Designed”.  Not sure what the hell that means.

What I like about the growth in engine sales is it can ramp up quite a bit, it produces good money for Ferrari and all while having very little impact on the Ferrari brand. I don’t know if the market even realizes that Ferrari makes money by selling and producing engines. Maybe, but I highly doubt they realize their is growth potential here.

Markets by Region

“We divide our regional markets into EMEA, Americas, Greater China and Rest of APAC, representing respectively 45 percent, 34 percent, nine percent and 12 percent of units shipped in 2014. In recent years we have allocated a higher proportion of shipments to the Middle East and Greater China and, to a lesser extent, the Americas and a lower proportion to Europe, reflecting changes in relative demand as part of our strategy to manage waiting lists and maintain product exclusivity.”

Screen Shot 2015-08-19 at 9.26.02 PM

True to the statement above you can see that Middle East and APAC shipments have been growing the most as a % of total cars shipped.

Economic Sensitivity

“During the financial crisis, suffered only a single year of modest (less than 5 percent) decline in shipments in spite of the luxury status of our cars and the discretionary nature of their purchase.”

I was happy to see this quote and it’s quite the accomplishment if true. Still I wish they would give more information on shipments and financials over the last decade, but I didn’t see anything prior to 2010. (If anyone has 10 year financials please let me know!)

Screen Shot 2015-08-19 at 9.28.25 PM

The chart above shows Ferrari shipments vs the luxury performance car index. You can definitely see a dip in 2008-2009, but much better than the index, which includes sport cars with 500hp and a retail price above 150,000 euro (Aston Martin, Bentley, Ferrari, Lamborghini, McLaren, Mercedes Benz, Rolls Royce). The Ferrari data is based on the top 22 countries (approx. 80% of total shipments in 2014).

“While affected by global macroeconomic conditions, the luxury goods market is also impacted by several more specific factors, such as, in recent years, the significant economic growth and wealth creation in certain emerging economies and rising levels of affluence and demand from the emerging middle and upper classes in Asia and a general trend towards urbanization. Particularly following the 2008-2009 downturn, this has led the global luxury goods market to return to perform better than global GDP, as shown in the chart below.”

Screen Shot 2015-08-19 at 9.31.53 PM

Platforms and Production

Just like the big boys Ferrari utilizes common platforms in order to reduce fixed costs by using two architectures that enable both front and mid-rear engines for flexibility.

Screen Shot 2015-08-20 at 9.01.48 PM

Over the last decade the Ferrari facilities have been significantly upgraded. This will allow them to ramp up production without any issues as the cap limit is lifted. It should also help boost margins by spreading production costs across more cars.

“Our facilities can accommodate a meaningful increase in production compared to current output with the increase of weekend shifts or, to address special peaks in demand, temporary employees. Production could be increased even further with the introduction of a second shift on car assembly lines compared to the single shift currently operated.”

I think this is one of the bigger parts of the bull case on Ferrari. As they raise production to 9,000 cars not only will that help the top line, but costs should rise slower leading to better margins going forward.

Limited Edition Cars/ Life Cycle

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“The exclusivity of a particular product offering is also a relevant factor in its profitability. For example, in November 2013, we launched the LaFerrari, our latest limited edition supercar, which was planned for a total production run of only 499 units. In light of the exclusivity of the offering, along with the supercar advanced technological and design content, LaFerrari has a sales price in excess of €1 million, which is much higher than other models in the Ferrari product range. Therefore, our 2014 and 2015 net revenues have benefited significantly from shipments of LaFerrari. We expect to complete the production run of the LaFerrari in early 2016. In general, more exclusive offerings generate higher net revenues and provide better margins than those generated on shipments of range models (which include Sports and GT models, V8 and V12 models and represent the core of our product offering) and special series cars. Similarly, our limited edition cars which we launch from time to time are typically sold at a significantly higher price point than our range models and therefore they benefit our results in the periods in which they are sold.”

I mentioned it earlier, but without more detail I’m not sure how one-off type models will affect revenues due to their lumpiness.

As for the range models:

“Generally, we plan for a four to five year life cycle for our range models. After four to five years, we typically launch a modified or M model based on the same platform but featuring significant aesthetic updates and technological improvements. This is, for example, the case of the California T, launched in 2014, which replaced and updated the earlier California, featuring new sheet-metal, new interior, a revised chassis and a new turbocharged powertrain. Typically, four years after the launch of the M-model, we start production of an entirely new model based on an completely new or overhauled platform. Therefore, the cumulative life cycle of each of our models is approximately eight to nine years, and typically we have launched one new model every year while keeping four or more range models in production at any time. The actual life cycles of our models vary depending on various factors including market response. Special series have different, typically shorter, lifecycles. We usually utilize additional platforms for production of our supercars, such as LaFerrari.”

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With the range models there is actually a nice steady cycle that can last 8 to 9 years with just one refresh. I do have a feeling Sergio is aware of the lumpiness and would push for a smoother more predictable one-off production roll out. But still, not sure how much can be done about this. We’ll just have to be wary of the possibility that current earnings are above average and figure out what the normal earnings power is through a full cycle.

