To be clear, this is not an in-depth write-up on the investment case for Mastercard. That might come later. With this post, I discuss what I think are some overlooked metrics that are the result of Mastercard’s scaled payment network.
Background
Formerly an organization mutually owned by a large collection of credit card issuing banks, Mastercard went public in 2007. No longer beholden to its bank shareholders, Mastercard had free reign to maximize the long-term value of only Mastercard, and thus embarked on a long journey to do just that. Through acquisitions and reinvestment back into its business, Mastercard has continually sought to increase the value of both its payment rails and the many value-added services it provides to its customers.
Transaction Growth is the Evidence of Customer Value
I believe one of the strongest barometers for whether Mastercard is creating value for customers is whether the number of transactions on its network is increasing. If customers found little value in doing business with Mastercard, transactions would stagnate or decline, and in turn so would Mastercard’s revenues and profits.
On the metric of transactions, Mastercard has had extraordinary success.
In 2007, the total worldwide purchase transactions using Mastercard’s network was a measly 23.8 billion. In 2023 alone, Mastercard recorded an increase of 20.8 billion in the number of worldwide purchase transactions on its network, from 150 billion in 2022 to 170.8 billion.
More Cards, Less Cash
But we can’t just stop at Mastercard’s numbers. Let’s look at data from the Federal Reserve Bank of San Francisco. They’ve conducted an annual survey of consumer payment choices since 2016. The chart below shows credit and debit cards had a combined share of 45% in terms of all available payment types in the United States. In just six years, this combined figure grew to 60%.
More data comes from the 2022 Federal Reserve Payments Study. This chart shows the trends in just noncash payments by number of transactions. Again, we see a steep rise in the popularity of credit and debit cards while more traditional methods have declined or failed to keep up the pace.
Simple Explanations for Credit/Debit Popularity
There are many explanations for the increase in use of credit and debit cards, but they all boil down to utility. The increase in online shopping over the last 15 years might be the primary contributor to the popularity of cards—it’s just impossible to use cash or check to buy something online! With many credit cards, consumers also have the opportunity to earn rewards or cash back.
Advancements in payment technology is another factor. Contactless payment technology has only in the last several years become mainstream in the U.S. despite being rolled out since 2015. Thanks to contactless, debit/credit cards are even more convenient to use in-person, whether at a physical store or in an increasing number of major public transportation systems. According to Sachin Mehra, CFO of Mastercard, on July 31, 2024:
“Card present growth was aided in part by an increase in contactless penetration as contactless now represents approximately 69% of all in-person switched purchase transactions.”
Faster, easier payments drives consumers to use cards more frequently. Like having a newspaper delivered to a mailbox, the days of using cash or check will only be a memory to those of certain prior generations.
But at What Cost?
Although more transactions enables Mastercard to earn more revenues, has this translated into profits? Although customers and end users have received value from Mastercard, have the shareholders of Mastercard received adequate value in return?
The short answer is “yes”.
Over the last 16 years, through the great financial crisis of 2008-2009 and through a global pandemic, Mastercard has grown revenues from $4 billion to $25 billion and has doubled its EBITDA margins from 30.2% to 61.1%. The returns to shareholders have been equally exceptional over that time.
So how have margins doubled over this time period? The answer lies in a scaled, trusted network with a plethora of value-added services attached to it. The marginal cost to take care of an additional transaction, let alone another few million, is extremely low. Mastercard’s investment in its enabling infrastructure—we measure this as the combined spend on capex and capitalized software—stands at just 4.3% of their total 2023 revenues. The benefits of scale will continue as Mastercard spreads its costs across a growing avalanche of transactions.
Expenses Per Transaction
Now we are finally at the overlooked metric I find useful in illustrating how Mastercard has achieved its extraordinary margins: the reduction in its expense per transaction. It’s a more precise way of saying “economies of scale”.
The chart below shows both the total operating expense per transaction (excluding litigation provisions and charitable contributions) as well as just the processing expense per transaction. (Please note that Mastercard labels what we describe as “processing expenses” as “data processing and telecommunications” expenses).
There has been a steady, long term decline in total operating expense per transaction. In 2007, it cost Mastercard about 12.3 cents to process every transaction in its network. This declined to just 6.2 cents per transaction in 2023. In other words, transactions have grown faster than total operating expenses.
The next chart is a simulacrum of the prior chart. This one shows the growth of transactions and total operating expenses (excluding litigation provisions and charitable contributions) with both indexed to 100 in 2007. We see that transactions in 2023 were 7.2x greater than in 2007 while operating expenses were just 3.6x greater than in 2007.
We can also dive a bit deeper into some of the operating expense categories. Although growth in processing expenses have kept up with growth in transactions, one line item that has benefited tremendously from scale is marketing and advertising. In its time as a public company, the largest amount Mastercard ever spent on this line item was in 2007: a grand total of $1.1 billion (26.6% of revenues). In 2023 the spend on marketing was $825 million (3.3% of revenues). The marketing spend as a percentage of revenue has declined significantly over time, which has contributed meaningfully to Mastercard’s margin expansion.
Summary
To summarize, here’s a great passage from page 100 of Joe Nocera’s book, A Piece of the Action (published 1994), about credit cards and processing:
“It’s a complicated array of things you don’t see, but it all happens so quickly and smoothly that you don’t even think about it. Here, then, was another paradox: computers weren’t important only because they managed highly complex tasks; they were important because they disguised highly complex tasks. By making a complicated process invisible, computers allowed people to forget about the complexity, and focus instead on what was visible: namely, how easy the thing was to use.”
Payment cards have become ubiquitous thanks to convenience and ease of use. Nilson Report says there were 26.71 billion payment cards in circulation worldwide at the end of 2023. They predict that number will reach nearly 30 billion at the end of 2028. As of right now, there’s 8.1 billion people alive on this planet, so it’s amazing there is still room to grow the number of cards in circulation.
Since its IPO in 2007, Mastercard has played its part in the war on cash, investing billions to accommodate more transactions and more payment methods. As it has invested in capacity, Mastercard’s financials have benefited greatly from its growing scale and the value realized by its customers. Operating costs per transaction has halved from 2007 to 2023. We believe they will slowly decline for years to come.
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Disclaimers and Notes
The content of this publication is for entertainment and educational purposes only and should not be considered a recommendation to buy or sell any particular security. The opinions expressed herein are those of Douglas Ott in his personal capacity and are subject to change without notice. Consider the investment objectives, risks, and expenses before investing.
This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the affiliates of Andvari.
Investment strategies managed by Andvari Associates LLC, Doug’s employer, may have a position in the securities or assets discussed in any of its writings. Securities mentioned may not be representative of the Andvari's current or future investments. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
Data sources for all charts come from SEC filings, Koyfin, and other publicly available information.
Tyler Technologies, based in Plano, TX, is the only public company focused solely on software for state and local governments in North America. Since 1998, Tyler has acquired over 40 software companies. Revenues have grown from $50 million in 1998 and will likely surpass $2 billion at the end of 2024. Cash flows and operating profits have grown at a faster rate over this time frame.
FIRST TRANSFORMATION
Although most of us know Tyler now as a pure software company, it actually started out as a manufacturing and industrial company.
The story begins with Joseph McKinney, a venture capital investor in the 1960s, who used his early financial success to start a company named Saturn Industries. McKinney acquired Tyler Pipe in 1968, a manufacturer of sewage pipes, and changed Saturn’s name to Tyler Corporation. In the ensuing two decades, McKinney used Tyler as a vehicle to acquire a variety of businesses, adhering to the M&A-driven conglomerate style of businesses in vogue during those years. Tyler ultimately hit its first peak in revenues in 1987, reaching $1 billion in sales.
In the late 1980s, McKinney saw private equity companies entering the M&A fray, doing larger and larger deals at larger and larger multiples. However, unlike many of his peers, McKinney had some discipline. Thus, McKinney began to sell most of the businesses he had acquired over the years. By the mid-90s, Tyler had sold 12 businesses and distributed over $400 million to shareholders.
However, the deal-making desire didn’t completely leave McKinney. In 1995, McKinney bought Forest City Auto Parts and Institutional Financing. These both turned out to be awful investments and McKinney resigned as CEO in 1997.
From here, with the help of Louis Waters, who had acquired a 10% position in Tyler, Tyler would sell all vestiges of its past and reallocate the capital into software businesses that served local and municipal governments.
TODAY'S TYLER
Again, today Tyler is the only publicly traded company focused solely on providing software solutions to local and state governments in North America. It is the market leader with just a 6% share in a highly fragmented market worth $35 billion. Furthermore, it is one of the vanishingly few companies that have successfully pivoted entirely from one industry to a completely new industry—from industrial conglomerate to vertical market software. (If anyone knows of other examples of companies who made such a pivot, I would love to hear about it!)
Tyler is now approaching $2 billion in annual revenues after a long and steady march. Over the years, it has acquired many companies, small and large, to round out its capabilities. It has an ERP system (enterprise resource planning), products for almost anything related courts and public safety, health and human services, tax appraisal, outdoor recreation, K-12 education, and many more.
Prior to 2019, Tyler had taken an agnostic approach to building and selling its products, deferring to the preferences of its customers. Historically, as with many software companies, Tyler offered two options to its customers. One was its on-premise option, where Tyler sold a license to its customer to install and use Tyler’s software on computer systems owned and operated by that customer. In the industry vernacular, this is an “on-prem” sales model, as its customers installed and kept the software on their own premises. The second option was for Tyler to install and host the software in datacenters owned/rented by Tyler and then charge its customers on a regular basis for use of the software. Historically, nearly all of Tyler’s customers preferred the on-prem way of doing things.
With the advent of cloud computing services from Amazon, Microsoft, and Google, most software companies have transitioned from on-prem offerings to “SaaS” offerings (i.e., software as a service). This is where the customer rents the software from Tyler who then hosts it in the cloud on someone else’s computers. Tyler then collects a rent on a regular basis. The upside to the customer is they don’t have to worry about investing in expensive hardware or investing in a skilled labor force that maintains the computers and the software. The upside to Tyler is they stand to earn 2x the lifetime revenues with a cloud deal than they’d typically earn with a standard on-prem deal.
Thus, Tyler decided to become a “cloud first” company. They announced a partnership with Amazon Web Services in October 2019 and began their second transformation, from that of an on-prem software company to one with a subscription-based business model.
SECOND TRANSFORMATION
Tyler’s second transformation is now five years underway. We can clearly see that something has been going on as margins have declined from the low 20s to the high teens over the last eight years.
The cause for the decline in margins is Tyler’s transition to a SaaS business model. They’ve been consolidating the many different versions of older products. The company has also been experiencing duplicative costs as they move current customers out of Tyler’s data centers and into the cloud with AWS. Finally, the transition to a SaaS model naturally pressures margins and revenue growth because there are less up-front revenues when a customer signs a SaaS contract with Tyler.
However, we are confident Tyler’s operating margins will trend upwards to the high 20s by 2030. The primary reason is that the headwinds from the cloud transition will be gone by that time. In 2030, most of Tyler’s revenues will be from cloud and SaaS arrangements.
To measure the progress of Tyler’s transition, we track new subscription contracts as a percent of total new contracts. On a dollar value basis and on the basis of absolute number of new customers, the choice has been overwhelmingly for the cloud over the last several years.
Tyler is also flipping hundreds of current on-prem customers to the cloud every quarter. Tyler also just reported two consecutive quarters of more than 200 new SaaS arrangements with customers.
Furthermore, as of a year ago, Tyler’s quarterly revenues from SaaS arrangements have started to exceed the combined revenues from maintenance and license deals. With negligible growth in maintenance revenues ceasing to be a headwind, the tailwind from SaaS arrangements will only increasingly be felt as the company moves forward.
Finally, our last chart shows the long term shift in segment revenues. It’s plain to see the drastic move from maintenance to subscription-based revenues over the last ten years.
SUMMARY
As Tyler stated in its 2023 Investor Day presentation, they have thus far flipped about 15% of its on-prem customers to the cloud. Their goal is to increase that cumulative amount to 75%-85% by the end of 2030.
With its recent 2Q 2024 results confirming the strong trend of more current and new customers choosing the cloud and SaaS offering, we believe Tyler is on track for its audacious, long-term goal of drastically improving gross and operating margins and attaining $1 billion of annual free cash flows by the end of 2030.
Git along, little dogie.
Disclaimers and Notes
The content of this publication is for entertainment and educational purposes only and should not be considered a recommendation to buy or sell any particular security. The opinions expressed herein are those of Douglas Ott in his personal capacity and are subject to change without notice. Consider the investment objectives, risks, and expenses before investing.
This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the affiliates of Andvari.
Investment strategies managed by Andvari Associates LLC, Doug’s employer, may have a position in the securities or assets discussed in any of its writings. Securities mentioned may not be representative of the Andvari's current or future investments. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
Data sources for all charts come from SEC filings, Koyfin, and other publicly available information.
Below is our latest letter to clients. Please share and enjoy.
Dear Friends,
For the first quarter of 2024, Andvari was up 7.7% net of fees while the SPDR S&P 500 ETF was up 15.2%.* Andvari clients, please refer to your reports for your specific performance and holdings. The table below shows Andvari’s composite performance while the chart shows the cumulative gains of a $100,000 investment.
The main reasons for Andvari’s lagging returns are twofold: (1) Andvari has not owned some of the largest and best performing companies such as Nvidia, Apple, Microsoft, Google, Meta, and Amazon; and (2) the poor performance from Mesa. To put Andvari’s performance in better context, it’s important to know we are invested in a wide range of companies in terms of market cap. We’ve owned, or currently own, companies valued at hundreds of millions to billions and tens of billions to hundreds of billions. Given the performance of the small cap Russell 2000 index ETF (up 1.6% for the first six months) and the performance of the large and mega cap S&P 500 index ETF (up 15.2%), it is reasonable that Andvari’s performance is somewhere in the middle at this moment in time.
It’s also worth noting that Andvari’s performance in just the first six months of the year is in line with what the market on average produces in a full year, which is nothing to sneeze at. But when compared only to the higher performance of the large caps, it can feel disappointing.
ANDVARI HOLDINGS
Andvari sold out of two holdings, the largest of which is Mesa. Mesa was one of our longest held investments at the time we sold. It had performed well up until the end of 2021. Unfortunately, we held on too long. Management made two large acquisitions, one before and the other during the COVID era. It eventually turned out they paid too much for both, which does not speak well of their ability to allocate capital.
Mesa later announced in June it would delay the filing of its annual audited financial statements. A significant part of Andvari’s investment thesis was that Mesa could transition from a small-cap company run in a small-cap way to a mid- to mid-cap company run in a more professional manner. After failing to file one of its most important documents in a timely manner, Andvari felt—regretfully—some vindication we decided to cut bait and throw our line out for better fish. Thinking about what Andvari could have done differently, we likely would have made the same investment given what we knew at the time, but we should have made it a smaller position.
With a large amount of capital to redeploy, we started positions in a handful of companies we’ve followed for years. The table below shows how Andvari views some of the qualitative and quantitative attributes of these companies. We also give a brief overview of each company in the remainder of our letter.
ARTHUR J. GALLAGHER
Founded in 1927 by Arthur J. Gallagher, the eponymous firm is now the third largest retail property and casualty insurance broker in the United States and also the third largest reinsurance brokerage firm in the world. In addition to their brokerage businesses, Gallagher is a significant player in third-party claims administration and HR & benefits consulting.
As hinted in the above table, Gallagher is an acquisitive company. It has been a major consolidator of the highly fragmented market of insurance brokers for decades. In just the past five full years, Gallagher has acquired 195 businesses. And the market still remains fragmented. The company estimates there are tens of thousands of independent firms across the English-speaking countries of the world.
Given Gallagher’s ability to grow organically, grow through acquisition, and the essential services it provides, there have only been three times in the past twenty-five years when revenues declined: down 0.56% in 2005, down 0.31% in 2008, and down 1.63% in 2020. Which is to say, revenues barely budged despite those tumultuous years. This is a resilient company.
METTLER-TOLEDO
Mettler-Toledo makes a variety of lab instruments as well as weighing scales for industrial and retail use. These products are essential to the end users and often required to comply with a variety of regulations. The company has the number one product in most areas where it competes. However, its market share ranges from 25% to 30% share in these business lines. This means, despite its top status, competition remains highly fragmented, which gives them opportunity to capture more share over time.
With an installed base of over $16 billion worth of machines across the world, revenues from services and consumable adds to the predictability of total revenues. Pricing power is strong given the high value and relatively low cost of their products to end customers. Mettler has consistently captured 200 basis points (or greater) of net pricing every year. The company even successfully raised prices during 2009.
O'REILLY AUTOMOTIVE
O’Reilly is the third largest auto parts retailer in the country with over 6,095 stores in North America and Mexico. Their sales are split 60% to people who want to repair their own car and 40% to professionals who fix and maintain cars for a living. Following the common theme, O’Reilly sells essential products that people will buy regardless of the state of the economy.
We love that this business gushes cash—it had an extraordinary return on invested capital of 43.7% in 2023. O’Reilly has also had negative working capital since 2017, which means customers pay O’Reilly before O’Reilly needs to pay its suppliers. Looking at its capex, O’Reilly does have a higher capex ratio when compared to the others in the table. However, the ratio is still quite low considering O’Reilly is growing its store count in the range of 150-200 per year. At this rate, O’Reilly is expanding its store count by about 3% annually. Also driving the recent increase in capex has been a shift towards owning their stores rather than leasing them.
PHILIP MORRIS
Andvari invested in Philip Morris a few months after initiating a position in fellow tobacco company Altria. The tobacco industry is one that has consolidated to only a handful of players. For decades, the industry has more than offset the continual decline in cigarette volumes with price increases. More recently, both Altria and Philip Morris have introduced several new product categories that deliver nicotine in much safer ways: vaping, nicotine pouches, and heat-not-burn products. Nicotine pouches in particular continue to have an extraordinary growth trajectory. In the most recent quarter, the volumes of Altria’s On! pouches and Philip Morris’ Zyn pouches continued their torrid growth rates at 30%+ and 70%+ year over year, respectively.
For Philip Morris and Altria, their margins are high, returns on equity and capital are high, and both trade at what Andvari views as cheap or very cheap multiples. Given the non-zero chance of a “nicotine renaissance” aided by less harmful products, we do not think the future for these companies is as dim as the market seems to think.
POOL CORP
Pool is the largest player in a niche market. They are a value-added distributor of all materials and equipment related to the maintenance, remodeling, and construction of swimming pools. Although they have an estimated 40% market share, the market remains highly fragmented, which means they can grow at an above average rate organically and via further acquisitions.
In general, Pool operates in an industry with good tailwinds. Population migration from the north to the south, primarily by retirees, means more new pools and more remodeling of old pools. As the CEO of Pool recently said, the industry joke is that trucks move north with oranges and move south with furniture. Furthermore, once a home has a pool, this ensures a long-term annuity stream of products used to maintain that pool. These are non-discretionary purchases, because if an owner allows a pool to fall into disrepair, this negatively impacts the value of their home. Thus, Pool can easily pass on price increases to their customers.
As a value-added distributor, Pool is a conduit between over 2,200 manufacturers and over 120,000 customers that maintain and build swimming pools. They have taken on the role of trusted partner to manufacturers and end users. They ensure quick, efficient delivery of products while also minimizing the chances of products being out of stock. They have the largest and widest selection of products. They strive for the best customer service. They can advise customers on the best products to meet maintenance or construction needs. They’ve developed software and apps that make owning and maintaining pools easier. For all this, suppliers and customers have rewarded Pool with their long-term business. And the great part about the business is that pools remain a desirable addition to homes. This ensures a slow yet steady growth in their installed base, which drives non-discretionary, recurring sales.
UNITED HEALTHCARE
United Healthcare is one of the largest providers and distributors of services in the $5 trillion U.S. healthcare market. The company provides services to employers, individuals, and those eligible for Medicare and Medicaid. United’s Optum segment provides pharmacy benefit services and a slate of other insights and services to the major players in the healthcare space: physicians, hospitals, government agencies, and life science companies.
This is a company that provides essential services and has a strong wind at its back. Over two million people are enrolling in Medicare and Medicare Advantage every year. With the increase of healthcare spending every year, the value of the services and insights provided by Optum will only increase. United is a solid business with a high teens returns on its capital. After reinvesting in its businesses, United will likely return $16 billion in 2024 in the form of dividends and share repurchases off a revenue base of ~$380 billion.
ZOETIS
Zoetis was spun out of Pfizer in 2013 and is the largest company serving the animal health market. They make medicines, vaccines, diagnostics, devices, and technology solutions for their pet owners and veterinarians. Their revenues are split 65% for pet care and 35% for livestock.
The nice thing about Zoetis, and the pet healthcare market in general, is the trend of increasing pet ownership and the increasing willingness to spend more money on pets every year. When compared to overall consumer spending, spending on pets has nearly doubled since 1990. The resilience of the pet healthcare industry is particularly exceptional—the industry has never had a year of negative growth in the last 15 years. Zoetis in particular has grown several percentage points faster than the industry.
