As you are certainly aware, over the last several weeks news of COVID-19 (coronavirus) has dominated the headlines, and increasingly our everyday lives. The country is using “social distancing” to slow the spread of the disease, and restrictions on human interaction and business activity continue to ratchet up. While effective at slowing disease spread, these measures are highly disruptive to our daily routines, and are causing significant hardship for many businesses and consumers.
We expect significant economic contraction in the short term, and continued pain in the intermediate term until a vaccine or highly effective therapeutic is widely available. Fortunately, fiscal and monetary response has been robust, and largely on target, limiting the risk of an uncontrolled downward spiral. With our nation’s productive capacity largely intact, we think that long-term GDP and corporate profits will not be significantly affected by this downturn.
As investors we face the challenge of how to react to various macroeconomic concerns that emerge on a semi-regular basis. Most often these concerns prove unfounded with the passage of time, but occasionally manifest in damage to the real economy and corporate profits. Our view is that it is extraordinarily difficult to make money by placing bets on macroeconomic events. The world is too complex with too many moving parts for this to be a consistently profitable exercise. Experience has taught us that we are most effective when building the portfolio one business at a time.
As long-term investors, we fully expect that our portfolio will face difficult economic environments at various points during our investment horizon. We prepare for this eventuality, not by exiting stocks at the first sign of trouble, nor by rotating our portfolio into more conservative sectors, but rather by seeking to own companies that can survive a downturn, and often use that downturn to their advantage. We seek to own superbly run companies with strong balance sheets that tend to be leaders in their industry. When times get tough, they are often in a position to go on offense by acquiring weaker competitors, introducing new products, or moving into new geographies. While the value created by such activities does not always reveal itself in the midst of a downturn, it becomes evident with the passage of time.
For example, during 2006 and 2007, O’Reilly Automotive received significant criticism from Wall Street analysts for having a balance sheet that was “too conservative.” Many argued that O’Reilly should take advantage of record low interest rates to issue debt and use the proceeds to repurchase shares as other auto parts retailers had done.
O’Reilly resisted that siren song, and in 2008 when a key competitor, CSK Auto, found itself in financial distress, O’Reilly attacked by launching a hostile takeover bid for the business. CSK had great strategic value because of its strong west coast footprint, which enticed other competitors to enter the bidding. However, debt markets were tight, and O’Reilly had an advantaged balance sheet, so it ultimately secured the acquisition.
O’Reilly got a great bargain acquiring approximately 1,300 well located CSK stores at a discount to what it would have cost to open a similar number of greenfield stores. The acquisition of CSK fueled outsized growth and financial performance for O’Reilly for many years after the transaction, an opportunity that would not have come about without the recession.
While we regularly analyze how our businesses might perform in a recession, a global pandemic leading to a cessation of economic activity for an extended period of time is not something we had ever specifically contemplated. We have since stress tested each business we own for this new reality. We have considered what impact this may have on short and long-term demand, and stress tested balance sheets to see if businesses can survive three months, six months, or even a year of nationwide social distancing.
While most of our businesses will suffer short-term revenue and profit declines, in general, we feel very good about their ability to weather this storm. We provide some brief thoughts below:
•The Good: Approximately 69% of the portfolio is in companies that we think will handle this downturn with relative ease. This includes American Tower (virtually no impact), Aon and SS&C (small negative demand impact), Markel (mark-to-market reduction in value of public equities portfolio), O’Reilly Automotive (sharp, but short lived reduction in miles driven and parts demand), Ametek (negative demand impact; strong balance sheet for acquisitions), Brookfield Asset Management (challenged mall portfolio; significant funds for new investments), Encore Capital (short-term reduction in collections due to job losses, rule changes, and court closures; intermediate term bonanza from increased credit card defaults), and Charles Schwab (lower interest rates reduce income for a while).