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Pricing

Since 2005 Ferrari has achieved a CAGR in net revenues of 7%. This is with production levels that didn’t increase much due to the 7,000 car cap limit. Without knowing the complete picture I think this gives us an idea into their ability to raise prices and how with expanding the cap limit what growth might be possible.

“We believe our cars performance in terms of value preservation after a period of ownership significantly exceeds that of any other brand in the luxury car segment. High residual value is important to the primary market because clients, when purchasing our cars, take into account the expected resale value of the car in assessing the overall cost of ownership. Furthermore, a higher residual value potentially lowers the cost for the owner to switch to a new model thereby supporting client loyalty and promoting repeat purchases.”

This was fascinating to me. The resale value of Ferrari’s are very high and sometimes higher than the original purchase price. I was aware of that fact, but didn’t think about how it makes customers more likely to be a repeat buyer (after selling the old car). Also, it provides stability in new car pricing.

“We seek to increase over time the average price point of our range models and special series by continually improving performance, technology and other features, and by leveraging the scarcity value resulting from our low volume strategy. Furthermore, the content of the cars we sell can be customized through our interior and exterior personalization program, which can be further enhanced through bespoke specifications. Incremental revenues from personalization are a particularly favorable factor of our pricing and product mix, due to the fact that we generate a margin on each additional option selected by the client.”

Customization offers items such as rare leathers, custom stitching, special paints, special carbon fiber and personalized luggage to match the car interior, which on average add 15% to selling prices.
And of course there are the limited edition supercars (La Ferrari) that can exceed $1 million per car; as well as, very limited edition series and one-off cars that all have higher average price points.

The Ferrari “Brand”/ Licensing

Marchionne has stated that Ferrari is a luxury brand not just a car company. A big part of that branding effort is expanding into other areas outside of actual car making. To achieve this Ferrari is looking to expand retail stores and licensing out the brand for theme parks, accessories, sportswear, toys, video games and who knows what else. You can see the list below. They are also planning on branching out into other luxury goods in adjacent lifestyle categories. Not sure what that means exactly, but I’ll be keeping an eye on whether this truly enhances the brand… or possibly has the opposite effect.

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A significant portion of licensing revenues comes from Ferrari World royalties. At the moment this is the only theme park, but there are plans to open one theme park in each geographical region. I assume this means at least 4 total, maybe more. They mention specifically having one in North America and Asia. There is a deal in place to open a European theme park in Barcelona, in which PortaVentura Entertainment will invest 100 million set for a 2016 opening.

“Net revenues generated from sponsorship, commercial agreements and brand management activities were €17 million for 2014, an increase of €5 million, or 1.2 percent, from €412 million for 2013. The €5 million increase in sponsorship, commercial and brand net revenues was mainly driven by new sponsorship contracts entered into by our Formula 1 racing team during 2014.”

As you can tell from the quote above, they lump F1 sponsorship money with the brand licensing so it’s hard to say what the parks and other accessories are bringing in.

Conclusion

As a Fiat shareholder I’m pretty excited about the Ferrari spin. I don’t know what the market will pay for it, but I’ve seen some pretty aggressive estimations including Sergio’s comment that Ferrari is worth “at least $11 billion”. The ADW Capital link below is even more aggressive. It assumes EBIT margins 3x the current level and 10k cars by 2018. Too aggressive in my opinion. And as we’ve seen in the F-1, they’re targeting 9,000 by 2019. I’ll need to do some more work (and get more information/detail) before I can confidently value Ferrari. If you made me guess I’d say $5 billion is a fairly reasonable number.

What I do know is Ferrari is one of the top brands in the world that will be growing revenues at a better than expected rate (4.5% p.a. alone in shipments not including pricing). From 2005 to 2014 they grew revenues at a 7% CAGR without much of an increase in shipments. They’ll be scaling to a level where R&D costs from F1 and costs for the production models should remain stable or grow slower than revenues allowing margins to expand. Also, we have upside potential from a significant increase in engine sales from both Maserati and Alfa Romeo (possibly not Alfa). Finally there is the expansion into Ferrari “the brand”. I don’t know what to expect from the theme parks and other Ferrari related products, but it’s worth keeping an eye on and if they do it tastefully it could be another boost to the bottom line.

It’ll be interesting to see what happens come October. Anyway, hopefully I added some value to the discussion. Let me know in the comment section if you have any gripes, questions or more information on Ferrari.

Todd & Ted, Concentrated Portfolios and Some Links

I recently tweeted out some of my favorite 13F’s and figured I would make a more expansive post for future reference. I personally like looking over select 13F’s, especially if there are a significant amount of new buys. Some people dismiss it as useless, but I think if you follow great investors that have concentrated portfolios with relatively long term holdings then it can be extremely useful for idea generation. I mean really with dataroma.com and whalewisdom.com it hardly takes anytime to notate new buys, adds, sells of gurus you’re interested in. At worst it’s simply entertaining to see what they’re are up to.