The financials of Zoetis are also exceptional. It has steady revenue growth, gross margins in the 70s, an ability to reinvest in the business at 20% returns, and is still able to return billions to shareholders with dividends and share repurchases. Despite having the highest ratio of capex to revenues in this group of new holdings, Zoetis is still very cash generative. The company generated $1.8 billion of free cash over the last twelve months off of $8.7 billion of revenues, a healthy 20% margin. In its first five years after being spun from Pfizer in 2013, Zoetis averaged 4.1% of capex to revenues. The reason for capex trending higher over the last five years is to support a slate of fast-growing new products, inventory buildups, and productivity enhancements. We believe this capex ratio will slowly come down over time as revenues come in for its newer products and as customers draw down inventories.
ANDVARI TAKEAWAY
Andvari redeployed capital into a handful of businesses which we believe will produce above average returns over the long term. Although we increased the total number of holdings in the equity portion of client portfolios (most have 21 or fewer individual names), we still maintain a high degree of concentration. Andvari’s top five equity positions continue to account for more than 50% of total assets under management.
With inflation continuing its slow decline, the probability of slightly lower interest rates by year’s end, and the eventual end to the COVID overhang for our life sciences holdings, Andvari expects better performance for many of its holdings over the coming years.
As always, I love to hear from clients and anyone else. Please contact me with your thoughts, comments, or questions.
Sincerely,
Douglas E. Ott, II
DISCLOSURES AND END NOTES
* Andvari performance represents actual trading performance of all, actual clients beginning on 4/12/13. Performance from 12/31/12 to 4/12/13 is actual performance of proprietary accounts, namely the accounts of Andvari’s principal, Douglas Ott. Andvari believes including Ott’s performance figures for the first 4 months and 12 days of 2013 is fair as he managed those accounts similarly to Andvari’s first clients. All performance, including the initial proprietary period, are net of management fees—assumed to be 1.25% per annum, paid quarterly, as currently advertised—net of brokerage commissions and expenses, time-weighted, and includes all cash and other securities. Performance includes realized and unrealized returns and excludes the effects of taxes on incurred gains or losses. Andvari does not certify the accuracy of these numbers. Performance data quoted represents past performance and does not guarantee future results.
The exchange traded funds (ETFs) are listed as benchmarks and are total return figures and assumes dividends are reinvested. The SPY ETF is based on the S&P 500 Index, which is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. The IWM ETF is based on the Russell 2000 Index, an index of 2,000 U.S. small-cap stocks. It is not possible to invest directly in an index. Because Andvari client portfolios are non-diversified, the performance of each holding will have a greater impact on results and may make them more volatile than a more diversified index. Andvari also engages or may engage in strategies not employed by the S&P 500 or the Russell 2000 including, without limitation, the use of leverage.
One may request a list of all securities mentioned or recommended for the preceding year as of the date of this letter. You may contact Andvari using the information below. Actual client results may differ from results depicted in this letter. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the loss of principal. Investment strategies managed by Andvari Associates LLC may have a position in the securities or assets discussed in this article. Securities mentioned may not be representative of the Andvari's current or future investments. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
The discussion of Andvari’s investments and investment strategy (including, but not limited to, current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) represents the views and opinions of Andvari’s portfolio managers and Andvari Associates LLC, the investment adviser, at the time of this report, and can change without notice.
This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the affiliates of Andvari.
The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. Any or all of Andvari’s forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties, and other factors, most of which are beyond Andvari’s control. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision.
Andvari's Douglas Ott, in collaboration with Lawrence Hamtil of Fortune Financial, is pleased to release a new 14-page white paper: "Going South: Implications of Business and Population Migration". The paper brings together many of the data and anecdotes showing the trend of people and businesses migrating to the South remains firmly in place. In addition to many charts and graphs, Doug and Lawrence pulled together over two dozen quotes from a variety of executives whose businesses are benefiting from this migration. Below are a few excerpts from the collaboration.
DECADES OF BUSINESS MOVEMENT
One unique dataset Doug and Lawrence found is the net migration numbers of firms moving to a new region of the country. The overwhelming benefactor has been the South for many decades.
MIGRATION CAUSES AND EFFECTS
Taxes have been one reason for the migration of businesses and individuals. With the chart below, Doug and Lawrence show the large tax gap between two high tax states (California and New York) and two low tax states (Texas and Florida). Since 1980, the tax gap has only widened for these two pairs of states.
One of the many, obvious effects of migration to the South has been faster growth all around. Here you can see the per capita income levels of a handful of Southern states versus the United States since 1947. All four states have grown at a faster rate than the national average.
NOTABLE QUOTES
In the white paper, we have over two dozen quotes from executives commenting on the outsized opportunity they have in the South. They represent businesses in retailing, home construction, home services, infrastructure, and regional banks. Here are quotes from just two regional banks with a heavy presence in the South: Synovus and Truist.
ANDVARI TAKEAWAY
For many reasons—pro-business policies, improved infrastructure, and a milder climate—the South has enjoyed strong economic growth. The region has absorbed a large population influx from 1) simply less fortunate states and 2) states with policies inimical to business growth and productivity. This trend has persisted for several decades and it shows no signs of abating.
The long-term shift of businesses and people to the South has real implications for major industries at the national and regional level. Because of this, we believe it is important for investors to factor this major secular change into their analysis of industries and of specific companies.
Please download the 14-page whitepaperfor the full array of charts, graphs, and quotes. Feel free to share by e-mail or social media and let us know what you think!
DISCLOSURES AND END NOTES
The information herein is provided for educational purposes only and should not be construed as financial or investment advice, nor should any information in this document be relied on when making an investment decision. Andvari and Fortune have no affiliation. Opinions and views expressed herein reflect the current opinions and views of the authors, Douglas Ott and Lawrence Hamtil, as of the date hereof and are subject to change without notice.
Past performance is not a guarantee or indicator of future results. This document and the information contained herein are for educational and informational purposes only and you should not be considered a recommendation to buy or sell any particular security. You should not assume any of the securities discussed in this report are or will be profitable, or that recommendations we make in the future will be profitable. Consider the investment objectives, risks, and expenses before investing.
Investment strategies managed by Andvari Associates LLC and Fortune Financial may have a position in the securities or assets discussed in this article. Securities mentioned may not be representative of the Andvari's or Fortune's current or future investments. Clients of Andvari and Fortune may own shares in any of the securities mentioned in this article. Andvari and Fortune may re-evaluate their respective holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
See the full Disclosures at the end of the white paper "Going South: Implications of Business and Population Migration".
In a recent Preferred Shares podcast, Andvari’s Chief Investment Officer and his two co-hosts continued with their series on the various industries benefiting from the construction (and continual maintenance) of the interstate highway system of the United States. In particular, the podcast focused on the early history of Vulcan Materials (VMC) and the handful of reasons of why these types of businesses are so great.
BIRMINGHAM SLAG HISTORY
The story of Vulcan begins with Birmingham Slag, a business founded in 1909 by Solon Jacobs. The purpose of the new venture was to repurpose the remnants of the steel making process for use in road construction and as ballast for railroad tracks. After years of successful operation, Jacobs sold the business in 1916 to the Ireland family.
With extreme frugality, the Irelands successfully grew the business. They opened new plants and acquired several sand and gravel pits in the southeast. With this growth, Birmingham Slag would eventually win bids on significant projects. They provided materials and services for the Tennessee Valley Authority and the Manhattan Project.
After World War II, Birmingham Slag and many other family-owned aggregates businesses had the enormous opportunity afforded them by the passage of the Federal Aid Highway Act of 1956. However, Birmingham Slag and its competitors all lacked the scale and capital to fully take advantage of this opportunity.
For Birmingham Slag, the solution was to acquire a public company called Vulcan Detinning in 1956. With this acquisition, Birmingham Slag became a public company (renamed Vulcan Materials) and could more easily raise capital. It also now had a currency with which it could acquire other aggregates businesses. For the other small players in the industry, selling to Vulcan was an attractive proposition as many were facing significant estate tax issues. They could sell to Vulcan not for cash, but in exchange for Vulcan shares, which eased their tax issues.
In four short years, Birmingham Slag transformed into Vulcan Materials, the nation’s largest producer of aggregates. Annual revenues went from $21.4 million in 1956 to $110 million in 1959 as they acquired numerous family-owned quarries.
INDUSTRY DYNAMICS
One great quality about the aggregates business is that there is no alternative to crushed rock for infrastructure and construction projects. For example, in 2006, the U.S. Geological Survey estimated that there was 1.5 billion metric tons of natural aggregates in use in the national highway system while there was just a combined 89 million metric tons of cement, asphalt and steel. Natural aggregates accounted for 94% of these total materials.
Another excellent quality of an aggregates business is its pricing power. The average price of a metric ton of crushed stone in the U.S. was $14 in 2022. However, transportation costs can quickly evaporate that purchase price based on travel distance. Thus, aggregates must be sourced locally, which gives these businesses the power to raise prices slowly and steadily above the rate of inflation. See Lawrence Hamtil's blog post “Rock Pile Riches”.
Despite several generations of consolidation, the industry remains highly fragmented. Further, the opening of new quarries is close to impossible given the permitting and regulatory hurdles. Thus, there is ample opportunity for the larger players like Vulcan, Martin Marietta, and others, to continue to consolidate by acquiring the large number of smaller players.
ANDVARI TAKEAWAY
The aggregates industry is one that will persist for many generations going forward. It exhibits many of the attributes that Andvari values. There is reliable and predictable growth from the continual spending on vital infrastructure maintenance and new construction projects. The industry has pricing power and there remains an opportunity for the large public companies to consolidate what is still a highly fragmented industry.
CCC Intelligent Solutions (CCCS) is a business that is central to the auto repair ecosystem. Its software helps coordinate the collective efforts of: auto insurers like GEICO and Progressive; salvage and auction companies like Copart and IAA; and repair shops such as those under the wing of Boyd Group. As part of its efforts, CCCS also collects data on over $100 billion of annual transactions in this space. It then regularly publishes a report—entitled “Crash Course”, naturally—that details all the trends affecting the auto repair journey. With their most recent “Crash Course” report, CCCS affirms that the trend of rising costs to repair a vehicle are still in place.
CCCS chart showing all the various industries involved after a vehicle accident
VEHICLE COMPLEXITY
The main trend contributing to increasing repair costs is that new vehicles continue to grow in complexity. Although complexity has allowed for vehicles that are “safer, more reliable, and more comfortable”, the average new car now has somewhere between 1,400 and 1,500 semiconductor chips and roughly 30,000 parts. Further, the electronic parts of a car now account for 40% of its total cost.
All the benefits allowed for by electronics and new material types come at a cost. These new parts and features are costlier to repair. The repair shop industry still grapples with an inadequate number of technicians who can tackle modern vehicles. Claims cycle times have increased along with costs. Thus, insurers are more and more likely to declare a car “totaled” after it’s been in an accident.
CCCS cites research from AAA regarding the repair costs that are over and above the normal bodywork required following a collision:
“ADAS-equipped vehicles can add up to 37.6% to the total repair cost after a crash due to expensive sensors and calibration requirements. Even minor incidents that cause damage to this technology found behind windshields, bumpers, and door mirrors can add up to $1,540 in extra repair costs.”
REPAIR COSTS
CCCS data shows that newer cars are in fact costlier to repair than older model cars. The following chart shows the average cost of repairs by vehicle age. “The cost differential for repairing older versus newer model year vehicles has grown by 35% over the last 10 years,” according to CCCS.
Tim O’Day, President and CEO of Boyd Group, confirms repair costs are higher for newer vehicles during Boyd’s 11/10/23 earning call:
“[W]e do continue to see increasing repair severity. And I would expect … that will continue over time. If we look at … newer vehicles, say, the 1- to 3-year-old range, the average repair cost of those vehicles is meaningfully higher than you would see in 4 to 7 and then 8 plus.… Newer cars are more expensive to repair anyway. But the newer vehicles also have more technology. So I think that's a trend that likely or not is more than likely to continue.”
TOTAL LOSS FREQUENCY
When the total cost to repair a vehicle exceeds the value of the vehicle, the insurance company will usually deem it a total loss. With rising costs to repair, there has been a concurrent increase in the total loss frequency. The chart below shows the total loss frequency increasing from 16.4% to 21.0% over eight years.
Once the insurer deems a vehicle a total loss, this is where companies like Copart and IAA step in. They collect the vehicle with a tow truck, clean them up a bit, test whether it can drive, take some photos, and then put it up for auction on their websites for anyone around the world to bid on.
Jeff Liaw, co-CEO at Copart, has often stated that it is his and Copart’s belief that the total loss ratio will eventually reach 30% over time due to increasing vehicle complexity and repair costs. Another factor that could boost total loss frequency would be some insurance carriers abandoning their practice of repairing cars when they should not. On Copart’s 2/22/24 quarterly conference call, Liaw noted that there is also still a wide difference total in loss practices on the part of carriers:
“I think there is long-standing conventional wisdom among some folks that drivers and owners prefer to have their cars back, and … insurance companies will sponsor repairs of cars that they economically should not. So that behavior does continue in the industry. And as a result then, we see a pretty wide dispersion of total loss practices across all carriers, though virtually all of them have increased total loss frequency over the long haul. As for your question about where total loss frequency—can it exceed 30%? I think the answer is affirmatively yes.”
The auto repair ecosystem is a vital component to the logistics and mobility of any country. As such, the various players in the repair ecosystem, from the insurers to the body shops and from the salvage yards to software providers like CCCS, have a nice steady tailwind thanks to the enormous U.S. auto market. Further, all players in this ecosystem are fairly recession resistant. Despite all the new technology that makes driving safer, there will always be accidents, in good times and bad. This industry is a space in which Andvari maintains a keen interest.
DISCLOSURES AND END NOTES
Past performance is not a guarantee or indicator of future results. The opinions expressed herein are those of Andvari Associates LLC and are subject to change without notice. This document and the information contained herein are for educational and informational purposes only and you should not be considered a recommendation to buy or sell any particular security. You should not assume any of the securities discussed in this report are or will be profitable, or that recommendations we make in the future will be profitable. Consider the investment objectives, risks, and expenses before investing.
Investment strategies managed by Andvari Associates LLC may have a position in the securities or assets discussed in this article. Securities mentioned may not be representative of the Andvari's current or future investments. Andvari clients own shares in Copart. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
Below is our latest letter to clients. Please share and enjoy.
Dear Friends,
For the first quarter of 2024, Andvari was up 12.1% net of fees while the SPDR S&P 500 ETF was up 10.4%.* Andvari clients, please refer to your reports for your specific performance and holdings. The table below shows Andvari’s composite performance while the chart shows the cumulative gains of a $100,000 investment.
ANDVARI HOLDINGS
In fits and starts, Andvari’s performance continues to climb back from the decline we suffered in 2022. The top two detractors to our performance in the quarter were Mesa Labs and American Tower. The top two contributors to performance were Topicus.com and Mastercard.
We have two holdings on which we can report several notable events. First is Kelly Partners Group, the Australia-based accounting and financial services firm. The company continues on its long-term mission of helping small businesses be better off by the provision of high-quality accounting and tax services. We’re pleased to share that Kelly has expanded into the United States. This is its first foray outside of its home country. After acquiring two accounting firms in the L.A. area, Kelly is now ranked 71 on Los Angeles Business Journal’s Top 100 Accounting Firm list. Notably, L.A. is home to one of the largest populations of Australian expatriates in the world. There are 60,000 Australian businesses in L.A. and until Kelly Partners arrived on the scene, there was not a single Australian-owned accounting firm there. This is a logical place for Kelly to begin its international expansion.
Another event, perhaps even more significant than its entry into the U.S., is its decision to eliminate its monthly dividend. This means Kelly can deploy more capital at much higher rates of return than Andvari can hope to provide. Given Kelly’s large opportunity to acquire and improve accounting firms in English-speaking countries, Andvari applauds the decision to eliminate the dividend.
Finally, as of February, the shares of Kelly Partners now trade in the U.S. via the OTCQX® Best Market. Although this is an over-the-counter market,1 Andvari believes this is a first step towards an aspirational—and perhaps eventual—up-listing to an exchange like the NASDAQ. At the minimum, Kelly can now garner more attention and support from a larger investor base. This will likely help its share price and Kelly will be better able to access capital if necessary.
CoStar Group is the second holding with significant news. As a reminder, CoStar is commercial real estate's leading provider of information, analytics, and online marketplaces. Sensing an opening to compete against Zillow, the leading residential real estate portal in the U.S., CoStar acquired Homes.com in 2021. CoStar is now planning to invest a cumulative $1 billion into this new business segment. Part of this investment will include the largest marketing campaign in the history of the residential real estate industry. If you watched the Super Bowl this year, you likely saw one of their four commercials. Homes.com will be a big advertiser at other major events in 2024.
Thus far, these investments have resulted in Homes.com going from an insignificant player to the second-most trafficked homebuying portal. CoStar announced the Homes.com Residential Network reached more than 149 million unique visitors in February. Further, Homes.com itself had a 567% year-over-year increase in traffic. As it did with Apartments.com, CoStar believes it can grow the unaided awareness from the low single digits to more than 50%.
CoStar then received news that could be a tailwind to its Homes.com business: the National Association of Realtors reached a $418 million settlement of claims that they and the industry conspired to keep real estate agent commissions high. The practice of two agents sharing a commission based on the value of a home is a big reason why commission rates in the U.S. are among the highest in the developed world. The practice also reduced the ability for the home buyer to negotiate on commissions. The commission sharing practice is also why many buyers’ agents steered clients away from homes when the shared commission would be lower than the going rate. Thus, as part of the settlement, the NAR agreed to disallow upfront commission offers from sellers’ agents to buyers’ agents.
The reason this settlement could provide a tailwind to Homes.com is because its business model is geared to the sellers’ agent. This contrasts with the business models of portals like Zillow and Realtor.com, which are geared towards taking the listing data from the sellers' agents, generating leads, and then selling those leads to buyers' agents. Understandably, this practice has been hated by sellers' agents for a long time. Thus, if the commissions of buyers' agents decline because of the changes stemming from this settlement, Zillow could suffer and Homes.com could increase its market share.
SILVER LININGS IN RATES
Although the rapid rise in interest rates contributed to Andvari’s underperformance in 2022, there are silver linings to rates having risen to more normal levels. One benefit is the opening of new opportunities to invest in businesses whose market values have declined too much. The other benefit is pure and simple: the yields on assets like bonds, preferred shares, and certain equities, are at levels finally worthy of notice.
One example of an attractive yielding asset is a bond fund Andvari has used for our clients who desire an income component to the equity strategy Andvari provides. This fund is the Western Asset Premier Bond Fund (WEA) managed by Western Asset Management, an advisor founded in 1971 in Pasadena, CA. We like the group for its value investment approach and its long-term track record in the fixed income arena. Furthermore, Western has an excellent reputation and a historical association with two extraordinary individuals: Lou Simpson and Ron Olson.
Lou Simpson is best known for his long career as the person in charge of GEICO’s investment portfolio. Warren Buffett’s Berkshire Hathaway owned a large stake in GEICO until it fully acquired the business in 1996. With the GEICO acquisition, Buffett acquired both a great business and great people. In his 2004 letter to Berkshire shareholders, Buffett wrote, “Lou is a cinch to be inducted into the investment Hall of Fame.”
What few people remember is Simpson was CEO of Western Asset prior to GEICO luring him away. Although Simpson’s tenure at Western was brief, he was attracted to the group for a reason. We believe at least a small part of his investment philosophy remains embedded within Western.
Ron Olson is the other person of note. Olson has a long association with Charlie Munger and Berkshire Hathaway. In 1968, Olson joined the law firm founded by the late Munger, which is now named Munger, Tolles & Olson. He has been a director on the board of Berkshire Hathaway since 1997. Olson has also been a director at Western Asset since 2005. It’s hard to imagine a better person to be a director on your board than Olson.
Now, getting to some of the specifics on WEA. It is a bond fund with a closed-end format. This means it has a fixed number of shares as opposed to the open-end fund format, which issues new shares to each new buyer. A closed-end fund also means its market price can trade at a premium or a discount to the net asset value (NAV) per share of the fund. In other words, we are frequently able to pay $95 for WEA shares that have a NAV of $100. The converse is also true. We might be able to sell shares at prices greater than the NAV. Currently, the fund has a yield of 7.9% on its market price in addition to trading at a ~6% discount to NAV.
SMOKE SIGNALS
Our second example of a high-yielding security is the stock of Altria Group. Before we get into the details of why we started a position in Altria, a brief history is in order. The company was formerly known as Philip Morris before rebranding to Altria in 2003. Cynically, the rebranding was to minimize the negative attention from its tobacco business. However, the company also owned Kraft Foods and Miller Brewing, so it was logical to reflect its status as a conglomerate. Since rebranding, Altria has slowly “de-conglomerated”. It spun out Kraft in 2007. It spun out Philip Morris International in 2008. In 2021, it sold its Ste. Michelle Wine Estates business. Finally, last month Altria announced it is selling part of its 10% ownership in Anheuser-Busch InBev (BUD).2
Andvari has followed Altria since we began our investment career. Profitability is extraordinary and the business requires minimal capital expenditures. Despite the volume of cigarettes having steadily declined—a great thing for our population health—Altria has still managed to grow revenues and profits with regular price increases.
Also offsetting the decline in Altria's cigarette business is the growth of its oral tobacco portfolio. Altria, and nearly all other tobacco companies, have developed or acquired multiple next generation products that deliver nicotine in a vastly safer way than cigarettes.3 These reduced risk products continue to grow rapidly. For example, Altria's on! brand of nicotine pouches is growing volumes at an annual rate of >30%. Over a long period of time, the reduced risk products will make up most of the revenues and profits for Altria and other tobacco companies.