•The Bad: Approximately 30% of the portfolio is in companies that we think are facing significant short-term business disruption, but ultimately have the management team and balance sheet to see it through to the recovery. In most cases we see limited impact on long-term demand, potential for market share gains, and only minor changes to our long-term estimates of intrinsic value. This group includes: Carmax (many stores closed; negative demand for autos; boost to online delivery solution), NVR (negative demand impact for new homes; in our view, best balance sheet among public peers), Ashtead Group (negative demand impact for construction equipment; best balance sheet among public peers), American Woodmark (negative demand impact for kitchen and bath cabinets), Hexcel (negative demand impact from reduced air travel).
•The Ugly: Approximately 1% of the portfolio is in two companies that we think face significant disruption with risk of not recovering from the downturn. Both now trade at a significant discount to our estimate of private market value, and upside is 3-4x in the next couple of years if they survive, so we have not exited these positions.
We acknowledge that the quotational value of our portfolio has not held up as well as the broader market this quarter. This is disappointing since we expected the stocks of our well run, competitively advantaged, reasonably valued businesses to do relatively well in a recession. But this downturn is just beginning to unfold. In the short term, the market has painted with a broad brush; there has been significant underperformance of the sectors we are overweight: consumer discretionary, real estate, and financials, and significant outperformance in sectors where we have virtually no exposure: technology, consumer staples, utilities, and health care. This reaction is understandable given the nature of this downturn. However, over time, we believe that the true value of the businesses in our portfolio will be recognized by the market as it becomes clear that they will not only make it through this downturn, but many will come out stronger and more profitable because of it.
We have made several modest changes to the portfolio this quarter, but nothing significant. We like the businesses we own today for the reasons articulated above. Many have sold off well in excess of the change in their intrinsic values, so it is hard to find better bargains elsewhere. We have already paid a price for owning companies exposed to “social distancing”; the stocks in “The Bad” bucket have declined 46.2% on average since February 19 (the day the market began its decline) compared to a decline of 24.8% for the S&P Total Market Index. We do not think that now is the time to move to a conservative posture and load up on utility and health care stocks, now is the time to pick through the rubble to find those gems that have been unduly discarded.
We have been reviewing our watch list and are actively considering several candidates for inclusion in the portfolio. At the end of the quarter, we added a new position in RH at 1% assets. RH’s share price has been crushed in this downturn, declining 60% from its recent high. RH fits the prototype of investments we want to make now; it is cheap because it is suffering in the near term, but has solid leadership and liquidity, and should emerge much stronger after the downturn. While a modest allocation, we have planted a seed that may grow into a mighty oak. We will look to plant other such seeds in the coming months and quarters.
RH (formerly known as Restoration Hardware) is a leading luxury retailer in the home furnishings marketplace. The company is in the early innings of a transformational change to its real estate/store design strategy. RH is replacing its legacy mall-based stores with larger “design galleries” located primarily in prestigious off-mall locations. RH believes there is the potential for 60-70 design galleries in North America versus 22 today. The larger design galleries produce 2x the sales volume of legacy stores on lower occupancy and expense rates, resulting in 2-3x higher four-wall profit.
Over the last 19 years, CEO Gary Friedman has transformed RH from a nearly bankrupt purveyor of home accessories into arguably the leading luxury home brand in the world. Gary has 28% beneficial ownership of RH and is relentlessly focused on return on invested capital (ROIC) and capital allocation. Even with its stores closed due to the pandemic, we believe RH’s direct to consumer business (about 40% of sales) will allow the company to remain free cash flow positive. We think that RH is a well-run, high quality business with a large growth opportunity — a “compounder” — that we can likely hold for the long term. Over time, should our continuing research reinforce our investment thesis, we will look to add to the position opportunistically.
In mid-March, we reallocated about 2% of capital to SS&C Technologies from Charles Schwab Corp. This brings SS&C to about a 4% position and Schwab to about a 4% position. We initiated a position in SS&C in the third quarter of 2019, and our conviction in our investment thesis has grown since then. While we continue to like Schwab, its profitability is hampered by the very low interest rates that have come about recently, and we now expect rates to stay low for an extended period. We also like that SS&C’s recurring revenue and acquisition engine give it more control over its own destiny than Schwab in this environment. We sold Schwab at about 17x our estimate of earnings run rate and purchased SS&C at about 10x our estimate of earnings run rate.