My personal favorites:

Arlington Value Capital (Allan Mecham)
Akre Capital Management (Chuck Akre)
SQ Advisors (Lou Simpson)
Berkshire Hathaway (WEB, Todd and Ted)
Markel Corp (Tom Gayner)

The first three are extremely concentrated and tend to favor great businesses (compounders). They all have had great long term success; although Mecham is relatively new/young he has done very well. I think Mecham and Akre have some great under followed ideas that are interesting for deeper dives.

Lou Simpson is great. As most of us know he was in charge of GEICO’s portfolio for decades under Buffett until he retired. Lot’s of high quality companies. His 10th position is ~5% of the portfolio! Love it. Lots of interesting names… from Liberty Global and VRX to UPS and Wells Fargo.

I’m biased on Berkshire and Markel. I own significant amounts of both, so selfishly I want to see what these guys are buying. Gayner has a great track record of beating the market, but honestly I don’t find many ideas from his 13F (although, maybe I should). He has quite a few holdings that are very small percentages of the portfolio. He calls these his “minor league team”, which i thought was interesting. Basically he’ll buy a business he’s interested in but doesn’t quite understand (like Amazon) and own it for awhile forcing him to pay closer attention. After awhile he’ll either bump them up to the majors or just get rid of the stock if he still doesn’t understand it.

With Berkshire I’m more interested in Todd and Ted’s picks. Buffett’s are so large and rarely change (although when they do change it’s fun to speculate/debate his reasoning, ie. IBM).

After looking at the Berkshire 13F I wanted to see what the portfolio allocations looked like without Buffett’s giant holdings lumped in. So as you can see below I did just that. It’s both Todd and Ted’s picks together. I took out Buffett’s Big 4 (WFC, AXP, IBM, KO), also PG, USB, WMT, GS, MCO, DE, MTB, USG, COST and QSR. There might be others I’m missing or maybe one of these isn’t actually his picks but it should give us a fairly accurate picture.

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Anyway, combined they have ~50% of the portfolio in the top 5 holdings and ~68% in the top 10 with a total of 34 holdings. The DTV/AT&T deal is going through and the recent PCP acquisition will free up quite a bit of cash for the T’s to allocate (I think DTV was a joint pick; PCP a Combs pick). One of the T’s made a new buy in Axalta Coating Systems (AXTA), which I’m not familiar with. Notable due to it being 3% of their portfolio off the bat. I’d be very interested to hear their thoughts on multiple media companies they own, especially the various Malone entities.

Ok enough Berkshire. There are a few newer 13F’s I’ve been following (new to me) that I like quite a bit:

Bares Capital Management (Brian Bares)
Abrams Capital (David Abrams)
Giverny Capital (Francois Rochon)
AltaRock Partners (Mark Massey)

These guys are EXTREMELY concentrated (anywhere from 7 to 25 holdings).
Bares
Bares specializes in Small-cap compounders so I really like to keep a close eye on his holdings for ideas possibly in the early innings. Currently Colfax (CFX) is his largest holding at 19.75% of the portfolio. Ouch.

(Links):
Brian Bares Interview MOI
Interview MOI (video)
Abrams
Abrams is a former Baupost guy. Very concentrated. Has a good mixture of ugly/cheap/hated and great businesses. One thing to keep in mind is like Klarman the equity portfolio is only a portion of the whole fund. Abrams owns some private held companies and debt investments from what I remember.

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(Links):
In Boston, Secretive Hedge-Fund Billionaire Stays in Shadows
Hedge Fund World’s One Man Wealth Machine
AltaRock

AltaRock owns 7 stocks:

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Respect.
(Links):
Hedge Fund AltaRock’s Investing Principles

Giverny
Giverny is run by Francois Rochon. Fully invested at all times, 25 positions and focuses on great businesses.

Top 10 Picks:

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(Links):
Rochon Interview
Rochon Gurufocus Interview

Honorable Mentions:

Pershing Square (Ackman)
Weitz Investment Mgmt (Wally Weitz)
Pabrai Funds/Dalal Street (Mohnish Pabrai)
Aquamarine Capital Mgmt (Guy Spier)
Wedgewood Partners (David Rolfe)
Smead Capital Mgmt (Bill Smead)
Yacktman Asset Mgmt (Don Yachtman)
ValueAct (Jeff Ubben)
MFP Investors (Michael Price)
FPA Crescent (Steven Romick)
FPA Capital (Bob Rodriguez)
Oakmark (Bill Nygren)
Tweedy Browne
Third Avenue (Marty Whitman)

A couple more interesting extremely concentrated funds: (h/t to @bluegrasscap who brought these to my attention and btw is probably my favorite follow on Finance Twitter)
Tesuji Partners
Lavasseur Capital Partners

And finally the most useless 13F for me:
Baupost (Seth Klarman)

I have no clue… Half are Bio names I won’t even try to figure out. He changes positions frequently sometimes, so I can’t gauge his timeframe/convictions. Plus the equity portfolio is just a part of his whole portfolio. Too hard pile. Probably the reason he’s one of the best.

Feel free to suggest any other good funds in the comment section (especially concentrated, long term value funds).