As to why Andvari started a position in Altria, it boils down to a combination of a business with excellent qualities and simple math. Andvari likes the business for its high margins, low capex requirements, and predictable revenues. The business also has extraordinary pricing power arising from its addictive products—a nice hedge against inflation.
Then there’s the welcome news of Altria raising cash from its BUD stake (roughly $2.1 billion if they obtain an average selling price of $60 per share for BUD) it will use to repurchase its shares. This is a rational choice because Andvari believes Altria shares are undervalued. Further, with fewer outstanding shares, Altria will have smaller total dividend payments to shareholders.
The math behind our purchase is simple. The dividend yield on Altria shares was at a level seen only two other times since the year 2000. Thus, Andvari purchased a security at a 9.7% dividend yield that can grow its dividend per share at an annual rate of 2%–3%. The odds are with us this type of investment will provide good long term returns.
ANDVARI TAKEAWAY
We're pleased to report positive results for this quarter and the positive developments at Kelly Partners and CoStar. The businesses within our investment portfolio continue to focus on their respective opportunities and all the things within their control. In the short term, the rapid rise in interest rates negatively impacted the market prices of many securities, but at the same time, it opened new investment opportunities for Andvari.
Over the long term, Andvari remains optimistic we can provide investment results that will make a difference for our clients. We intend to do this by investing in great businesses with great managers that have ample opportunities to deploy capital at high rates of return.
As always, I love to hear from clients and anyone else. Please contact me with your thoughts, comments, or questions.
Sincerely,
Douglas E. Ott, II
DISCLOSURES AND END NOTES
* Andvari performance represents actual trading performance of all, actual clients beginning on 4/12/13, managed under the primary Andvari investment strategy. Performance from 12/31/12 to 4/12/13 is actual performance of proprietary accounts, namely the accounts of Andvari’s principal, Douglas Ott. Andvari believes including Ott’s performance figures for the first 4 months and 12 days of 2013 is fair as he managed those accounts similarly to Andvari’s first clients. All performance, including the initial proprietary period, are net of management fees—assumed to be 1.25% per annum, paid quarterly, as currently advertised—net of brokerage commissions and expenses, time-weighted, and includes all cash and other securities. Performance includes realized and unrealized returns and excludes the effects of taxes on incurred gains or losses. Andvari does not certify the accuracy of these numbers. Performance data quoted represents past performance and does not guarantee future results.
The exchange traded funds (ETFs) are listed as benchmarks and are total return figures and assumes dividends are reinvested. The SPY ETF is based on the S&P 500 Index, which is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. The IWM ETF is based on the Russell 2000 Index, an index of 2,000 U.S. small-cap stocks. It is not possible to invest directly in an index. Because Andvari client portfolios are non-diversified, the performance of each holding will have a greater impact on results and may make them more volatile than a more diversified index. Andvari also engages or may engage in strategies not employed by the S&P 500 or the Russell 2000 including, without limitation, the use of leverage.
One may request a list of all securities mentioned or recommended for the preceding year as of the date of this letter. You may contact Andvari using the information below. Actual client results may differ from results depicted in this letter. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the loss of principal. Investment strategies managed by Andvari Associates LLC may have a position in the securities or assets discussed in this article. Securities mentioned may not be representative of the Andvari's current or future investments. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
The discussion of Andvari’s investments and investment strategy (including, but not limited to, current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) represents the views and opinions of Andvari’s portfolio managers and Andvari Associates LLC, the investment adviser, at the time of this report, and can change without notice.
This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the affiliates of Andvari.
The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. Any or all of Andvari’s forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties, and other factors, most of which are beyond Andvari’s control. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision.
Brokerage firm Schwab describes over-the-counter securities as ones “that are not listed on a major exchange in the United States and are instead traded via a broker-dealer network, usually because many are smaller companies and do not meet the requirements to be listed on a national exchange.”[↩]
South African brewer SAB acquired Miller in 2002 to form SABMiller, with Philip Morris retaining a 36% ownership share. In 2015, Anheuser-Busch InBev acquired SABMiller.[↩]
Nicotine itself is not the primary cause of smoking-related diseases. The smoke produced by the burning of a cigarette contains over 6,000 chemicals, of which 100 have been classified as causes or potential causes of smoking-related diseases such as lung cancer, cardiovascular disease, and emphysema. Thus, tobacco companies have created products that do not require the burning of tobacco to deliver nicotine. Altria has research showing the reduction of harm in their smokeless tobacco, heated tobacco, and e-vapor products.[↩]
Below is our latest letter to clients. Please share and enjoy.
For the full year of 2023 Andvari was up 17.5% net of fees while the SPDR S&P 500 ETF was up 26.2%.* Andvari clients, please refer to your reports for your specific performance and holdings. The table below shows Andvari’s composite performance against two benchmarks while the chart shows the cumulative gains of a $100,000 investment.
ANDVARI HOLDINGS
Looking at the holdings which we held at the beginning of 2023 and that remained at the end of the year, there was a wide mix of good and bad performers. The worst performing holding was Mesa Labs whose shares had a total return of -36.7% for the year. The reasons for poor performance remain the same. First, they lost a significant customer in their Clinical Genomics business. Second, Mesa and the life sciences industry in general continued to experience the negative effects of customers de-stocking the inventories they had built up after the pandemic. Likely third and fourth reasons are higher interest rates and the overhang of Mesa’s $173 million worth of convertible debt which comes due in 2025. Mesa has the option of satisfying this debt either through issuing new common shares, with cash, or some combination of both. Neither are great options right now. Issuing new shares at low prices will excessively dilute shareholders. If Mesa wants to refinance this debt, they would be doing so at a much higher rate.
Turning to some positive news, Andvari’s best performing holding in 2023 was Constellation Software whose stock had a total return (share price and dividends) of 58.9%. Constellation’s spin-offs, Topicus.com and Lumine, also had stellar years. In just twelve months, Constellation acquired over 100 niche, vertical market software businesses. Most of the acquisitions were small enough that the purchase price was not reported. However, there were several large transactions in 2023 where Constellation was able to allocate hundreds of millions of capital.
To demonstrate the solid growth and compounding of Constellation’s results, it was just 7 years ago in 2016 that the company first reported annual revenues of $2 billion. Starting with the second quarter of 2023, Constellation reported $2 billion of revenues for a singlequarter. Although Constellation has not yet reported its results for 2023, Andvari believes annual revenues will be at least $8.2 billion and free cash flows will be about $1.7 billion.
Because the businesses Constellation acquires usually have high margins and low organic growth, Constellation is not able to fully reinvest the cumulative free cash flows back into the businesses it owns. Thus, much of the intrinsic value of Constellation is dependent upon its ability to reinvest these free cash flows at high rates of return by acquiring more mission critical software businesses around the world.
As Constellation has grown larger, it has continued to produce excellent results by maintaining its decentralized operating structure. Constellation founder and CEO Mark Leonard has also pushed down capital allocation responsibilities further and further down to business unit leaders. Whereas ten years ago Leonard and the board of directors would be approving nearly every proposed acquisition, business unit leaders now decide for themselves whether to pursue an acquisition if the purchase price is below a certain threshold. Leonard and the board of directors now only consider large acquisitions. This delegation of responsibility has allowed Constellation to deploy capital at a sustained and rapid pace.
Finally, it’s important to note Constellation’s acquisition criteria have evolved slightly to enable the acquisitions of larger businesses while maintaining a relatively high hurdle rate for returns. Small acquisitions have been Constellation’s bread and butter for decades. Average returns on these have been 20% or higher. But to be competitive in large deals that have a purchase price of $100 million or more, Constellation has conceded it must accept a return in the mid-teens. This is still quite high by the standards of any investor. As shareholders, we’ve seen a handful of larger deals come to fruition in the last several years. Some examples are in the table below.
In sum, Constellation remains an impressive business. Andvari estimates Constellation is currently trading at a forward free cash yield of just under 3%. This, coupled with a track record of having compounded free cash flows at an annualized rate of 18.8% over the last eight full fiscal years, suggests future returns to shareholders are likely to remain above average even if free cash flow growth declines to the low teens.
ANDVARI TAKEAWAY
We’re pleased to report positive results for 2023, but Andvari is still unhappy to be trailing one of the best-known benchmarks, the S&P 500. As unpleasant as it is for us, we must expect this to happen from time to time. To achieve differentiated results, it makes sense to us that we must act differently. Nearly half of Andvari’s assets under management are not part of the S&P 500 index. Furthermore, we run a concentrated investment strategy which can exacerbate results in the short-term.
As always, Andvari does its best to remain focused on what we can control. And that is identifying and studying high quality businesses with excellent managers that can deploy capital at high rates of return for a long period of time. Buying shares of these businesses at sensible prices skew the odds in our favor of producing excellent returns over the long-term for ourselves and for our clients.
As always, I love to hear from clients and anyone else. Please contact me with your thoughts, comments, or questions.
Sincerely,
Douglas E. Ott, II
DISCLOSURES AND END NOTES
* Andvari performance represents actual trading performance of all, actual clients beginning on 4/12/13, managed under the primary Andvari investment strategy. Performance from 12/31/12 to 4/12/13 is actual performance of proprietary accounts, namely the accounts of Andvari’s principal, Douglas Ott. Andvari believes including Ott’s performance figures for the first 4 months and 12 days of 2013 is fair as he managed those accounts similarly to Andvari’s first clients. All performance, including the initial proprietary period, are net of management fees—assumed to be 1.25% per annum, paid quarterly, as currently advertised—net of brokerage commissions and expenses, time-weighted, and includes all cash and other securities. Performance includes realized and unrealized returns and excludes the effects of taxes on incurred gains or losses. Andvari does not certify the accuracy of these numbers. Performance data quoted represents past performance and does not guarantee future results.
The index ETFs are listed as benchmarks and are total return figures and assumes dividends are reinvested. The S&P 500 ETF (SPY) is an exchange traded fund based on the S&P 500 index, which is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. The Russell 2000 ETF is an exchange traded fund based on the Russell 2000 Index, which is an index of 2,000 U.S. small-cap stocks. It is not possible to invest directly in an index. Because Andvari client portfolios are non-diversified, the performance of each holding will have a greater impact on results and may make them more volatile than a more diversified index. Andvari also engages or may engage in strategies not employed by the S&P 500 or the Russell 2000 including, without limitation, the use of leverage.
One may request a list of all securities mentioned or recommended for the preceding year as of the date of this letter. You may contact Andvari using the information below. Actual client results may differ from results depicted in this letter. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the loss of principal. Investment strategies managed by Andvari Associates LLC may have a position in the securities or assets discussed in this article. Securities mentioned may not be representative of the Andvari's current or future investments. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
The discussion of Andvari’s investments and investment strategy (including, but not limited to, current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) represents the views and opinions of Andvari’s portfolio managers and Andvari Associates LLC, the investment adviser, at the time of this report, and can change without notice.
This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the affiliates of Andvari.
The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. Any or all of Andvari’s forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties, and other factors, most of which are beyond Andvari’s control. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision.
Andvari's Chief Investment Officer, Douglas Ott, recently recorded a new episode of the Preferred Shares podcast on the history of Orkin, the pest control business owned by publicly traded Rollins, Inc. It's an amazing story about a young immigrant from Latvia who started a business selling rat poison door-to-door in 1901 at the age of 14. Otto grew the business through two world wars and a Great Depression and turned Orkin into the largest pest control business in the world by the 1960s. Otto's children would sell Orkin to Rollins in 1964 for $62.4 million in the first-ever leveraged buyout in corporate history.
Although Otto lacked an education, he had an abundance of energy, tenacity, and business savvy. Otto would soon take full advantage of the power of advertising and marketing, but he focused first on creating a great product and a great service. Otto once said, "I wasn't very good at speaking the English language. But when my customers saw what my products could do, it did my speaking for me."
When it was time to expand beyond the rural Pennsylvania farm upon which he grew up, he would choose Richmond, VA, and then Atlanta, GA, to locate Orkin headquarters. He chose both cities for the same reason: both growing and with no established pest control business. Otto instinctively knew to go where there was no competition!
When it came to advertising, Otto started with telephone books, dabbled in radio, and then hit gold with a series of 20-second spots for television in the early 1950s. This was an animated series depicting "Otto the Orkin Man" (a spray gun) doing battle with other characters such as Legs the Roach and Rags the Rat. Each spot would conclude with a victorious Otto singing a jingle to the tune of "Popeye the Sailor Man".
Image via December 16, 1957, Television Age
Young kids were hooked when they saw these ads. They loved the ads so much that parents would use it as a bribe to get them to go to bed. Orkin would also receive hundreds of fan mail every year from children.
More importantly, the ads were extraordinarily effective for adults. The company shared that tests in several of the 300 cities in 26 states where Orkin has offices showed nearly 70% of unsolicited calls were the result of its TV advertising. The ads were instrumental in increasing Orkin's sales to $12.3 million in 1954, a doubling in less than three years.
We heartily recommend listening to the full conversation about Orkin where the hosts go over all the above, and much more. Just follow this link to the Preferred Shares podcast, where you'll also find a transcript, charts, graphics, and links to resources and additional reading.
IMPORTANT DISCLOSURE AND DISCLAIMERS
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of publication of this blog, Andvari clients had a position in Rollins. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document con
Recently, Andvari’s founder and Chief Investment Officer, Douglas Ott, discussed Mars Incorporated in a Preferred Shares podcast. Preferred Shares was created in partnership with Lawrence Hamtil (co-founder and principal at Fortune Financial Advisors) and Devin LaSarre (author of the Invariant newsletter). The podcast explores the forgotten and lesser-known subjects of business, history, and business history.
In this latest episode, Douglas, Lawrence, and Devin discuss the history of Mars, its culture of quality and excellence, its extreme secrecy, how and why it got into the pet food and pet care business, and many other interesting anecdotes. Below is an edited transcript of a portion of the podcast where we discuss the corporate culture of Mars Inc.
LAWRENCE HAMTIL So along the way, Frank Mars has a heart attack or a stroke. He ends up passing away. And Forrest goes back to the US to claim his share of his father's company. And he eventually, I think this is sort of a polite way to put this, but he kind of bullies his sister and some other holders into selling him their shares and so he combines his father's company with his company and that is really where the modern Mars story begins. He then pretty much overhauled the corporation from that standpoint. He got rid of a lot of executives he thought were just hangers on and people who were there to cash a check. He got rid of corporate cars, corporate expense accounts. One of the funny stories is that he was so dramatic he gets down in the boardroom in front of the employees and says, "I'm a godly man. I'm going to pray. I pray for Milky Way, I pray for Snickers." He's basically saying Mars better be your religion because this is what we do here. Profit is the goal and that's the only reason we show up to work.
DOUGLAS OTT And another example is this mix of thriftiness and egalitarianism. He knocked down almost all the walls of the corporate headquarters. There are no offices for managers and employees. It was an open floor plan.
LAWRENCE HAMTIL Also, everybody knew what everybody else was making. There was nothing hidden as far as their salaries are concerned. So, it's sort of like part Adam Smith, part Mao Tse-Tung, as far as Forrest's corporate ideology went. But one of the interesting things was he was always interested in streamlining. Unlike a lot of chocolatiers or confectionary entrepreneurs, he was always focused on making the highest quality products with the least amount of human interaction. If you think about that, it's a big deal, because human interaction introduces chances for germs and impurities.… He invested large sums of money back into the company, never relied on debt, and as far as we know, didn't take many dividends out for himself. He had a time card just like his employees did. His children, when they went to work for the company, were given time cards.
DOUGLAS OTT That's another interesting thing, Lawrence, is I don't know if that policy is still in effect, but everyone had a time card to punch in, even the CEO, like you said. And if they were on time for work throughout the entire year, you got a 10% bonus, right?
LAWRENCE HAMTIL I think that's true and everybody's compensation was tied to the performance of the company. So you sank or swam together. The company makes more money, you make more money. The company sales are down, your salary is also going down. So everybody was very much sort of the mindset that this is a team, this is what we're out to build, and our goal is not just to make money but also to dominate.…
DOUGLAS OTT Other areas of the company's operations also speaks to that striving towards the highest quality. Another example is that they overpay their employees and managers. In one or two articles I read, it said the pay is two times that of a similar position for one of their competitors like Nestle or Hershey. Two times the compensation! And that affords Mars the ability to pick the cream of the crop in terms of employees and managers.
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of publication of this blog, Andvari clients had no position in any company mentioned. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results.Full Disclaimer.
Below is our latest letter to clients. Please share and enjoy.
Dear Friends,
For the first nine months of 2023 Andvari was up 6.9% net of fees while the SPDR S&P 500 ETF was up 13%.* Andvari clients, please refer to your reports for your specific performance and holdings. The table below shows Andvari’s composite performance against two benchmarks while the chart shows the cumulative gains of a $100,000 investment.
ANDVARI HOLDINGS
After good results for the first half of the year, Andvari’s performance suffered at the end of the third quarter for two reasons. First, renewed fears of interest rates remaining higher for longer impacted multiple holdings that are most sensitive to rates. These include companies like American Tower and Digital Bridge. American Tower is a REIT (real estate investment trust) that owns and leases antennae space on cell towers while Digital Bridge is an investment manager that invests in the digital infrastructure space. Both companies require debt in their operations and the prospect of higher interest rates continues to impact share prices in the short term. Companies with high growth prospects, like Topicus.com and Tyler Technologies, also declined. A third group also declined: our investments in fixed income and preferred securities for retirement accounts naturally declined in value as the prices of these securities go down when interest rates go up.
As an aside, American Tower is not a new holding of Andvari. We’ve owned it in the past. Although we may have started putting American Tower back into client portfolios a bit early, we believe shares are extremely attractive. First, the shares trade at a current 3.8% dividend yield at the end of October. This yield is near the highest in American’s entire history as a public company. Second, the company will likely grow dividends per share by 9% annually over the long term. As a nice kicker, Andvari believes American Tower will sell its assets in India before year’s end, which will free up capital it can use to pay off debt and repurchase shares.
The second reason for the third quarter decline in Andvari’s performance is due to our holdings in the life sciences industry. This is an industry that continues to weather difficult times. During 2021 and 2022 many pharmaceutical companies, labs, and hospitals stocked up on more supplies than they inevitably needed in 2023. The life sciences industry has thus experienced declines in revenue growth due to the “de-stocking” of its customers. Andvari remains ready to add to our positions in this industry as we believe the above-average prospects for growth in revenues and profits outweigh any declines in valuation caused by this one-off de-stocking period.
INTRODUCING ROLLINS
Rollins is the holding company for multiple pest control businesses of which the largest and best-known is Orkin. After market close on September 6, the company announced the Rollins family would be selling up to $1.76 billion worth of its 50.5% ownership stake in Rollins. This caused the share price to decline nearly 10% the following morning. We decided to take advantage of this decline.
Andvari has admired Rollins for over a decade as the business has many attractive qualities. First, the company has the wind at its back as it operates primarily in the warmer climates of the southern states of America. This region is where bugs and other pests are most pernicious. This also happens to be the region where people continue to migrate for work and for retirement. This migration is a steady trend that will continue to drive the growth of Rollins at an above average rate for decades to come.
Second, Rollins is one of the largest companies that is consolidating a very fragmented industry. For context, there are 17,670 pest control companies in the U.S. with combined annual revenues of $11.04 billion.1 Over just the last three years, Rollins has acquired over 100 pest control businesses. Rollins’ annual revenues in the U.S. will be about $2.87 billion for 2023, so this means it has about a 26% market share. A tremendous opportunity to grow organically and through acquisitions still remains for the company.
Third, Rollins provides valuable services that are a small portion of the total cost of either owning a home or operating a business. For a business owner, rules and regulations make it so they must purchase pest control services from someone. This gives Rollins’ pest control brands the ability to raise prices 4%–5% a year very easily. We also view pest control services as non-discretionary and recession resistant. Few home or business owners will tolerate pests within their dwellings. Thus, revenues for Rollins are highly predictable: about 80% of revenues are recurring.
Slide from Rollins presentation at Wells Fargo 2023 Industrials Conference.
Fourth, the size and scale of Rollins gives it an advantage over smaller competitors on two fronts: purchasing supplies and acquiring other pest businesses. On the supplies front, scale enables Rollins to purchase at lower prices for its stable of pest brands. On the acquisition front, because Rollins has acquired hundreds and hundreds of businesses over the decades, it has become a very disciplined buyer that will walk away from deals that are too expensive. Further, when Rollins acquires a pest control business, it can easily improve the acquired company by helping them increase prices, modernize marketing tools, share best practices, and by providing capital for faster growth.
Fifth, the pest control business—like most service businesses—is one that does not require large capital expenditures. Over the last ten years, capex has ranged between $18 million and $42 million annually. This is all while annual revenues have increased from $1.3 billion to nearly $3 billion today. Rollins gushes free cash flows that it uses to acquire more businesses, pay an increasing dividend, and occasionally repurchase shares.
Finally, Andvari likes the fact this business is unlikely to ever become obsolete due to changes in technology. Rodents and pests will always be around and there will always be a need for pest control services. Methods used to combat critters and creepy crawlies in twenty or fifty years are unlikely to be much different than the methods of today.
When you put all the above together, you wind up with a business with excellent financial characteristics. Average annual revenue growth has been 8.2% over the last ten years. Profits have grown faster than revenues. Gross margins are above 50% and EBITDA margins are now at 22.3%. The incremental margins—the percentage of every additional dollar of revenue growth that is converted to EBITDA—are very good: they range from 30% to 40%. Andvari believes both gross and EBITDA margins can slowly go higher over the long term. We also believe we purchased Rollins at a reasonable price that will allow us to compound our money at above average rates.
ANDVARI TAKEAWAY
Performance remains volatile for the market in general and Andvari in particular due to our concentrated investment philosophy. Although increased volatility has temporarily harmed short-term performance, this has also set the stage for what we think will be stronger performance going forward. Importantly, although it is never easy to experience volatility, we should all welcome these periods as they afford all investors the opportunity to invest at more favorable prices in companies we know well—or to finally invest in companies we’ve followed for a long time, like Rollins.
As always, I love to hear from clients and anyone else. Please contact me with your thoughts, comments, or questions.
Sincerely,
Douglas E. Ott, II
DISCLOSURES AND END NOTES
* Andvari performance represents actual trading performance of all, actual clients beginning on 4/12/13, managed under the primary Andvari investment strategy. Performance from 12/31/12 to 4/12/13 is actual performance of proprietary accounts, namely the accounts of Andvari’s principal, Douglas Ott. Andvari believes including Ott’s performance figures for the first 4 months and 12 days of 2013 is fair as he managed those accounts similarly to Andvari’s first clients. All performance, including the initial proprietary period, are net of management fees—assumed to be 1.25% per annum, paid quarterly, as currently advertised—net of brokerage commissions and expenses, time-weighted, and includes all cash and other securities. Performance includes realized and unrealized returns and excludes the effects of taxes on incurred gains or losses. Andvari does not certify the accuracy of these numbers. Performance data quoted represents past performance and does not guarantee future results.
The index ETFs are listed as benchmarks and are total return figures and assumes dividends are reinvested. The S&P 500 ETF (SPY) is an exchange traded fund based on the S&P 500 index, which is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. The Russell 2000 ETF is an exchange traded fund based on the Russell 2000 Index, which is an index of 2,000 U.S. small-cap stocks. It is not possible to invest directly in an index. Because Andvari client portfolios are non-diversified, the performance of each holding will have a greater impact on results and may make them more volatile than a more diversified index. Andvari also engages or may engage in strategies not employed by the S&P 500 or the Russell 2000 including, without limitation, the use of leverage.
One may request a list of all securities mentioned or recommended for the preceding year as of the date of this letter. You may contact Andvari using the information below. Actual client results may differ from results depicted in this letter. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the loss of principal. Investment strategies managed by Andvari Associates LLC may have a position in the securities or assets discussed in this article. Securities mentioned may not be representative of the Andvari's current or future investments. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
The discussion of Andvari’s investments and investment strategy (including, but not limited to, current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) represents the views and opinions of Andvari’s portfolio managers and Andvari Associates LLC, the investment adviser, at the time of this report, and can change without notice.
This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the affiliates of Andvari.
The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. Any or all of Andvari’s forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties, and other factors, most of which are beyond Andvari’s control. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision.
This figure is according to the 2022-2023 annual report of the National Pest Management Association. Rollins says they have more than 20,000 competitors in the United States.[↩]
Andvari’s founder and Chief Investment Officer, Douglas Ott, is proud to announce the first episode of the Preferred Shares podcast.
Douglas helped create the Preferred Shares in partnership with Devin LaSarre (author of the Invariant newsletter) and Lawrence Hamtil (co-founder and principal at Fortune Financial Advisors). The podcast will explore the forgotten and lesser-known subjects of business, history, and business history. In the first episode, they explore the brief mania of vending machine stocks that occurred in the early 1960s.
During the research process, one of the stories Douglas focused on was the founding of Automatic Canteen by Nathaniel Leverone in 1929.
INSPIRATION FOR A BETTER VENDING EXPERIENCE
During the early 1900s, Nathaniel had had a successful career as a salesperson for several different businesses. He had also diligently saved and invested his money in Chicago real estate. In 1928, at the age of 44, he had been semi-retired for several years so he could look after his real estate.
The inspiration for founding Automatic came to him after a horrible experience with vending machines in 1928. While waiting on the ‘L’ train in a Chicago station, he looked for a way to pass his time. He spotted a weighing machine. He put in a penny to see his weight and out dropped a card saying he was 260 pounds. Unsatisfied with this spurious result, Nate put in another penny and out popped another card with a number that was drastically lower than his actual 155 pounds.
Nate then tried to buy some gum from a machine. The machine ate his money and returned nothing. He then went to a snack vending machine where all he got was a handful of moldy peanuts.
Although Nate was incensed at this pitiful vending experience, this is where he got the idea and desire to start his own vending company. He thought to himself (emphasis Andvari’s), “If inefficient service could keep those machines on walls all over the country, how much more could be accomplished by an honest, well-organized method of doing business!”
Automatic Canteen vending machines. Photo via "The Vend Diagram" by Steven Heller.
THE BUSINESS PRINCIPLES OF AUTOMATIC CANTEEN
Nate started Automatic Canteen soon after in 1929. He started with eight business principles which we share verbatim. Nathaniel wrote, for a vending machine to succeed, it must:
Give the public a square deal by operating machines that invariably returned the coin if no merchandise was vended.
Give the public a square deal by selling full-size, standard units of merchandise of known value.
Protect owners of locations where machines were placed by sharing receipts honestly and equitably.
Protect the public by servicing machines at least once a week so that only strictly fresh merchandise would be vended.
Immediately win the public's confidence by selling only goods of wide consumer acceptance.
Reduce, if not eliminate completely, the temptation of the public to cheat the machines, with slugs, by creating mechanisms which would reject them.
Create such a big volume that a small profit would insure a reasonable total profit.
Be manned by a high type of trained service personnel which would constantly build up, instead of tear down, public confidence.
ANDVARI TAKEAWAY
These are timeless principles. Most get to two important ideas. The first is to just always do the right thing. Warren Buffett and Charlie Munger frequently talk about this. Businesses will make more money in the end with good ethics than with bad ethics. Acting with morality is always the best policy. Finally, to paraphrase Munger, if rascals knew how well honor worked, they would all flock to it!
The second timeless principle is to invest the time and money to provide a superior service or product and you’re likely to win business. Although Canteen had a tough road ahead of it—the Great Depression was just around the corner—Nate built a successful business that withstood the test of time. He did this by “simply” improving the experience of his customers in a meaningful way. He championed new technology to combat the use of slugs and to return valid coins to customers when no merchandise was vended. Operational improvements came in the form of regular maintenance of the machines and investing in higher quality merchandise. Starting with zero revenues in 1929, Automatic survived the Great Depression and went on to earn $200 million in revenues in 1963.
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of publication of this blog, Andvari clients had no position in any company mentioned. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results.Full Disclaimer.
Below is a selected portion of our latest letter to clients. Contact us for access to the full letter. Please share and enjoy.
Dear Friends,
For the first quarter of 2023 Andvari was up 16.7% net of fees while the SPDR S&P 500 ETF was up 16.8%.* Andvari clients, please refer to your reports for your specific performance and holdings. The table below shows Andvari’s composite performance against two benchmarks while the chart shows the cumulative gains of a $100,000 investment.
ANDVARI HOLDINGS
With one of Andvari's holdings having a large unrealized loss, we've decided to realize a portion of these losses in the coming months. This will offset some gains we've already realized and we will also be able to reinvest the proceeds in some other attractive opportunities. We have started to acquire a basket of companies that are similar in style to the one we'll be selling.
The basket contains a handful of serial acquirer types of businesses. They all produce free cash flows above and beyond what they need to reinvest in their own business, so they choose to use their excess cash to acquire other businesses. Here are summaries of just two in this basket of serial acquirers.
KELLY PARTNERS GROUP
Brett Kelly founded Kelly Partners in 2006 in Australia as a specialist chartered accounting network. Since its founding, the results have been incredible. Revenues started out at less than a million and will likely be above $100 million in their 2024 fiscal year. In other words—revenues have doubled five times since founding. This is a result of good organic growth and by acquiring many other like-minded accounting firms. Since going public in 2017, 31 accounting firms have joined Kelly Partners, 24 of which have come in just the past three years.
Andvari believes there are two main reasons for the recent increase in the pace of acquisitions. First, Kelly Partners has grown its reputation as a great permanent home for the accounting firms built up over the decades by accountants looking to retire. Second, Kelly has developed a repeatable system of best practices and standards that enables them to increase the growth and profitability of acquired accounting firms. For example, Kelly Partners operates with 30%+ EBITDA margins while the average accounting firm in Australia is at 19%.
When it comes to the qualitative aspects of the company, there are several we like. First, Kelly Partners is consolidating share in a highly fragmented market. Second, the accounting business itself is solid and predictable. Accounting relationships with private businesses and their families can last several generations. People and businesses will always have taxes to pay. Further, the complexity and quantity of tax rules only seems to increase.
The last qualitative aspect to the company is the founder and CEO Brett Kelly. He is by all accounts a great person and leader. His actions mirror his words. He is aligned with shareholders as he still owns 50% of the company. Kelly speaks Andvari’s language of accounting, investing, and capital allocation. His investing and business heroes are ones that inspire us as well. Like Berkshire Hathaway, Kelly Partners has an owner's manual that serves as a handbook for current and prospective shareholders to better understand the business. There is no doubt Brett Kelly knows what it takes to enable success for his employees, customers, and shareholders.
The opportunity to acquire and improve more accounting firms is still significant. Kelly Partners is just beginning to expand in the United States and the United Kingdom. We expect the company to double revenues another two times over the next decade.
[Section on Kingsway Financial Services removed. Contact us for access to the full letter.]
ANDVARI TAKEAWAY
We’re thankful for good positive performance thus far this year but we remain unsatisfied. Performance over the last two years has negatively impacted Andvari’s long-term, aggregate net performance. As unpleasant as this has felt for me personally, I do my best to remind myself that performance can come and go in waves. Bouts of under and outperformance inevitably occurs in a concentrated investment strategy such as the one Andvari employs. However, periodic suffering is the price one pays for a chance at earning above-average long-term returns.
Rather than focusing too much on short-term performance, or anything else over which we have little to no control, we remain focused on what we can control. And that is identifying and studying high quality businesses with high quality managers that can deploy capital at high rates of return for a long period of time. Buying shares of these businesses at sensible prices skew the odds in our favor of producing excellent returns over the long-term.
As always, I love to hear from clients and anyone else. Please contact me with your thoughts, comments, or questions.
Sincerely,
Douglas E. Ott, II
DISCLOSURES AND END NOTES
* Andvari performance represents actual trading performance of all, actual clients beginning on 4/12/13, managed under the primary Andvari investment strategy. Performance from 12/31/12 to 4/12/13 is actual performance of proprietary accounts, namely the accounts of Andvari’s principal, Douglas Ott. Andvari believes including Ott’s performance figures for the first 4 months and 12 days of 2013 is fair as he managed those accounts similarly to Andvari’s first clients. All performance, including the initial proprietary period, are net of management fees—assumed to be 1.25% per annum, paid quarterly, as currently advertised—net of brokerage commissions and expenses, time-weighted, and includes all cash and other securities. Performance includes realized and unrealized returns and excludes the effects of taxes on incurred gains or losses. Andvari does not certify the accuracy of these numbers. Performance data quoted represents past performance and does not guarantee future results.
The index ETFs are listed as benchmarks and are total return figures and assumes dividends are reinvested. The S&P 500 ETF (SPY) is an exchange traded fund based on the S&P 500 index, which is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. The Russell 2000 ETF is an exchange traded fund based on the Russell 2000 Index, which is an index of 2,000 U.S. small-cap stocks. It is not possible to invest directly in an index. Because Andvari client portfolios are non-diversified, the performance of each holding will have a greater impact on results and may make them more volatile than a more diversified index. Andvari also engages or may engage in strategies not employed by the S&P 500 or the Russell 2000 including, without limitation, the use of leverage.
One may request a list of all securities mentioned or recommended for the preceding year as of the date of this letter. You may contact Andvari using the information below. Actual client results may differ from results depicted in this letter. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the loss of principal. Investment strategies managed by Andvari Associates LLC may have a position in the securities or assets discussed in this article. Securities mentioned may not be representative of the Andvari's current or future investments. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
The discussion of Andvari’s investments and investment strategy (including, but not limited to, current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) represents the views and opinions of Andvari’s portfolio managers and Andvari Associates LLC, the investment adviser, at the time of this report, and can change without notice.
This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the affiliates of Andvari.
The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. Any or all of Andvari’s forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties, and other factors, most of which are beyond Andvari’s control. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision.
A recent report found that nearly a fifth of S&P 500 CEOs spent part of their careers at just two companies: General Electric (GE) and Procter & Gamble (P&G). This is not terribly surprising. First is simply the large size of these global behemoths. But perhaps more important is that both, over multiple generations, have done an extraordinary job of internal development of young executives and managers. Knowing the location of outstanding “executive training grounds” that are producing the next great crop of CEOs is one part of Andvari’s process in finding investment opportunities and judging the quality of leadership.
GE'S CORPORATE UNIVERSITY
Let’s demonstrate by using GE. The company was the first to establish a corporate university in the country. It did so by purchasing in 1956 a 50+ acre site in Crotonville, NY for its Management Research and Development Institute.
GE's Crotonville campus
Despite its troubles in the recent decade, GE developed numerous executives who climbed the ranks within GE and then led other public companies. Here are some of the most notable examples:
Larry Bossidy joined GE in 1957 and rose through the ranks over the next 34 years. Because Bossidy was too close to the mandatory retirement age at GE, he left in 1991 to become CEO at Allied Signal, a company in need of turning around. Bossidy executed a successful turnaround and his career culminated with Allied acquiring Honeywell. For more on Bossidy, see Andvari’s blog, “The Cultural Component to 10-Bagger Returns”.
Robert Nardelli joined GE in 1971 as an entry-level engineer. He worked his way up and eventually became CEO of GE Power Systems. Nardelli lost out to Jeff Immelt to become GE’s next CEO. Nardelli then became CEO of Home Depot in December 2000 and then CEO of Chrysler in August 2007.
David Cote started working at GE in 1974 as an hourly laborer on the nightshift while he attended college. Cote joined GE full-time in 1976 and became CEO of GE Appliances in 1976. He was also passed over for Jack Welch’s position. Cote left GE to become CEO at Honeywell in 2002, where he created extraordinary shareholder value during his tenure. He stepped down as Honeywell CEO in March 2017.
Scott Donnelly started at GE in 1989 as a manager in the Ocean Systems Division. He worked his way up in several different divisions and ultimately became CEO of GE’s jet-engine business. He left GE in July 2008 to become COO at Textron. Donnelly then became CEO of Textron in December 2009 where he still serves as CEO as well as Chairman.
GE certainly has a storied history of developing executives who can lead large organizations. However, for the GE executives who left to lead another public company, their track record for producing decent returns for shareholders has been mixed.
If one had followed Nardelli to Home Depot, the returns would have been slightly negative. If one had been a shareholder of Allied Signal during Bossidy’s leadership, returns would have been excellent. An investor would also have enjoyed excess returns by being a shareholder of Honeywell during Cote's time as CEO.
HOME DEPOT UNDER BOB NARDELLI
ALLIED SIGNAL UNDER LARRY BOSSIDY
HONEYWELL UNDER DAVID COTE
ANDVARI TAKEAWAY
Following the managers that earned their stripes at a high performing organization can be a useful way to identify potential investment opportunities. And it need not apply to business. Just look at the Bill Walsh era of the San Francisco 49ers. Walsh turned the last place 49ers into an organization that won 3 super bowls over the span of 8 years. After this performance, seven of Walsh’s assistant coaches would become head coaches at other teams across the NFL. These seven would earn a cumulative three Superbowl wins.
Nevertheless, it's important to remember following a leader from a lauded organization doesn't always work out. Just consider the difference in outcomes between Bob Nardelli and David Cote. Under Nardelli, Home Depot underperformed the market and Chrysler went bankrupt. On the other hand, Allied Signal shares outperformed under Bossidy, and then Honeywell outperformed under David Cote . There’s no sure thing in business, but it is still worth the time to track the managers who have graduated from their executive training grounds.
Article about GE’s famed corporate university in Crotonville
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IMPORTANT DISCLOSURE AND DISCLAIMERS
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of publication of this blog, Andvari clients had no position in any company mentioned. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results.Full Disclaimer.
For the first quarter of 2023 Andvari was up 12.3% net of fees while the SPDR S&P 500 ETF was up 7.5%.* Andvari clients, please refer to your reports for your specific performance and holdings. The table below shows Andvari’s composite performance against two benchmarks while the chart shows the cumulative gains of a $100,000 investment.
WHY ANDVARI DISLIKES BANKS
The recent failures of Silicon Valley Bank, Signature Bank, and Credit Suisse reminded us why we are skeptical of investing in banks. To Andvari, banking—in general—is not a great business to be in for the long-term. This is because the industry has multiple unattractive qualities. The following five attributes are among our least favorite for any business we follow.
Commodity Products
First, banking is a commodity business. According to the Wikipedia definition, commodities are "economic goods that have full or partial but substantial fungibility; that is, the market treats their instances as equivalent or nearly so with no regard to who produced them." Loans from Bank A are generally indistinguishable from Bank B. Any business selling a commodity distinguishes itself by having the lowest price or by giving away the most concessions along with that commodity.
When customers have no regard for who produces the good or service in question, it means they look for the lowest price. It means lower margins and lower returns for the producer of the commodity. This does not lend itself to long-term profitability or above-average returns to shareholders.
At Andvari, we instead seek out businesses with highly valued products or services. This in turn enables higher than average margins and returns, more robust free cash flows, more dependable revenues, and often commands a stronger and longer lasting relationship with customers.
Rising Input Costs Difficult to Predict and Offset
Another sticking point for Andvari over banks is they have little control over a huge input cost to their product, which is interest rates. Uncontrollable and unpredictable input costs—like interest rates for a bank—do not heavily influence the cost structures of the companies Andvari favors. Even if input costs go up at an Andvari company, they can more easily raise prices to offset those costs. They have this ability because the products they sell are highly differentiated or else not easily switched out for a competing product.
Leverage is Necessary to Generate Acceptable Returns
Next, banks have low profitability from a ROA ("return on assets") perspective. Over the last ten years, the average ROA for all banks in the U.S. was a measly 1.08%. On the other hand, banks do earn a higher figure on ROE ("return on equity") that some find acceptable. Over the last ten years the average ROE for all banks in the U.S. was 10%.
However, this higher ROE is only possible because a small amount of capital supports a large amount of assets—i.e., they are highly leveraged. The businesses that interest Andvari have naturally high margins and returns on equity. They do not require debt or leverage to provide adequate returns to shareholders.
Highly Regulated
Although many of our companies sell products or services into highly regulated industries, they themselves are lightly regulated by comparison. On the other hand, a bank holding company that provides a multitude of financial services must deal with a handful of regulators. For example, here are the main regulators of JPMorgan Chase (JPM)1, the largest bank in the U.S.:
The Board of Governors of the Federal Reserve System supervises and examines the holding company of JPM;
JPM’s national bank subsidiary is supervised and regulated by the Office of the Comptroller of the Currency and by the Federal Deposit Insurance Corporation;
JPM’s U.S. broker-dealers are supervised and regulated by the Securities and Exchange Commission and the Financial Industry Regulatory Authority. The Commodity Futures Trading Commission regulates subsidiaries that engage in futures-related and swaps-related activities.
JPM and its national bank are subject to supervision and regulation by the Consumer Financial Protection Bureau with respect to federal consumer protection laws.
So many regulators and overlapping rules. This all detracts from profitability and the ability to serve customers.
Customers Can Cause the Business to Fail in a Matter of Days
Any business can make a mistake that causes customers to leave. However, only in the world of banking can customers tip the business into bankruptcy in a matter of days simply because of a lack of confidence. Andvari prefers to own businesses devoid of this "bank run" risk.
ANDVARI HOLDINGS: TYLER TECHNOLOGIES
One of Andvari’s worst performers in 2022 was Tyler Technologies. Tyler was down 40% while the S&P 500 was down 18.2%. We think Tyler currently sits at a valuation favorable to above average returns going forward. Furthermore, Tyler’s recent proxy statement2 supports Andvari’s view.
The proxy tells shareholders the board is incentivizing management to increase margins by several percentage points by the end of 2025. For context, Tyler’s margins used to be several percentage points higher than today. This is because the company sold more of its software via on-prem licenses as opposed to selling a subscription to use the software hosted “in the cloud” in an off-prem3 data center. Tyler historically let the customer decide how they wanted to purchase Tyler’s software. Since 2020, Tyler’s agnosticism has changed. Tyler now is a “cloud first” software company and has a partnership with Amazon Web Services (“AWS” is Amazon’s on-demand cloud computing platform). The company has been actively encouraging customers to choose the cloud version of their software products and to have it hosted on AWS.
While the change to a cloud-first, software-as-a-service (SaaS) business model has been a headwind for Tyler, it will lead to more predictable revenue growth and higher free cash flows in the long run. In the short term, Tyler has had lower revenue growth and profitability due to selling fewer on-prem software licenses and more subscription agreements. This stems from the fact that Tyler can recognize more revenues and profits up-front with the sale of an on-prem license. A subscription agreement means Tyler recognizes revenues ratably over the life of a contract.
During this transition period, Tyler has also been paying for duplicate costs and one-time expenses. They are optimizing software for the cloud and supporting multiple versions of the same software. However, as Tyler's transition progresses, these costs will decline and the boost to long-term profitability will be significant. Tyler’s management has stated 2023 will be an inflection point for the company. They estimate the adjusted operating margins4 of Tyler will begin to increase in 2024 at a rate of ½% to a full 1% per year. Based on Tyler’s proxy statement, Andvari thinks management might be sandbagging with these estimates.
For 2023, the Compensation Committee of Tyler’s board of directors approved grants of long-term, performance-based stock units (PSUs) to the CEO. The total target value of awards is divided into two equal parts, with 50% of PSUs granted subject to 3-year cumulative recurring revenue growth performance and the other 50% subject to operating margin performance. If Tyler’s CEO achieves maximum targets of two financial metrics, he stands to earn upwards of $6.5 million worth of Tyler shares. The following tables set forth the criteria that must be met for 2023 PSUs to be earned and eligible for vesting.
For 2022, recurring revenues were $1.47 billion (out of a total of $1.85 billion). Tyler’s adjusted operating margins for 2022 were 23.6% versus 28.0% in 2017. For the CEO to earn 100% of PSUs, the cumulative recurring revenue growth would need to be at least 36.9% and operating margins would need to reach 24.5%. Given that most boards give executives achievable goals, Andvari believes Tyler’s CEO will likely earn 100% or more of the PSUs. This in turn will mean excellent financial performance that hopefully translates into good returns for shareholders.
If we assume recurring revenue growth of 40% as the base case, by 2025 recurring revenues will have grown to $2.06 billion. We’ll also assume non-recurring revenues grew at a slower pace, a cumulative 30%, to $494 million. This would bring total revenues to $2.55 billion. Then, multiplying the revenues by a 25% adjusted operating margin (they had these margins in 2021), this gets us $638 million in adjusted operating profits for 2025 versus $437 million for 2022. Assuming the multiple the market puts on Tyler’s revenue or adjusted profits remains the same, this would potentially produce annualized returns for shareholders in the range of 11% to 15%.
ANDVARI TAKEAWAY
As we finish writing this letter, Andvari will have served its first set of clients for ten years. We personally will have been in the investment profession for over 13 years. Our goal since the beginning has been to achieve above average performance, net of our fees, over the long term. Our method towards this goal is through a concentrated portfolio of high-quality businesses purchased at sensible prices. After a valuation reset during 2022, we are excited to see how our portfolio of companies will grow over the coming years.
As always, I love to hear from clients and anyone else. Please contact me with your thoughts, comments, or questions.
* Andvari performance represents actual trading performance of all, actual clients beginning on 4/12/13. Performance from 12/31/12 to 4/12/13 is actual performance of proprietary accounts, namely the accounts of Andvari’s principal, Douglas Ott. Andvari believes including Ott’s performance figures for the first 4 months and 12 days of 2013 is fair as he managed those accounts similarly to Andvari’s first clients. All performance, including the initial proprietary period, are net of management fees—assumed to be 1.25% per annum, paid quarterly, as currently advertised—net of brokerage commissions and expenses, time-weighted, and includes all cash and other securities. Performance includes realized and unrealized returns and excludes the effects of taxes on incurred gains or losses. Andvari does not certify the accuracy of these numbers. Performance data quoted represents past performance and does not guarantee future results.
The index ETFs are listed as benchmarks and are total return figures and assumes dividends are reinvested. The S&P 500 ETF (SPY) is an exchange traded fund based on the S&P 500 index, which is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. The Russell 2000 ETF is an exchange traded fund based on the Russell 2000 Index, which is an index of 2,000 U.S. small-cap stocks. It is not possible to invest directly in an index. Because Andvari client portfolios are non-diversified, the performance of each holding will have a greater impact on results and may make them more volatile than a more diversified index. Andvari also engages or may engage in strategies not employed by the S&P 500 or the Russell 2000 including, without limitation, the use of leverage.
One may request a list of all securities mentioned or recommended for the preceding year as of the date of this letter. You may contact Andvari using the information below. Actual client results may differ from results depicted in this letter. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the loss of principal. Investment strategies managed by Andvari Associates LLC may have a position in the securities or assets discussed in this article. Securities mentioned may not be representative of the Andvari's current or future investments. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
The discussion of Andvari’s investments and investment strategy (including, but not limited to, current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) represents the views and opinions of Andvari’s portfolio managers and Andvari Associates LLC, the investment adviser, at the time of this report, and can change without notice.
This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the affiliates of Andvari.
The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. Any or all of Andvari’s forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties, and other factors, most of which are beyond Andvari’s control. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision.
These bullet points are taken nearly verbatim from JPMorgan’s most recent 10-K filing.[↩]
The proxy statement is an important document that allows shareholders to make informed decisions about the matters to be voted on at the annual meeting of a company. Among other things, it also contains information about executive compensation.[↩]
“On-prem” is the abbreviation for on-premises software, which is software that is installed and runs on computers on the premises of the organization using the software, rather than at a remote facility.[↩]
Tyler’s adjusted operating margins starts with operating profits and adds back one-time expenses and other non-cash items. The two largest expenses added back are amortization expenses and share-based compensation (i.e., stock given to employees).[↩]
For the full year of 2022 Andvari was down 33.8% net of fees while the SPDR S&P 500 ETF was down 18.2%.* Andvari clients, please refer to your reports for your specific performance and holdings. The table below shows Andvari’s composite performance against two benchmarks while the chart shows the cumulative gains of a $100,000 investment.
Terry Smith is the founder of a successful investment firm based in London. Back in 2012 when a Brit won the Tour de France for the first time, Smith wrote a note comparing investing to the Tour. It is an apt comparison as both are endurance races. The Tour has 21 stages and takes place over 23 days. The winner of the Tour is the cyclist with the least amount of time accumulated over all the stages. Likewise, success in investing can only be determined by the accumulation of performance over a long period of time. In the case of investing, it is decades.
Another trait the Tour and investing share is the fact the victor is unlikely to be the person who has won every single stage or had the highest return in every calendar year. Since the Tour’s inception in 1903, there is no Tour winner that has won all 21 of the stages. The most number of stage wins by a cyclist in a single Tour is eight. This has happened only four times in Tour history: Charles Pélissier in 1930, Eddy Merckx in 1970 and 1974, and Freddy Maertens in 1976. Furthermore, of these three cyclists, only Merckx became the ultimate Tour winner. This is because there are a variety of terrains and events that favor different types of cyclists. There are stages where the terrain is flat, there are stages for a cyclist to race individually against the clock, and there are stages that go straight up into the mountains. Thus, as Smith wrote, “[T]he search for an investment strategy or fund manager which can outperform the market in all reporting periods and varying market conditions is as pointless as trying to find a rider who can win every stage of the Tour.”
At Andvari, we believe the best way to compound our capital is to own a small group of high quality businesses, with great management teams, and where there is an opportunity for the businesses to reinvest their cash flows at high rates of return for a long period of time. If we can purchase these businesses at sensible prices, we believe this skews the odds in our favor of outperforming the major stock indexes, net of our management fee.
However, this investing method assuredly means our results will be more volatile in the short term. Andvari underperformed the S&P 500 ETF (SPY) in the last 5 out of 10 calendar years. Our composite 10-year annualized net performance of 11.7% puts Andvari slightly behind the 12.5% annualized performance of the SPY and comfortably ahead of the Russell 2000 ETF’s 9.0% annualized performance. Interestingly, if in 2022 Andvari had simply achieved the same monthly performance of the S&P 500 ETF, and subtracted our management fee to get the net performance, Andvari’s 10-year annualized net performance would have been 13.9% versus 12.5% for the SPY.
ANDVARI FRAMEWORK
Although Andvari’s performance in 2022 hurt our long-term performance, we are confident as ever about the future. We are closing in on ten years of being in business and excited about the next ten years. Thus, it’s an appropriate time to share our thoughts on what it means to be a high quality business.
When Andvari researches a business, we desire quality businesses because these tend to be the ones an investor can own for a long time. Being able to own a business for a long time is good because this allows the beauty of compounding to unfold. In terms of financials, quality to Andvari usually means a business with high margins, high returns on invested capital, and a track record of growth. However, simply looking at the financials is never enough. A business that looks high quality based on past results does not mean it will continue to be high quality going forward. Thus, Andvari seeks the underlying reasons behind superlative financial results. We want to understand the competitive advantages the company has and how likely they will persist, grow, or shrink.
Here’s a list of some questions Andvari asks that help us measure the quality of a business:
Does management have skin in the game? Appropriate incentives? A good record of allocating capital? Andvari wants managers to think and act like owners of the business. If they aren’t the founder, the managers should have a meaningful amount of their personal wealth tied to the value of the business. Having skin in the game increases the likelihood of management growing the value of the business over the long term.
How close is the relationship between the business and its customers? Being a trusted partner and providing highly customized solutions tends to mean the business can charge more and be less susceptible to competition.
Is it a dominant player in a niche market? This question gets to the level of competition a business faces. If the business is the dominant player in a small, specialized market, it likely has several important things. One is pricing power over its customers. Another is intimate knowledge of a specific industry that they have accumulated over decades. Finally, a small market also dissuades huge companies from entering to compete. It is too risky to try to take some share of a small market that in the end won’t move the needle for a big company.
Is it hard (or nearly impossible) to compete with this company? From Andvari’s perspective, life tends to be easier when you don’t have to worry about competitors. Here are two examples of when a company might have de minimis competition. First, a company might benefit from network effects like Meta’s Facebook and Instagram, Google’s search engine, or the payment rails of Visa and Mastercard. Second, a company’s product may have become a de facto standard for its users. Think of the credit rating services of Moody’s and S&P, Autodesk’s CAD software for engineers and architects, or Adobe’s software for creative professionals.
Does is it have a product that provides a high amount of value relative to its cost? If the answer is yes, the company has leeway to continually raise prices or use value-based pricing, both of which can enable higher margins and above-average growth.
Does the company require a lot of investment to sustain or grow its business? Andvari prefers businesses that require little or no investment to sustain and grow its business. Spending no money to grow 5% is better than spending lots of money to grow 5%.
How cyclical is the business? How predictable or recurring are revenues? Is it resistant to recessions? Andvari prefers businesses that are less cyclical, more predictable, and that can perform relatively well during an economic downturn. With greater predictability of revenues, a management team has an easier job deciding whether to reinvest in their business or to return capital to shareholders.
Can the company reinvest its free cash flows back into the business? Is management thoughtful about allocating capital? Andvari prefers a business that can invest all its cash at high returns. If the business still has extra cash after reinvesting in their business, we want a management team that will allocate that capital in an intelligent fashion. This could mean returning capital to shareholders via dividends or share buybacks or acquiring other businesses.
When the answers to these (and many other) questions are to our satisfaction, we often find a business with above average gross margins, above average returns on invested capital, more predictable revenues, and above average rates of growth. We also might find other positive qualities. For example, when a product has a high value to the customer relative to the cost, the company making the product has pricing power. This means it can easily raise prices for a long period of time. Furthermore, there also might be little or no customer churn, which in turn means the business can spend less money on sales and marketing. With less money spent on sales and marketing, the business can keep the savings for itself, pass the savings on to customers, spend more money on research and development, or return it to shareholders in the form of dividends or share repurchases, or some combination of all the above!
ANDVARI HOLDINGS
As of January 27, Andvari clients own up to ten different stocks in their portfolios. In alphabetical order, we give an overview of each.
Adobe
Adobe is one of several software companies we own. Its suite of creative products (Photoshop, Illustrator, Acrobat, Lightroom, etc.) are the industry standard for creative professionals. Adobe also has a suite of customer experience products that help other businesses sell more easily to consumers. All of Adobe’s products have high switching costs and sold on a subscription basis.
Adobe’s business qualities enable extremely high margins and predictable, recurring revenues. The company had revenues of $17.6 billion in its last fiscal year with operating margins in the mid-30s. The company has also grown revenues at double-digit rates every year since 2015. Despite a good record of investing in its businesses, it still has an excess of cash on its balance sheet. As such, Adobe has returned cash to shareholders in the form of share buybacks. Since 2015 the company has returned a total of $24.5 billion.
Constellation Software
Founded in 1995 by Mark Leonard with just $25 million, Constellation Software (CSI) is now worth over $35 billion. CSI acquires and manages vertical market software (VMS) businesses. It’s pitch to owners of these businesses is similar to the pitch Warren Buffett has made to hundreds of other business owners. CSI will be the permanent home for these businesses. Although the owner will receive less for their business than if they had sold to a private equity buyer, they can rest assured knowing Constellation will take a hands-off approach to the business they spent decades building.
The hallmark of a VMS business is that its product is tailored to a very specific industry, like equipment rental, public transportation, or mine planning. This requires direct industry knowledge and working very closely with customers. The software is usually mission critical for VMS customers and thus it provides a tremendous value relative to its cost. Revenues of a VMS business are very sticky and predictable and margins are high.
One downside to many VMS businesses is that organic revenue growth tends to be low. Also, cash tends to pile up in these businesses as there is no easy way to reinvest the money back into a business with low growth. This is where CSI again resembles Buffett’s Berkshire Hathaway. If a VMS business is unable to reinvest its capital, CSI takes it back to redeploy into other opportunities. CSI has redeployed capital by acquiring over 600 VMS businesses since its founding.
Even though CSI now has over $6 billion in revenues, there is still ample opportunity to redeploy capital at high rates of return. The founder Mark Leonard still owns 7% of the company, a stake that is now worth over $2.5 billion. Mark also stopped taking a salary and incentive compensation in 2015, turning himself into more of a partner than an employee. Mark’s wealth grows only when the value of CSI’s shares grows. This is an excellent arrangement.
Copart
Willis Johnson founded Copart as an auto salvage business in 1982 and the company is now the largest auctioneer of damaged and totaled vehicles in the world. It sells more than 3.5 million vehicles per year and operates more than 250 locations in 11 countries. It lists 250,000 vehicles for auction every day.
Copart’s primary customers are auto insurance companies. This would be the GEICOs, the Progressives, the State Farms, and many others around the world. When a policy holder’s car is damaged, the insurance company makes a determination of whether to repair the car or to consider it totaled and pay the owner the value of the car. The insurance company will total the car if repair costs outweigh the pre-accident value of the car. If they total the car, the insurance company writes a check for the pre-accident value of the car and then uses Copart to auction the car to salvage any remaining value.
Copart is a company of extraordinary quality. It is the number one player in an effective duopoly. The business has multiple layers of competitive advantages. First, it owns over 80% of the land it uses for its salvage yards and car parks. Copart bought most of this land decades ago. Having accessible land closer to where most accidents happen decreases the costs of towing. Copart also never has to face rent increases or a landowner choosing not to re-lease to Copart. Finally, because of zoning restrictions and the growth of cities, it is impossible for a competitors to duplicate Copart’s land advantage.
Second, Copart has built the largest and most liquid online auction market for totaled vehicles. This means insurance companies will get higher auction values. Copart should continue to slowly gain market share from its competitor. Thirdly, Copart has invested to build up specialized infrastructure to handle the times when weather catastrophes strike its auto insurance customers. In 2013, CEO Jay Adair wrote about Copart’s response after Hurricane Sandy:
Even our experience with Hurricane Katrina did not prepare us for the damage done by Hurricane Sandy. The inflow of flood-damaged cars was far more immediate and compressed. We mobilized the full force of our Catastrophe Action Team, marshaling more than 325 employees and 575 car transporters. In 90 days, we picked up more than 85,000 vehicles in a market that normally wouldn’t do that many vehicles in a year. Employees from as far away as England and car transporters from as far away as Seattle were sent in; and at one point, Copart had more than 14 additional yards created to deal with so many vehicles. At the peak of the effort, we picked up more than 2,300 cars in one day, or almost one car every 25 seconds. We consumed almost 11 acres a day in storage capacity. The cost to Copart was no small issue either, as we expended over $36 million to handle the additional volume.
Copart’s catastrophe team most likely is a money-loser, but it’s an invaluable capability to Copart’s insurance customers. From a long-term perspective, it’s an investment that’s all about retaining clients and gaining market share. The investment has paid off because several large insurance carriers have shifted more of their business to Copart after Sandy.
In regards to future growth for Copart, the company has the wind at its back because insurance carriers will choose to total more and more vehicles involved in accidents. They will total more cars for two reasons. One reason is the cost to repair a car will continue to rise. There is an increasing amount of technology, sensors, cameras, and computer chips in vehicles. These parts cost thousands of dollars and it takes more time for repair shops to install and recalibrate this technology. The other reason is the average age of cars will continue to slowly increase. Older vehicles are simply worth less than the total cost to repair, and thus are more likely to be totaled.
Finally, Copart is a shining example of capital allocation. First they have always invested for the long-term. The evidence here is the fact they choose to buy and own their land rather than lease. Second, they have continually reinvested in their business. Total capital expenditures as a percent of revenues has recently been in the range of 10%–20%. However, about 80% of this spending has been for new land and expanding current locations. Thirdly, when management has felt Copart shares were undervalued, they have repurchased large chunks of stock. Over the last 20 years, Copart has reduced shares outstanding from 739 million to 476 million.
Costar Group
CoStar is a provider of online real estate marketplaces (LoopNet and Apartments.com are the best known ones) as well as data and analytics services to the commercial real estate industry. CoStar’s products are essential to its customers, the products provide a high value relative to their cost, and revenues are mostly recurring. 93% of the top 1,000 commercial real estate brokerage firms are CoStar customers. Virtually all large apartment complex owners advertise their inventory on Apartments.com. If you have commercial property to sell or lease, the best place to go is CoStar’s LoopNet because they have 20x the monthly web traffic of its next closest competitor.
Andy Florance is the CEO and founder. He started the company in 1987 and has grown revenues to over $2 billion annually. The company has a market value of $32 billion. There is still room for decades of growth and reinvestment: CoStar can grow much larger in Europe; it has an online real estate auction platform called Ten-X that can become much larger; and CoStar might soon become a real challenger to Zillow in the online residential real estate market.
Digital Bridge
Digital Bridge is one of the world’s largest digital infrastructure investment firms. It invests in data centers, cell towers, and fiber networks. Its founder and CEO is Marc Ganzi who sold his previous business, Global Tower Partners, to American Tower for $4.8 billion. Everything we know about Ganzi points to him being a highly driven workaholic who is focused on creating value for himself and all other shareholders.
The investment management business on its own is incredibly attractive. Margins are high and management fees are sticky. For Digital Bridge in particular, Ganzi puts it this way: Digital Bridge is “[m]anaging long-term capital on behalf of the leading global LPs and shareholders in a sector with strong secular tailwinds led by a team with a 25-plus year track record of execution.” With shares currently trading in the low teens, Ganzi stands to receive a $100 million payout if the share price reaches $40 by mid-2024. If the stock market fails to recognize the value of the business by then, it’s highly possible Ganzi will once again sell to a larger competitor to realize the true value of the business he has built.
Mastercard
Mastercard is the second largest payment technology company in the world. Its network enables the transfer of value and information between banks, merchants, and consumers. Despite the seeming ubiquitous presence of debit and credit cards, about 85% of the world’s purchase transactions are still in cash or check.
Due to its network effects, sharing an oligopoly with Visa, and providing an extraordinary amount of value to its stakeholders, Mastercard enjoys high free cash flow margins that are in the mid-40s. It has minimal debt on its balance and returns the majority of its cash flows to shareholders in the form of share repurchases and a small, but fast growing, dividend. We continue to own Mastercard as it wages its “war on cash.”
Mesa Laboratories
Mesa sells equipment, instruments, and consumables for niche applications in the highly regulated life sciences, healthcare, and pharma markets. More than 60% of revenues are recurring or highly predictable. All its products provide high value relative to their cost. The company has high margins, robust cash flows, and minimal capex needs.
Furthermore, Mesa has vastly increased its potential since the hiring of CEO Gary Owens from Danaher. Danaher is a public company with an extraordinary business system of continuous improvement, problem solving, and listening to the customer, which enabled exemplary shareholder returns over the last 20 years. Gary has been created and implemented Mesa’s own business system—The Mesa Way—that has helped boost margins, increase growth, and increase customer satisfaction. The board has been upgraded with individuals with experience leading businesses with billions of revenues. Mesa is well positioned to continue growing as a serial acquirer of other high quality businesses.
S&P Global
S&P is another company we own that is part of a duopoly in the business of credit rating. S&P and Moody’s have roughly equal market shares and rate more than 90% of all bonds worldwide. The service provides high value for the cost. A company that chooses to issue debt without a rating will pay an interest rate that could be higher by half of a percent. The cost of a higher interest rate far exceeds any savings gained by not using the services of S&P.
We think of S&P as a toll road that earns fees from its customers in exchange for cost-effective access to capital. As such, the company has extraordinary margins and pricing power and requires little of its own capital to grow. Even after fully reinvesting in its business, S&P still has an excess of cash. In 2021, S&P produced $3.5 billion of free cash from $8.3 billion of revenues. The company returns the majority of its free cash to investors in the form of dividends and share repurchases.
Topicus.com
Topicus is a spin-out from Constellation Software. It operates in almost exactly the same way as Constellation, but its focus is on acquiring VMS companies in Europe.
Tyler Technologies
Tyler is the only public company focused on software for state and local governments in North America. Since 1998, Tyler has acquired over 40 software companies. Annual revenues have grown from $50 million in 1998 to now over $1.8 billion while cash flows and profits have grown at a faster rate.
Tyler has few competitors that can match its offerings and service levels. Large, potential competitors stay away Tyler’s market because the sales cycle is measured in years and products require too much customization. Once Tyler wins a client, they usually stick around for decades. Client retention for Tyler is nearly 100%, which gives them highly predictable revenues. Also, Tyler management has a record of effective capital allocation. Finally, Tyler has the wind at its back as local governments continually upgrade decades-old systems. Tyler will steadily increases its market from the low-teens into the 20s and 30s over the next decade.
ANDVARI TAKEAWAY
In 2023, Andvari will have been in business for ten years. Our goal since the beginning has been to achieve above average performance, net of our fees, for ourselves and our clients, over the long term. Our method towards this goal is through a concentrated portfolio of high quality businesses purchased at sensible prices. Although poor performance in 2022 hurt Andvari’s long term performance, we are still proud of our accomplishments over the last ten years. It is in Andvari’s nature to strive for excellence and we are excited for the challenge of the next ten years.
As always, I love to hear from clients and anyone else. Please contact me with your thoughts, comments, or questions.
Sincerely,
Douglas E. Ott, II
DISCLOSURES AND END NOTES
* Andvari performance represents actual trading performance of all, actual clients beginning on 4/12/13. Performance from 12/31/12 to 4/12/13 is actual performance of proprietary accounts, namely the accounts of Andvari’s principal, Douglas Ott. Andvari believes including Ott’s performance figures for the first 4 months and 12 days of 2013 is fair as he managed those accounts similarly to Andvari’s first clients. All performance, including the initial proprietary period, are net of management fees—assumed to be 1.25% per annum, paid quarterly, as currently advertised—net of brokerage commissions and expenses, time-weighted, and includes all cash and other securities. Performance includes realized and unrealized returns and excludes the effects of taxes on incurred gains or losses. Andvari does not certify the accuracy of these numbers. Performance data quoted represents past performance and does not guarantee future results.
The exchange traded funds (ETFs) are listed as benchmarks and are total return figures and assumes dividends are reinvested. The SPY ETF is based on the S&P 500 Index, which is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. The IWM ETF is based on the Russell 2000 Index, an index of 2,000 U.S. small-cap stocks. It is not possible to invest directly in an index. Because Andvari client portfolios are non-diversified, the performance of each holding will have a greater impact on results and may make them more volatile than a more diversified index. Andvari also engages or may engage in strategies not employed by the S&P 500 or the Russell 2000 including, without limitation, the use of leverage.
One may request a list of all securities mentioned or recommended for the preceding year as of the date of this letter. You may contact Andvari using the information below. Actual client results may differ from results depicted in this letter. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the loss of principal. Investment strategies managed by Andvari Associates LLC may have a position in the securities or assets discussed in this article. Securities mentioned may not be representative of the Andvari's current or future investments. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
The discussion of Andvari’s investments and investment strategy (including, but not limited to, current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) represents the views and opinions of Andvari’s portfolio managers and Andvari Associates LLC, the investment adviser, at the time of this report, and can change without notice.
This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the affiliates of Andvari.
The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. Any or all of Andvari’s forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties, and other factors, most of which are beyond Andvari’s control. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision.
Constellation Software (CSI) acquires and manages industry-specific, vertical market software companies. Since its founding in 1995, CSI has acquired over 600 businesses that provide specialized, mission-critical software to customers. To better understand how and why CSI has earned extraordinary returns with its business strategy, Andvari looks at CSI's mining vertical. (See also our previous blog: "The 'Permanent Home' Advantage").
STEP ONE: ENTER A NEW VERTICAL
The first step in CSI's playbook is to simply find an attractive software business in a new vertical. In this case, CSI acquired Datamine in 2015 from CAE for $32 million with the potential for CAE to earn another $10 million based on Datamine’s results. CAE itself acquired Datamine in 2010 for $23 million.
STEP TWO: CONSOLIDATE AND ADD VALUE
Since the Datamine acquisition, CSI (primarily through Datamine) has acquired 16 more businesses that provide software and services to mining companies. Through its acquisitions, CSI accomplishes three things. First, CSI has consolidated various facets of the mining software vertical. Second, CSI has added new services and functions to further enhance the value of previously acquired businesses. Finally, the acquired companies benefit greatly from being part of CSI because leadership of the acquired company has access to greater resources as well as CSI's handbook of best practices.
Simply put, operating under the CSI umbrella can enable an acquired to company grow revenues and profits at a greater pace than before.
In an interview in August 2022, Datamine’s CEO Dylan Webb confirms the benefits of being owned by CSI. Webb said the acquisition was "a pivotal moment in the history of Datamine." Webb also talks about how CSI has a large group of developers that work as "outsourced" developers for all the various businesses in CSI:
"We tap into some internal groups with hundreds of developers; [we've] got two main groups in Romania and another one in Pakistan. That expertise is really the main thing. But also the ability to scale up and down our teams using those groups. All up we’ve got access to probably around 800-to-1000 developers for projects that we have."
Under Constellation's ownership, Datamine has created a comprehensive suite of software products for the entire mining value chain.
STEP THREE: CONTINUE GROWING
The benefits to being a part of CSI have been enormous for Datamine. In the past five years, Datamine’s headcount has grown from 135 to more than 700. Webb expects the company to continue growing in the double-digits and are ready for staff numbers to go "beyond 1000 in the next couple of years."
ANDVARI TAKEAWAY
The CSI playbook of entering and succeeding in a vertical market is on full display in the mining vertical. Through consolidation of the mining vertical, CSI created a stable base of customers. By adding new functions and features to its products, CSI increased the value and the stickiness of its already sticky products. As CSI founder Mark Leonard wrote in his 2016 letter, "partnering with the right clients, and helping them survive and prosper is an important part of our job." CSI today helps 125,000 customers in over 100 countries survive and prosper. CSI's acquisition playbook and its focus on customers are why it has earned exceptional returns for its shareholders over the years.
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IMPORTANT DISCLOSURE AND DISCLAIMERS
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of publication of this blog, Andvari clients own shares of Constellation Software. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results.Full Disclaimer.
For the first nine months of 2022 Andvari was down 41.5% net of fees while the SPDR S&P 500 ETF was down 23.9%. Andvari clients, please refer to your reports for your specific performance and holdings. The table below shows Andvari’s composite performance against two benchmarks while the chart shows the cumulative gains of $100,000 investments.
ANDVARI HOLDINGS
Stock market indices recorded their worst first nine months of the year since 2002. The share prices of most of the companies we own continued to fall during the third quarter. With only a few exceptions, our holdings continue to underperform the market year to date.
The reasons for the underperformance remain the same. The companies we tend to own are of the “growthier” variety (see the table on the next page). These are the types of companies that can underperform in the short run during a period of rising interest rates.
Furthermore, as we have frequently reminded you over the years, Andvari’s style of investing in a small number stocks lends itself to bouts of exaggerated performance. In some years Andvari has outperformed the market by wide margins: by 24 percentage points in 2013, 15 points in 2019, and 12 points in 2020. In some years Andvari has underperformed by wide margins: 9 percentage points in 2014, 17 points in 2021, and thus far in 2022 by 17 points. However, Andvari believes volatility is a price worth paying if it leads to outperformance over the long run.
Thus far in 2022, the underlying businesses of Andvari’s holdings continue to perform well. Quarterly revenue growth for all holdings has been squarely in the double digits for their two most recent quarters. This growth for our holdings is usually some combination of organic and inorganic (i.e., growth has come by acquiring other companies). Whatever the exact source of growth, Andvari believes the companies in which it is a part owner are allocating capital at high rates of return.
The only company-specific news worth mentioning is Adobe’s announcement in September that it will acquire collaborative design platform Figma for $20 billion. Adobe’s share price dropped 16.8% on the day of the announcement. Shareholders signaled that paying an extraordinary 50x Figma’s annualized run-rate revenues is likely to destroy value.
Although Andvari is skeptical of this deal, there are a few reasons why it could turn out to be a decent use of capital. First is Figma’s astounding growth. Since its first dollar of revenue in late 2017, Figma has grown to $400 million in annualized revenues in just five years. Furthermore, they achieved this growth through the viral adoption of their product, not by employing an army of salespeople. Second, Adobe is experienced at acquiring products and then accelerating growth with its distribution network and access to large enterprise customers. Adobe built its suite of products over the decades by making over fifty acquisitions. Adobe even acquired its best-known product, Photoshop. Andvari thinks Figma can continue its rapid growth when it has access to Adobe’s ability to spend $5 billion annually on sales and marketing.
LOOKING TO HISTORY
Amid challenging times, Andvari often takes solace and inspiration from history. Over the last few months, we’ve spent many hours reading old issues of Business Week, Fortune and The New York Times to give us some perspective on what our economy and markets have experienced this year.
The post-World War II period is an interesting one to compare with our current post-COVID period. Both periods had unprecedented government stimulus and forced consumer saving. In both, after winning the war and after getting through the pandemic, inflation reared its ugly head.
POST-WWII ECONOMY
Click for larger image
As the Allies pushed forward during WWII, the U.S. stock market continued its upward trajectory. The markets continued going up even during a technical recession that began in February 1945 and ended October 1945. The reason for this recession was the winding down of government spending on the war, which in turn caused GDP to decline by about 12%.
One might think that the end of a world war would be a good reason for markets to continue going up. However, this was not the case. The Dow-Jones Industrial index peaked in May 1946 and hit its lowest point of the year in October, a decline of about 25%. Sectors with the highest expectations—the automobile stocks and the rail stocks—peaked earlier and declined even more. Auto stocks declined 40% from peak to trough. Compare this to the software and internet/tech stocks of today, which have declined 40% or more from their peaks last year.
Another similarity between then and now is the extraordinary pent-up consumer demand. During the war, people earned high wages and had no way to spend their earnings. During the pandemic period of 2020 and 2021, consumers also engaged in forced saving. Many people could work from home and the government engaged in unprecedented support of the unemployed. When the war and pandemic periods ended, demand for consumer goods and services was insatiable, which helped kickstart a period of high inflation.
Although consumer demand was strong, economic challenges in the U.S. after the war were numerous. Businesses took longer than expected to reconfigure plants and supply chains from war time to peace time. There were still shortages of raw and partially finished materials necessary to make finished products. Like today, auto manufacturers couldn’t make enough cars to meet demand and the prices of new cars went higher and higher. A new car in 1946 sold for 50% higher than in 1941. Finally, the country also had to deal with thousands of labor strikes, many of which were settled with wage increases of 15%–20%.
Rising input costs, material shortages, the end of war time price controls, voracious consumer demand, and other logistical challenges, all caused inflation to reach nearly 20% at its peak (see the above chart). High inflation, combined with high expectations for the stock market, caused the bear market in stocks in 1946. However, there was no economic recession that coincided with this ’46 bear market. The country continued to grow, consumer demand remained strong, and unemployment rose to just 5.2%—from 1948 through 2022, unemployment has averaged 5.7%.
ANDVARI TAKEAWAY
The 1946 bear market in stocks was a temporary phenomenon created by numerous challenges. And it was just a bear market in stocks, not the economy. Eventually, the economy adjusted itself, inflation subsided, and the stock market made new highs. We take comfort from the fact that businesses have survived and thrived in spite of tough times.
With all this said about just one period of history nearly 80 years ago, Andvari makes no predictions on when the current economy and markets will overcome their current challenges. Instead, we continue to do what we do in good years and bad. Andvari focuses on what is most within its control: to research and invest in excellent companies, run by great management teams, and that can earn exceptional returns for long periods of time.
We do know that our portfolio of companies will continue to grow and they will continue to compound their cash flows. When this happens, the intrinsic values of these businesses will increase. Over time, their share prices should follow the increase in intrinsic value.
As always, I love to hear from clients and anyone else. Please contact me with your thoughts, comments, or questions.
Sincerely,
Douglas E. Ott, II
DISCLOSURES AND END NOTES
* Andvari performance represents actual trading performance of all, actual clients beginning on 4/12/13. Performance from 12/31/12 to 4/12/13 is actual performance of proprietary accounts, namely the accounts of Andvari’s principal, Douglas Ott. Andvari believes including Ott’s performance figures for the first 4 months and 12 days of 2013 is fair as he managed those accounts similarly to Andvari’s first clients. All performance, including the initial proprietary period, are net of management fees—assumed to be 1.25% per annum, paid quarterly, as currently advertised—net of brokerage commissions and expenses, time-weighted, and includes all cash and other securities. Performance includes realized and unrealized returns and excludes the effects of taxes on incurred gains or losses. Andvari does not certify the accuracy of these numbers. Performance data quoted represents past performance and does not guarantee future results.
The exchange traded funds (ETFs) are listed as benchmarks and are total return figures and assumes dividends are reinvested. The SPY ETF is based on the S&P 500 Index, which is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. The IWM ETF is based on the Russell 2000 Index, an index of 2,000 U.S. small-cap stocks. It is not possible to invest directly in an index. Because Andvari client portfolios are non-diversified, the performance of each holding will have a greater impact on results and may make them more volatile than a more diversified index. Andvari also engages or may engage in strategies not employed by the S&P 500 or the Russell 2000 including, without limitation, the use of leverage.
One may request a list of all securities mentioned or recommended for the preceding year as of the date of this letter. You may contact Andvari using the information below. Actual client results may differ from results depicted in this letter. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the loss of principal. Investment strategies managed by Andvari Associates LLC may have a position in the securities or assets discussed in this article. Securities mentioned may not be representative of the Andvari's current or future investments. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
The discussion of Andvari’s investments and investment strategy (including, but not limited to, current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) represents the views and opinions of Andvari’s portfolio managers and Andvari Associates LLC, the investment adviser, at the time of this report, and can change without notice.
This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the affiliates of Andvari.
The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. Any or all of Andvari’s forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties, and other factors, most of which are beyond Andvari’s control. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision.
Over the last 20 years, Analog Devices (ADI) and Texas Instruments (TXN) have become two of the largest and most profitable manufacturers of analog semiconductors in the world. Both achieved margins well above their closest competitors and have produced exceptional long-term returns for shareholders. They’ve accomplished this via two ways that always grabs Andvari’s attention. One is by consolidating their industry through selective acquisitions and the second is by selling products based on the value they create for the customer.
ANALOG VS. DIGITAL SEMICONDUCTORS
Before learning more about ADI and TXN, let’s go over the difference between an analog and a digital semiconductor or chip. We know that semiconductors are essential to the function of all our electronic devices. Our devices require a combination of digital and analog chips. Analog chips are the ones that capture and change real-world signals such as sound, temperature, pressure, electrical current, or images. This real-world data captured by analog chips can then be converted to a binary format and sent over to a digital chip that can further process or store that data. Analog products from both TXN and ADI are present in thousands of different products, but primarily in industrial, automotive, and personal electronics.
HIGHER MARGINS THROUGH CONSOLIDATION
Both ADI and TXN have made a total of 11 significant acquisitions since 1990. As a result, their margins have increased over time. First, a larger catalog of high-end products (80,000+ in the case of TXN) means more customers can buy more products from a single company. Thus, it’s easier to sell more without spending more to make those additional sales. Second, both companies have reduced redundant positions in the Sales, General, & Administrative expense categories after making their acquisitions.
HIGHER MARGINS THROUGH HIGH-END PRODUCTS AND VALUE-BASED SELLING
The first reason behind the high margins at ADI and TXN is their focus on the high-end of the analog semiconductor market. By focusing on the high-end, both companies design and manufacture products for which they can charge a price based on the value the product delivers. This means they can charge more and thus earn higher margins.
Linear Technology (acquired by Analog Devices in 2017) summed up what encompasses high value in 2005:
Our whole strategy has been to develop unique parts that solve a problem a customer has and sell it for its value. And its value is based on its performance. It’s also based on reliability, … support, delivery, all of that. So when we have a unique product, we can sell that product based on its value. As soon as somebody else, some other competitor, manages to catch up with any given product and produce a product that in a customer’s eyes is indistinguishable then we can’t sell it based on its value.
So in addition to just a product that is of physically high quality, factors like the company’s ability to have available inventory of the product, the ability to provide support, and an ability to ship on time, are all reasons that enable the high margins of ADI and TXN. Without these qualities, the product would just be a low-value commodity for which no company can charge a premium.
As the chart below shows, gross margins and EBITDA margins at ADI and TXN have grown and have remained consistently higher than their peers.
ANNUITY-LIKE PRODUCTS WITH LONG LIFETIMES
Another feature of high-end analog semiconductors is they can have extremely long lifetimes. Bob Dobkin, a co-founder of Linear Technology (see Andvari's recent blog on "The Analog Chip Company That No One Leaves"), confirmed the potential for long-lived analog products in a 2014 interview:
“It’s interesting that standard circuits, when they’re done well, will sell for 20 years plus in high volume. We’ve got circuits that we came out with when we first started that are still selling in really high volume 30 years plus later.”
When a product can live for 10 years or more, this means there is less need for capital expenditures on new equipment. From 2013 to 2021, capex as a percent of revenues has averaged 5.6% for TXN and 4.4% for ADI. This in turn means ADI and TXN produce very high free cash flows that in turn can be used to further consolidate market share or be returned to shareholders in the form of dividends and share repurchases.
ANDVARI TAKEAWAY
Through consolidation and a focus on high-value products, ADI and TXN have grown their margins and grown their market shares in the analog semiconductor markets. The business model also lends itself to highly predictable revenues and high free cash given the long lives of the high value analog products both companies sell. Finally, there is still room for both to taking market share in a highly fragmented market. With over $14 billion revenues, TXN still has only ~19% market share. With $11 billion in revenues, ADI has ~13% share. Both are worth adding to any watch list of high quality companies.
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IMPORTANT DISCLOSURE AND DISCLAIMERS
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of publication of this blog, Andvari clients had no position in any company mentioned. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results.Full Disclaimer.
In 1981, two National Semiconductor engineers, Robert Swanson and Bob Dobkin, became so fed up with their employer that they left to start their own company. They founded Linear Technology to do what they had been doing at National, designing and manufacturing analog semiconductors, just with greater focus and less bureaucracy. Over the decades, Linear earned great financial success in part because of its unique culture. It built such a reputation for its low employee turnover (and extraordinary profitability), that a book was written about it: The Company That No One Leaves. (See also our prior blog on “Why Nobody Leaves the Largest Private Software Company in the World”).
FOUNDING PRINCIPLES
Towards the end of his career at National as head of National’s analog division, Swanson experienced too much bureaucracy and office politics. One specific problem was National’s new matrix management system—a system where “everybody was in charge of everything and nobody was responsible for anything.”
Swanson also had become frustrated by National wasting the money generated from National’s analog division. National got into the business of building wristwatches and computers and trying to compete with Japanese memory manufacturers. Although the analog division was the most profitable division at National, Dobkin recounts that National had built such a high manufacturing queue of low margin digital products, that he had to bribe the line manager with bottles of wine to insert their analog products higher up in the queue.
All this frustration, coupled with Swanson’s skepticism in National’s belief that digital technology was the only future for the semiconductor industry, led them to leave and found Linear Technologies. They wanted a company with “absolutely zero office politics”.
ELIMINATING POLITICS AND EMPIRES
In a 2015 interview, Dobkin spoke of how and why there was no room for politics at Linear:
“We are very careful that people do not have their own empires. Everybody who works for Linear is working for Linear.… Then the cooperation is great, the interchange of ideas is great; we are all marching to the same tune. It helps the company and the customer.”
Harmonizing with Dobkin’s thoughts, Swanson added that Linear can have the right culture forever by simply keeping politics to a minimum. If bureaucracy and politics get out of hand, innovators become frustrated and leave. If all your innovators leave, the future of the business is in doubt.
Photo of The Company That No One Leaves credited to Todd Nelson
FOCUSED ON PEOPLE
According to The Company That No One Leaves, Linear was an engineer’s paradise for three broad reasons:
Engineers could expect high compensation (higher than average base salary and a profit sharing equivalent to 50% of their annual income);
Engineers have great freedom with product planning and development; and
Engineers had the opportunity to work with the best analog designers (Linear’s stable of “gurus”) in the world. Good engineers attract other good engineers.
A Linear advertisement from 1983 highlighting their world renowned analog gurus.
The high level of freedom also correlates to a high level of responsibility an engineer has at Linear. Engineers are highly involved with every aspect of designing a new product:
“Engineers present an outline specification and describe the product they hope to produce, as well as the market demand for the product. The presentations … describe similar products manufactured by other companies and how the product proposed is superior to these others. The proposing engineer even touches on manufacturing processes. Before making their appearance at such a meeting, an engineer will think carefully about issues such as yield, packaging and the size of the final product.”
Engineers must have a high degree of intimacy with customers to understand their current and future needs. The engineer can then design and develop a product for which the customer will pay a premium. This is a type of decentralization and widespread entrepreneurialism that Andvari loves to see in any company it investigates.
ANDVARI TAKEAWAY
Linear grew steadily and profitably from its founding in 1981 until Analog Digital acquired it in 2016 for $14.8 billion. In 2016, Linear had revenues of $1.4 billion and an operating margin of 44%. A big reason for Linear’s sustained success in the cutthroat semiconductor industry is the company’s culture. Swanson said that if there was only one thing he could take credit for as founder and CEO, it would be building that kind of culture where bureaucracy is kept to a minimum and where it’s a paradise to be an engineer. Companies with cultures like Linear, where no one wants to leave, are exactly what Andvari looks for in its continuing search for great businesses.
Sources and Additional Reading/Viewing
Audio / Video
“Interview with Bob Swanson”, March 11, 2006, Stanford University, Department of Special Collections and University Archives
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of publication of this blog, Andvari clients had no position in any company mentioned. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results.Full Disclaimer.
SAS Institute, founded in 1976 by James Goodnight, is now the largest private software company in the world with $3.2 billion in annual revenues. Engineers, scientists, and anyone whose job involves data and statistical analysis, are the users of SAS software. Most unique about SAS is its longstanding notoriety for extraordinarily generous employee perks. Given Andvari’s emphasis on qualitative factors such as corporate culture in our research process, SAS is worth studying. It is an exemplar of how a company can have exceptional business results while treating its employees in an exceptional manner.
A GREAT PLACE TO WORK
Some of the perks of working at SAS include:
On-site day care services that are about a third of the normal cost
Subsidized cafeterias
Unlimited paid sick time
Medical services are provided for free to employees at (or nearby) SAS offices
Employees are encouraged to work no more than 35-hours per week
Free recreation and fitness centers
Flat corporate organization with high intradepartmental mobility
A profit-sharing plan that can sometimes add up to 15 percent of an annual salary
Goodnight, who still runs SAS as CEO, admits SAS’s philosophy on employee perks is not entirely altruistic. There are clear benefits to SAS’s business. But the business benefits were not the motivating factor behind the philosophy. Goodnight primarily wanted people to enjoy being at work and went backwards from there.
Way back in 2003,60 Minutes had a 13-minute segment on SAS and its perks. One of the employees they interviewed was Mark Britt, who joined in SAS in 1989. He explained to Morley Safer, “If someone offered to double my salary, I wouldn’t even think about [taking] it.” According to the LinkedIn profile Andvari found, Mark is still at SAS—thirty-three years after he joined.
TANGIBLE BUSINESS BENEFITS
There are many benefits to the business because of its generous perks. The obvious ones are SAS can attract higher quality employees who stay with the company longer. Annual employee turnover at SAS ranges from 3–5%. Compared that to the Silicon Valley range of 20–30%. In the early 2000s, Stanford University professor Jeffrey Pfeffer estimated that SAS’s low turnover translated into annual savings of $75 million.
In addition to staying longer at a company, happier employees are more productive. Goodnight’s frequent mantra is: “If you treat employees as if they make a difference to the company, they will make a difference to the company.” Making work more enjoyable doesn’t just mean adding lots of perks, it also means a work environment where there is less bureaucracy and more resources to support projects and new ideas.
From a 1999 Fast Company article, one employee said, “You’re given the freedom, the flexibility, and the resources to do your job. Because you’re treated well, you treat the company well. In a case study by the Wharton Work/Life Roundtable, everyone they talked to mentioned they have been given what they need to do their jobs.
SAS Institute founder and CEO James Goodnight is a rock collector.
Regarding the decision to create a profit-sharing plan, the reasoning was simple and logical for Goodnight and his co-founder John Sall:
I'd rather give it to the employees than give it to the government. That's certainly been one of the guiding…concepts. I don't want to make a huge profit so I can send it to Washington. I'd rather make a smaller profit to send to Washington and make sure the employees are well taken care of with all the benefits we can afford to give them.
SAS, with over 12,000 employees in 60 countries around the world, is also a remarkably flat organization. There are only four layers between the bottom and Goodnight. In Andvari’s experience, organizations with flat or decentralized structures usually have a greater amount of entrepreneurialism and drive. These qualities in turn tend to produce exceptional results over the long-term.
ANDVARI TAKEAWAY
With news that SAS is planning to go public in 2024 (despite the fact the company has never needed to raise capital), employees will finally have the ultimate perk: a chance to become a shareholder in the business they’ve been part of for so long. Although generous perks will cost a company in the short run, it can be the right thing to do in the long run. By taking excellent care of its employees, SAS has attracted and retained thousands of employees around the world. SAS employees have in turn been able to take excellent care of their customers who in turn generated over $3 billion in revenues for SAS. Andvari looks forward to perusing the official SEC filings from SAS in 2024!
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of publication of this blog, Andvari clients had no position in SAS. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results.Full Disclaimer.
Below is our latest letter to clients. We hope you enjoy.
For the first six months of 2022 Andvari was down 30.9% net of fees while the SPDR S&P 500 ETF was down 20.0%.* Andvari clients, please refer to your reports for your specific performance and holdings. The table below shows Andvari’s composite performance against two benchmarks while the chart shows the cumulative gains of $100,000 investments.
ANDVARI HOLDINGS
Activity within accounts managed by Andvari was higher than normal this quarter. We sold out of Visa and Liberty Broadband. We sold Visa because the combined position of Visa and Mastercard had become quite significant. Given the large combined investment, and our preference for Mastercard, we reduced exposure to the card networks by selling Visa.
Regarding Liberty Broadband, Andvari has owned it for the last 7+ years primarily because of its large stake in cable company Charter Communications. Given that Liberty also traded at a wide discount to its own net asset value, Andvari saw this as an even cheaper way to own Charter. We sold Liberty because we saw (too slowly) a violation of one of the core parts to our investment thesis: pricing power at Charter was not as great as we imagined. Charter has not been able to raise prices in line with inflation. To add insult to injury, the trade association for the U.S. cable industry started proudly advertising about how internet price increases have remained far behind the rate of inflation.
We added to our positions in other current holdings and we also started a new position in a company we have known for decades: Adobe Inc.
ADOBE
Adobe is a software company that has been around for nearly 40 years. We are intimately familiar with the company. Andvari’s own founder and Chief Investment Officer started using Adobe products over 25 years ago. Adobe is also one of several companies featured in an Andvari white paper about business lessons learned from the evolution of the desktop publishing software industry (please contact us for access).
There are many reasons why Adobe is a high quality company, but let’s first outline what the company does. The company divides its offerings into two groups: Digital Media and Digital Experience. The Digital Media segment contains the products with which most people are familiar, such as Photoshop for photo editing, Illustrator for digital illustrators, and Acrobat for creation, editing and signing of documents in Adobe’s own ubiquitous PDF file format.
Adobe’s Digital Experience segment is the smaller of the two and thus the one with greater potential. Digital Experience offers software applications that enable large enterprises to manage, execute, measure, monetize and optimize customer experiences across different sales channels and different devices. Companies like BMW, Nike, Prada, Verizon and Walgreens are Digital Experience customers.
Andvari admires how most of Adobe’s tools in Digital Media have market shares exceeding 90%. The content creation industry has standardized on Adobe products and thus the cost to switch to a competing product is extremely high. Content creators have spent their entire careers using Adobe products. The time to learn the ins and outs of another piece of software, and the loss in productivity that would result in doing so, prohibits the creative professional from switching. On the Digital Experience side, we believe Adobe has dominant and growing share when it comes to mid-sized and large enterprises. Switching costs are also high.
Adobe has even more attractive attributes. There is little to no customer concentration. This contributes to Adobe’s ability to raise prices and maintain high margins because there is no customer large enough to negotiate significantly on pricing. Next, regulatory risk is decidedly less compared to our former investment in Liberty Broadband. The cable and telecom industry has always faced extraordinary scrutiny from the Federal Communications Commission, Justice Department, and Congress. To our knowledge, no executive at Adobe has been hauled in front of a Congressional committee to be grilled about charging excessive prices for Photoshop.
Finally, Adobe’s financial profile is outstanding. Total annual revenues will be ~$17.7 billion this year and subscription-based revenues make up 90%+ of that. Revenues have been growing at mid-teens in recent years and will likely continue at low double-digit rates. Margins are high, working capital is negative, and annual capital expenditures are very low at 2%–3% of revenues. Free cash flows are copious and Adobe has returned 57%–68% of them to shareholders in the form of share repurchases over the last three fiscal years.
ANDVARI TAKEAWAY
“I won’t argue that it wasn’t a no-holds-barred adrenaline-fueled thrill-ride, but there’s no way that you could perpetrate that amount of carnage and mayhem and not incur a considerable amount of paperwork.”
– Nicholas Angel (played by Simon Pegg) in the film Hot Fuzz after watching the film Point Break
“How can you tell if you’re drunk if you're never sober?”
– Andrew Knightley (played by Nick Frost) in The World’s End
If an investor wasn’t already a fan of Simon Pegg and Edgar Wright, they’d probably think the above quotes aptly refer to fiscal and monetary policy since the Great Financial Crisis of 2008. Perhaps even more apt descriptions of just the past two and half years. Congress and the Federal Reserve have enabled a “no-holds-barred adrenaline-fueled thrill ride” by providing huge amounts of stimulus for an extended period of time. Thus, it is perfectly understandable why some investors might have believed high inflation (and high interest rates) to be a thing of the past. Perhaps even more understandable why young investors may have believed inflation to be a mythical creature inhabiting a tale told by the “olds” and the “boomers.”
It only took a confluence of events—many related to COVID and then Russia’s invasion of Ukraine—to remind us all that inflation is not a mythical creature, but indeed a real beast that can ravage the economy. With inflation rates reaching heights not seen since the early 1980s, there is now a “considerable amount” of work needed to remedy the situation. Most notably, the Federal Reserve this year started raising short-term interest rates from zero to now 1.25%, which could then go towards 4% by year-end. This is why so many fast-growing companies have declined 40% or more from their recent all-time highs. This is why we’re either already in a recession or why we’re likely heading into a recession.
All this said, we remind you that Andvari’s expertise is in analyzing and investing in individual businesses. We are unskilled at analyzing the economy and its multitude of data points (constantly changing) and how those in turn might (or might not) impact current and potential investments. Our goal is to invest in quality companies with long runways to invest their cash flows at rates well above their cost of capital. Attempts to scry the future by reading economic tea leaves is beyond Andvari’s ken.
Instead, we believe it is much better to allow the beneficial effects of compounding to endure for as long as possible by following the advice of investing legends Peter Lynch and Charlie Munger. We remain fully invested (to the extent clients allow us) and do our best to sit and do nothing with the fine companies in which we have invested. This is the best way Andvari knows of that will allow us to grow money for decades at rates exceeding the market average.
Finally, Andvari believes that during times of inflation, one of the best types of assets to own are businesses that can grow their revenues in line with or above the rate of inflation. It’s even better if these businesses don’t have to replace fixed assets at continually rising prices! We think that each of the companies in our current portfolio has these characteristics.
With the short-term hit to performance our holdings have taken so far this year, we believe the odds are now even more in our favor that their long-term performance will outpace the market average. As always, I love to hear from clients and interested parties about anything on your mind. Please contact me with your thoughts, comments, or questions.
Sincerely,
Douglas E. Ott, II
DISCLOSURES AND END NOTES
* Andvari performance represents actual trading performance of all, actual clients beginning on 4/12/13. Performance from 12/31/12 to 4/12/13 is actual performance of proprietary accounts, namely the accounts of Andvari’s principal, Douglas Ott. Andvari believes including Ott’s performance figures for the first 4 months and 12 days of 2013 is fair as he managed those accounts similarly to Andvari’s first clients. All performance, including the initial proprietary period, are net of management fees—assumed to be 1.25% per annum, paid quarterly, as currently advertised—net of brokerage commissions and expenses, time-weighted, and includes all cash and other securities. Performance includes realized and unrealized returns and excludes the effects of taxes on incurred gains or losses. Andvari does not certify the accuracy of these numbers. Performance data quoted represents past performance and does not guarantee future results.
The exchange traded funds (ETFs) are listed as benchmarks and are total return figures and assumes dividends are reinvested. The SPY ETF is based on the S&P 500 Index, which is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. The IWM ETF is based on the Russell 2000 Index, an index of 2,000 U.S. small-cap stocks. It is not possible to invest directly in an index. Because Andvari client portfolios are non-diversified, the performance of each holding will have a greater impact on results and may make them more volatile than a more diversified index. Andvari also engages or may engage in strategies not employed by the S&P 500 or the Russell 2000 including, without limitation, the use of leverage.
One may request a list of all securities mentioned or recommended for the preceding year as of the date of this letter. You may contact Andvari using the information below. Actual client results may differ from results depicted in this letter. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the loss of principal. Investment strategies managed by Andvari Associates LLC may have a position in the securities or assets discussed in this article. Securities mentioned may not be representative of the Andvari's current or future investments. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
The discussion of Andvari’s investments and investment strategy (including, but not limited to, current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) represents the views and opinions of Andvari’s portfolio managers and Andvari Associates LLC, the investment adviser, at the time of this report, and can change without notice.
This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the affiliates of Andvari.
The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. Any or all of Andvari’s forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties, and other factors, most of which are beyond Andvari’s control. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision.
Andvari is pleased to share a shortened version of our recent research report on Novanta (NOVT). We provide a summary of the important intangible business qualities we seek. We also share a full summary of the corporate history that led to a Chapter 11 bankruptcy and then subsequent amazing turnaround.
Novanta supplies technology solutions to medical and advanced industrial original equipment manufacturers (“OEMs”). The company has deep proprietary expertise in photonics, vision, and precision motion to engineer core components and sub-systems. Since 2012, revenues have grown from $225 million to $835 million. Free cash flows and operating profits have grown at an even faster rate.
The company has several attributes that has driven and will continue to drive its success. First, Novanta management have been adept capital allocators. They’ve divested businesses with limited prospects and have acquired over half a dozen companies with brighter futures. The M&A process prioritizes cash returns and return on invested capital.
Second, the products sold by Novanta’s subsidiaries add a huge amount of value for being a relatively minor part of the total cost. Further, these products are designed into OEM systems with typical life spans of 7–10 years. This gives them pricing power and predictable streams of revenue. Third, Novanta has an active and effective R&D department which is launching new products at an ever-increasing rate and driving a high-single-digit organic growth rate.
Finally, the company has their “Novanta Growth System” (NGS), a system of continuous improvement and lean manufacturing. This has helped sustain and improve improved both margins and revenue growth. Novanta is able to consistently realize synergies and extract additional value from acquisitions after implementing NGS. Also important is the fact that there are many former Danaher managers and executives now at Novanta.
With a current revenue base of ~$835 million, Novanta has ample room to grow organically and via M&A. Further, Novanta will improve over time through application of NGS. Andvari believes Novanta will grow revenues at high single or low double-digit rates and cash flows at a slightly faster rate. At the current share price, Novanta can provide shareholders annualized returns in the range of 10%–13% over the next 8.5 years.
History
The history of Novanta begins with two companies, General Scanning, Inc. (GSI) and Lumonics. GSI was founded in Massachusetts in 1968. Lumonics soon followed, incorporating in 1970 under the laws of Ontario. Both GSI and Lumonics designed, developed, manufactured, and marketed laser-based advanced manufacturing systems for semiconductor, electronics, aerospace, and automotive industries. In 1999, they combined in a merger of equals to create GSI Lumonics, Inc. This created the largest publicly traded company in the industrial laser systems industry. Charles Winston, the CEO of GSI and former management consultant, became the CEO for the newly combined company.
Over the next 10 years, GSI Lumonics acquired more companies to expand its product offerings, addressable industries, and geographic markets. At the same time, they were divesting non-core, lower margin business lines. Management eventually transitioned its focus to developing laser products and components for OEMs instead of selling fully integrated laser systems directly to end markets (a trait that continues to define Novanta today).
In 2006, Dr. Sergio Edelstein took on the role of CEO after Charles Winston stepped down. Edelstein’s tenure would be brief due to a disastrous turn of events. In 2008, GSI acquired Excel Technology for $360 million in cash. GSI took on $210 million in debt to help fund the transaction. Soon after, GSI failed to file quarterly reports to the SEC due to discovered accounting errors. Upon further investigation, accounting errors had tainted multiple years of reports. The failure to file quarterly reports breached the terms of their debt, but senior creditors agreed not to take any actions if GSI brought in financial advisors.
In the following months, Sergio Edelstein resigned as CEO, GSI’s market cap plummeted from $325 million to $31 million, their shares were delisted and put on the pink sheets, and by mid-2009 they entered into a pre-agreement Chapter 11 bankruptcy. GSI also recorded a $215 million impairment charge to goodwill and Stephen Bershad, a major shareholder, urged shareholders to replace the existing board.
GSI emerged from Chapter 11 in 2010 with the company’s prior shareholders retaining approximately 86.1% of the company’s capital stock. The remaining 13.9% of the capital stock was issued to the holders of the senior notes, and their $210 million in debt was restructured to $107 million. 5 members of the board resigned, Stephen Bershad was added as a director, and John Roush was hired as CEO.
Under the new leadership, GSI would prioritize long-term growth instead of short-term margins, seek out acquisitions primarily in the medical devices market, and divested 12 businesses with limited growth prospects. By 2016, 45% of total revenues would be from medical sales, and GSI was renamed to Novanta. With the turnaround of the business complete, John Roush stepped down as CEO and passed the reins to Matthijs Glastra, the COO of Novanta. Since Glastra became CEO on August 2, 2016, Novanta’s share price increased from $15.55 to $112, an annualized rate of growth of 40%.
After consistently divesting underperforming businesses and reinvesting the proceeds into businesses with secular growth trends, Novanta transformed itself from a distressed company entering chapter 11 to an 11-bagger in 11 years.
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of publication of this blog, Andvari clients had a position in Novanta. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results.Full Disclaimer.
Robert Shillman (“Dr. Bob”) left academia in in 1981 to start Cognex with his entire life savings of $87,000. Since then, he has helped grow Cognex into one of the world’s largest providers of high quality machine vision systems used in manufacturing and logistics automation. Cognex is now worth over $8 billion and does $1 billion in annual revenues.
Andvari has long admired Dr. Bob as he is the epitome of a founder who has achieved success while having undeniable fun along the way. Dr. Bob instilled an extraordinarily unique culture that has helped drive the success of Cognex. When Dr. Bob retired from Cognex and recorded a three-part interview of life lessons. Andvari shares two of our favorite lessons.
CUSTOMERS FIRST
As a kid, Dr. Bob would help in his dad’s yarn shop on Saturdays. His father had a policy of encouraging people to buy more than they needed for a project and allowing them to return what they didn’t use. Dr. Bob remembers a woman that wanted to return two skeins of yarn that he knew was from Woolworth’s. He told his father they shouldn’t give her money back for something she didn’t purchase from them. Dr. Bob’s father said, “Give her the money back. She’s a customer and I don’t want to lose a customer.”
Another customer-centric experience occurred after Cognex expanded into Japan. Dr. Bob shares that he met with the President of Shinkawa, a maker of assembly equipment for semiconductors. The President told Dr. Bob there was a problem with the Cognex product. Dr. Bob asked if it worked. The President clapped his hands and in rolled a cart with several damaged protective boxes in which the Cognex products were shipped. The President confirmed the actual Cognex products worked, but he also said the fact the packaging was damaged was unacceptable.
Dr. Bob, who was 30 years old at the time, nearly began to lecture a 65-year-old executive on how the only purpose of the damaged boxes was to protect the product. However, Dr. Bob remembered what had happened when he had bought a set of souvenir chopsticks prior to the meeting. After Dr. Bob had chosen the chopsticks, the salesperson cleaned and polished the chopsticks, brought out and carefully examined a box for them, put the chopsticks in the box and carefully wrapped it.
“I realized that in Japan, the box is a statement about the quality of the product and the company. The box has to be perfect,” explained Dr. Bob. He then got on the phone with the Cognex head of manufacturing to explain why the packaging had to change: “This is what’s required in Japan.”
A culture and attitude that puts the customer first, that always tries to understand and meet their needs, is a big part of what has made Cognex successful.
Cognex's Chief Culture Officer Dr. Bob (left) and CEO Bob Willett (right) celebrating Halloween with Cognoids.
COGNEX CULTURE
Culture is another factor that has helped Cognex succeed. On the culture at Cognex, Dr. Bob explains, “It’s work hard, play hard, and move fast—in that order.” Employees are called Cognoids. The company’s favorite holiday is Halloween. Dr. Bob has driven to Cognex offices in an ice cream truck during the summer to hand out ice cream to Cognoids. The official Cognex salute is adopted from The Three Stooges. Dr. Bob appointed himself Chief Culture Officer in 2011 to focus on maintaining the culture across offices in 20 different countries. A fun and rewarding workplace has led to low turnover and a place that leads to more connections, collaboration, and growth.
Cognex has also turned the boring requirement of publishing an annual report into an opportunity to showcase its unique culture. For the past few decades, Cognex has parodied a variety of magazines, publications, and pop culture icons. Cognex annual reports have parodied Sky Mall, Mad, Bon Appétit, The National Enquirer, Back to the Future, and X-Men. Andvari has written before about several “conference call mavericks” (see Part 1 and Part 2). For its 40th anniversary in 2021, Cognex even put together a high quality video in the style of a dramatic movie trailer!
For their fun and zany communications, Cognex is worthy of inclusion in this group of outstanding companies with non-standard investor relations efforts.
Dr. Bob demonstrating the Cognoid salute, borrowed from The Three Stooges.
ANDVARI TAKEAWAY
In the Bon Appétit-themed 2019 annual report, Dr. Bob aptly describes “Chez Cognex”:
“While dining trends are fickle, what makes a restaurant great remains constant. Quality ingredients and knowledgeable, hard-working employees who are dedicated to the Cognex value of Customer First. By maintaining our focus on these important fundamentals, Chez Cognex will always be a five-star operation that is a cut above the rest.”
Founder-led companies with a unique culture and that operate differently than your typical enterprise are always worth following. Differentiated cultures and business practices are usually a good signal of differentiated business results and shareholder performance.
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of publication of this blog, Andvari clients had no position in Cognex. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results.Full Disclaimer.
In the previous bi-weekly, Andvari shared our observations from a few rare interviews of Autodesk co-founder Dan Drake. This week, Andvari shares highlights from another Autodesk co-founder—and likely the most prolific and outspoken of the founders—John Walker. Although Autodesk had over a dozen initial co-founders, it is John Walker that set things in motion in the early 1980s that would lead to a company that is now worth over $40 billion.
Thankfully, Walker (and others) kept the many letters and documents they wrote during the early years of Autodesk. This corporate and technical archive is available for free as The Autodesk File on John Walker’s website. As the most frequent author of the documents contained in the File, it is clearly Walker that had the greatest ambition and vision that a group techies could strike it rich at the particular moment in time.
ALMOST LIKE COUNTERFEITING
In addition to being an extraordinarily intelligent human with huge ambition, Walker also had a gift for writing and a good sense of humor. In January 1982, Walker writes "Information Letter 1" to go over the business opportunity their newly formed group had in front of it:
"I think that we're at an absolutely unprecedented juncture of history. I can’t think of any time in the entire human experience when so much opportunity existed for technical people, opportunity which they could participate in with very limited risk. Most great business opportunities have required far greater infusions of start up capital which was consumed just paying for physical plant before anything was made to sell. Our products are created by almost pure mental effort, and are manufactured on trivially cheap equipment at a tiny fraction of their wholesale cost. It’s almost like counterfeiting, but legal."
Walker nails the most attractive feature of the software business on the head. Even back then, when computing power was eve more expensive than today, little capital was needed to start up a software business. Secondly, the cost of "manufacturing" a completed software program is super cheap. A software company like Autodesk could, and did, achieve enormous growth with high margins.
AMBITION AND VISION
Walker also had an intuitive sense of how intelligence and hard work in the form of software could be leveraged by the proliferation of cheap personal computers. It was impossible for him to ignore the obvious potential for wealth creation.
"The potential rewards of this business, which is the field that you and I are technically proficient in, almost compel one to participate on an equity basis. There's almost no salary that's enough to reward one for giving up his seat at this cosmic money gusher."
Walker successfully convinced over a dozen programmers to become founders of Autodesk. In the early days, it was more of a collective of programmers working on five different projects. One of the projects was AutoCAD, a computer aided drawing program for architects that could be installed on a personal computer. After making a splash at the 1982 Fall COMDEX (one of the largest computer trade shows in the world at the time), AutoCAD quickly grew in popularity.
KIBBLE TIME
By June 1983, AutoCAD had grown so quickly that Walker penned a "crisis letter" to the group of Autodesk founders, most of whom had full time jobs elsewhere. Walker implored that it was now the moment for people to devote all of their attention to making Autodesk a success.
"This is the time to take that leave of absence from the foundry and work for Autodesk. Spend that long awaited vacation in front of the terminal. This is the time to tell the boss you've got cholera and take a month off. Let the plants die, leave the dog with a 55 gallon barrel of kibble and work around the clock for Autodesk. If you have skills as a programmer, use them—if you need any resources, machines, peripherals, software tools, coercion, let me know and they will be provided."
This passage illustrates the importance of having a leader with skin in the game that can also inspire (or cajole) people to dig deep to make the company as successful as possible. Andvari always looks for companies with leadership like this.
PRODUCT MARKET FIT
Thankfully, Walker was able to convince everyone to devote more time to the company. Sales of AutoCAD would be growing 30% month over month at the end of 1983. In “Information Letter 11” in 1984, Walker reminds everyone why they’ve done well so far.
"We've done so well because we created a product which fills a basic need. This is a product which excites people by its very existence. It's fun to use, and it lets people do work they couldn't otherwise do without spending hours of tedious labour. This product has put in the hands of the individual and small company the power which previously was only available to large companies—which contributes to leveling the playing field and eliminating advantages of scale."
ANDVARI TAKEAWAY
Although Autodesk is now a vastly different and much larger company now versus its first 10 years of existence, studying its history is worth the time. We learn again the important lessons of what it takes to start a business and the trials and tribulations as it grows rapidly. There are several lessons we believe are timeless and universal. First, true wealth creation is possible only through owning a stake in a growing business. Second, the window to take advantage of a business opportunity can be fleeting and as such, it’s a requirement to focus all of your time and effort on the opportunity.
Finally, success will find its way to those who create a product that fills a basic need. As if channeling Charlie Munger, Walker wrote in 1984 (emphasis Andvari's): "Buying anything, but especially something as intangible as a computer program, involves putting your trust in the person who's selling it. If we continue to deserve that trust, we'll do very well, indeed."
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IMPORTANT DISCLOSURE AND DISCLAIMERS
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of publication of this blog, Andvari clients had no position in Autodesk. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results.Full Disclaimer.
It’s now been forty years since the founding of Autodesk. The company started from nothing and its AutoCAD product is now the de facto standard in two-dimensional computer aided design (CAD) software. Millions of engineers, designers, and architects around the world use Autodesk's software to aid them in their work.
Andvari has long considered Autodesk to be a high quality company. Due to the mission-critical nature of Autodesk products to its architect, design, and engineering customers, Autodesk has long had predictable and growing revenues, high margins, and high returns.
As with all companies in which Andvari is interested, we go back as far as possible to learn about the founders and the evolution of the business. Although Autodesk had over a dozen co-founders, there are really two that are most important: John Walker and Dan Drake. Below, we summarize some of Dan Drake’s important insights we gleaned from a 2005 and 2020 interview.
SOFTWARE STARTUP COSTS ARE DE MINIMIS
One of the reasons Andvari likes software businesses is that it takes very little capital. Even back in the early 1980s, when programmers lacked the super cheap resources they have today, it required little capital. Autodesk’s founders put in just a little over $59 thousand in cash and they were off to the races.
Autodesk founders, photo from co-founder John Walker
SPREADING BETS
The founders of Autodesk knew there was a lot of money to be made in the software business, but they did not initially know which direction they wanted to go. However, they did know that 80% of startups failed. Thus, they decided to spread their efforts across five different projects. Whichever project became a hit, they would stop everything else and focus on that one. AutoCAD became the hit.
The simple lesson here is it can make sense to spread your bets, especially if you don’t have a clear idea yet of what you want to do. But if and when you find the clear winner, it’s best to go all-in on it!
DIFFERENTIATING FROM THE COMPETITION
There were CAD programs in the 70s and 80s, but these were extremely expensive and the software only worked on proprietary machines. If you wanted the software, you had to buy the machine as well. Autodesk differentiated themselves by selling cheap software that could be installed on nearly any personal computer at the time. In 1985, at a time when PCs were not that standardized, AutoCad could work on 31 different PCs. Regarding the price of AutoCAD, Autodesk chose $1,000 as the starting price for the base version because this compared very favorably to the typical $10,000 price point an architect would pay for a proprietary workstation with CAD software.
Slide from Autodesk's 1985 IPO road show
WHY THE GIANTS NEVER CAME AFTER AUTODESK
The giant tech companies of the day (e.g., IBM, Computervision, and Intergraph) could have crushed Autodesk if they had wanted. The reason it didn’t happen is they didn’t have the will to disrupt their own business model of selling CAD software that was tied exclusively to expensive machines. According to Drake, “[T]hey couldn’t afford to compete with themselves. It would undermine the entire big business.”
The investing lesson here is to try to find a company which has few if any true competitors. In Autodesk’s case, it only competed against other tiny CAD companies at first. Next, because the giants chose not to disrupt their own business to compete against Autodesk, they slowly lost all of their business to a small start-up.
ASTOUNDING GROWTH AND PROFITS
Autodesk achieved astounding growth in its first ten years of existence. Architects and engineers loved its low-priced software that could work on cheap, non-proprietary computers. Autodesk got started in early 1982 without any idea that it would be making and selling CAD software. The company then went public in 1985 with $10 million in revenues. Annual revenues reached $100 million in 1989. Annual revenues in 2022 were $4.4 billion. All this from a group of founders bootstrapping their company with $59 thousand in cash and some computer equipment.
Slides from Autodesk's 1985 IPO road show
FROM FOUNDER-LED TO PROFESSIONALLY MANAGED
Drake also related that “techies” typically aren’t suited for taking on management responsibilities. It takes a different type of person to be a good manager:
"One thing in management, you have to have a lot of tolerance for people who don’t do things right, and a lot of patience in telling them over, and over and over again, because they keep doing it wrong. None of us was very well qualified for that. Yeah, so [Walker] learned to play these games of pleasing the analysts and so on, but they’re no fun and they distract you from running the company. They are detrimental to the company."
Walker led the company since its founding and only lasted until 1986. Walker had several reasons quitting. First, he enjoyed programming more than running the company. He also knew he was a poor candidate to lead and grow the company from $10 million to $100 million in revenues. Finally, the pressures of leading the company were detrimental to his health.
Andvari knows too well that evaluating management is one of the hardest things to do. We prefer skilled managers who have significant wealth tied to the value of their company. This frequently, but not necessarily, means that a founder is still leading the company in which we’re interested. Two important questions we always wrestle with are: (1) whether a founder has the ability to lead their company for another decade and (2) whether a founder has the self-awareness to recognize when they need to hand the reins to someone else.
ANDVARI TAKEAWAY
We hope you found these historical tidbits about Autodesk to be interesting and helpful. In addition to learning more about a specific company, studying corporate history frequently reinforces important business and investing concepts. What’s most impressive about Autodesk is how little capital it took to start a company that would go from zero revenues to over $4 billion in 40 years. Yet another example of how amazing a software business can be.
RetroCAD: AutoCAD Version 1. For the true computer nerds out there, this is a very cool video demonstrating one of earliest versions of AutoCad operating on a DOS-based PC.
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IMPORTANT DISCLOSURE AND DISCLAIMERS
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of publication of this blog, Andvari clients had no position in Autodesk. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results.Full Disclaimer.
Below is our latest letter to clients. During the past quarter, Andvari unfortunately underperformed the S&P 500. We also introduce Topicus.com, a spin-out from Constellation Software.
For the first quarter of 2022 Andvari was down 15.5% net of fees while the S&P 500 was down 4.6%. Andvari clients, please refer to your reports for your specific performance and holdings. The table below shows Andvari’s composite performance against two benchmarks while the chart shows the cumulative gains of $100,000 investments.
ANDVARI HOLDINGS
With the exception of Visa and Mastercard, all of Andvari’s holdings underperformed a market that declined 4.6% this past quarter. The decline is due to the Federal Reserve signaling a strong desire to raise interest rates to combat 8%+ inflation. All else equal, higher rates depresses the values of all assets. The assets most impacted by higher rates are companies with fast growth rates, high returns, or very high shareholder expectations. Most of the companies in Andvari’s portfolio have one or several of these qualities. We’ve thus had poor performance relative to the market.
For example, Tyler Technologies is a software company focused on the state and local government vertical. The company has grown revenues over the last decade at a 17.8% annualized rate. Operating margins have ranged from 18% to 23% and can go much higher. The market has recognized the quality of Tyler’s business by putting an extremely high multiple on what it is likely to earn over the next year. Tyler traded at 48x EBITDA at the beginning of the year. It now trades at 37x EBITDA. Tyler’s share price went down 17.3% in the quarter versus the market being down 4.6%.
CONSTELLATION SOFTWARE AND TOPICUS.COM
Constellation Software (a long-time Andvari holding) recently spun out one of its operating groups. The spin-out is Topicus.com, formerly known as TSS. TSS is based in the Netherlands and Constellation acquired it in 2014. Under Constellation, TSS in turn has acquired over one hundred vertical market software (VMS) companies. TSS’s largest acquisition was another Dutch company, Topicus.com, in 2020. A condition of that deal was for TSS to adopt the Topicus name and for the combined group to be spun out as a separate public company.
With the share price of Topicus declining over 40% since October 2021, Andvari has turned it into a substantial position. We like Topicus for the same reasons Constellation originally attracted us.
Skin in the Game
Mark Leonard started Constellation in 1995 and owns nearly 7% of the company. Leonard’s shares are worth about $2.4 billion right now. The founder of TSS is Robin van Poelje who is now the CEO and Chairman of Topicus. Robin and other managers own nearly 40% of Topicus, Constellation owns 30%, and public shareholders own the remaining 30%. Management at these companies are well-aligned to create long-term value for themselves and other shareholders.
The Advantage of Being a Permanent Home
Similar to Warren Buffett at Berkshire Hathaway, Constellation and Topicus pitch themselves as the permanent homes for people who want to sell their business. However, in the case of Constellation and Topicus, they are only acquiring VMS companies that serve niche markets.
In exchange for the promise to be a permanent home, Constellation and Topicus can pay lower prices for businesses. Private equity buyers that flips a company to another buyer 5–7 years down can pay a business founder more, but then they must cut costs, fire employees, and take on debt to achieve their return targets. We are impressed that Constellation and Topicus have achieved returns on acquisitions of >20% on average and they’ve done it without employing private equity tactics.
The Advantage of Data and Experience
Constellation and its operating groups have acquired hundreds of software businesses over the last two decades. This data and experience gives them an enormous advantage when looking at any potential acquisition and the appropriate price to pay. They also share this data and best practices with the leaders of the acquired business to help them maximize growth and profits.
VMS Businesses Are Inherently Attractive
VMS Businesses have many important qualitative features that lead to attractive financials. Here are a few:
The threat of new competition from a large company is low. The size of the addressable market for software that addresses the unique needs of horticultural nurseries is tiny compared to the market for enterprise software. It’s not worth the time for software giants like Oracle and SAP to compete in tiny markets.
VMS businesses require a high degree of customer intimacy. This intimacy is required for the VMS to create a piece of software that addresses the unique needs of the user. This requirement of detailed knowledge of a small, niche market is another form of protection against new competition.
Constellation and Topicus seek to acquire VMS businesses whose products are essential to the everyday operation of their customers. The switching costs for the customers are high. Sometimes there are no other software choices. This gives Constellation and Topicus pricing power.
Finally, as Mark Leonard has written, “For an annual cost that rarely exceeds 1% of a customers’ revenues, our products help them run their businesses efficiently, adopt their industry’s best practices, and adapt to changing times.” Because their software is a low cost relative to revenues, this again gives Constellation and Topicus pricing power.
The aforementioned qualities all lead to an attractive financial profile. Revenues are extremely predictable and come primarily in the form of software licenses and maintenance contracts. Margins and returns are high given the low incremental cost to sell the same software to another customer. Growth can be achieved with little or no capital expenditures. Finally Constellation and Topicus serve an enormously diverse set of customers across all industries. The misfortunes of one or several customers will not have a large impact.
Topicus still has a vast opportunity to apply the Constellation playbook in Europe. There are hundreds of VMS businesses in Europe that Topicus can acquire over time. The original TSS had revenues of €174 million in 2012. If Topicus earns revenues of over €900 million in 2022, they will have achieved an annual growth rate of about 18%. Andvari believes Topicus can maintain a mid-teens growth rate for the next decade. This will come from low to mid-single digit organic growth and the rest from acquisitions.
ANDVARI PARTNERS LP
In August 2021 we launched our first investment fund, Andvari Partners LP. For more information please contact us at info@andvariassociates.com.
ANDVARI TAKEAWAY
Despite most of our holdings being down in the first quarter, and down some more in April, these are still strong businesses. Short-term declines in share price do not necessarily equate to declines in business quality. Our holdings have excellent management teams striving every day to increase the value of their businesses over the long term.
As always, I love to hear from clients and interested parties about anything on your mind. Please contact me with your thoughts, comments, or questions.
Sincerely,
Douglas E. Ott, II
DISCLOSURES AND END NOTES
[i] Andvari performance represents actual trading performance of all, actual clients beginning on 4/12/13. Performance from 12/31/12 to 4/12/13 is actual performance of proprietary accounts, namely the accounts of Andvari’s principal, Douglas Ott. Andvari believes including Ott’s performance figures for the first 4 months and 12 days of 2013 is fair as he managed those accounts similarly to Andvari’s first clients. All performance, including the initial proprietary period, are net of management fees (assumed to be 1.25% per annum, paid quarterly, as currently advertised), net of brokerage commissions and expenses, time-weighted, and includes all cash and other securities. Performance includes realized and unrealized returns and excludes the effects of taxes on incurred gains or losses. Andvari does not certify the accuracy of these numbers. Performance data quoted represents past performance and does not guarantee future results.
The indexes are listed as benchmarks and are total return figures and assumes dividends are reinvested. The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. The Russell 2000 Index is an index of 2,000 U.S. small-cap stocks. It is not possible to invest directly in an index. Because Andvari client portfolios are non-diversified, the performance of each holding will have a greater impact on results and may make them more volatile than a more diversified index. Andvari also engages or may engage in strategies not employed by the S&P 500 or the Russell 2000 including, without limitation, the use of leverage.
One may request a list of all securities mentioned or recommended for the preceding year as of the date of this letter. You may contact Andvari using the information below. Actual client results may differ from results depicted in this letter. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the loss of principal. Investment strategies managed by Andvari Associates LLC may have a position in the securities or assets discussed in this article. Securities mentioned may not be representative of the Andvari's current or future investments. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
The discussion of Andvari’s investments and investment strategy (including, but not limited to, current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) represents the views and opinions of Andvari’s portfolio managers and Andvari Associates LLC, the investment adviser, at the time of this report, and can change without notice.
This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the affiliates of Andvari.
The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. Any or all of Andvari’s forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties, and other factors, most of which are beyond Andvari’s control. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision.
Hemnet, Sweden’s largest residential property portal, went public last year. Its business is similar to Zillow in the U.S., REA Group in Australia, and Rightmove in the UK. Although Hemnet has the attractive financials of a dominant marketplace, its business is even more attractive than the aforementioned geographical peers.
DOMINATING COMPETITORS AND PEERS
Since its founding in 1998, Hemnet has grown into Sweden’s largest online property listing service. When comparing Hemnet to its peers in other geographies, we can see the true extent of its dominance. The table below shows the competition within the respective real estate classifieds markets, and shares several key performance indicators between the market leader and the closest competitor:
Relative to its closest competitor in Sweden (Booli), Hemnet has 12.2x revenues and 10.7x the monthly web traffic. Compare this to REA Group that is dominant in Australia. REA only has 3x the revenues and 2.3x the web traffic relative to its own closest competitor.
Monthly web traffic to Hemnet and its two closest competitors in Sweden.
Even more amazing is the fact that Hemnet is the most popular property platform in the world when measured by visits per capita. Another measure of Hemnet’s popularity is the fact that the average Swede spends 38 minutes on Hemnet every month.
Hemnet is the most popular property portal in the world on a per capita basis.
STABLE & RESILIENT HOUSING MARKET
Another attractive feature of Hemnet is that a stable and resilient real estate market supports its business. During the Great Financial Crisis in 2008, the number of real estate transactions in Sweden dropped only 11%. Compare this to larger European markets. The UK shrank by 47% and Spain by 33%.
OPPORTUNITY TO GROW SALES AND MARGINS
With the top position in Sweden, one might be right to ask whether there’s any opportunity left to grow. We think the answer is a definite “Yes” for two reasons.
First, there is a wide gap in revenues earned per listing between Hemnet and leaders in other geographies. The difference in revenue per listing between Hemnet and REA Group in Australia is 5.6x.
Second, Swedes spend very little on real estate classifieds advertising. When looking at this spending as a percent of average property value, Sweden and Hemnet are at the bottom. The gap between Sweden and Australia is 5.9x.
These two reasons are why there is very likely a decade of above-average revenue growth for Hemnet. The company can bridge these two gaps by increasing its listing fees, adding enhanced services, and by adding ancillary services for listing agents and home buyers/sellers.
Further, by growing revenues from a relatively fixed cost base, Hemnet will also bridge the gap between its current margins and the higher margins of its peers. As shown below, Hemnet already has excellent adjusted EBITDA margins of 39%. However, there is an opportunity to expand margins by 10–20 points. Hemnet's peers, Rightmove and REA, have margins of 75% and 58%, respectively.
ANDVARI TAKEAWAY
Hemnet has many qualities that Andvari likes. It is a dominant marketplace that comes with extraordinarily high margins (see our post about online marketplaces, "The Fulcrum of Scale and Profitability"). A uniquely robust real estate market underpins Hemnet’s business. And despite a commanding market share, Hemnet still has not reached its full potential. Hemnet’s financial goals are revenue growth of 15–20 percent and to achieve adjusted EBITDA margins of 45–50 percent. Further, we suspect few investors outside of Sweden are aware of Hemnet’s existence, which could mean a better opportunity to purchase shares in a wonderful business at a fair price.
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IMPORTANT DISCLOSURE AND DISCLAIMERS
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of publication of this blog, Andvari clients had no position in Hemnet. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results.Full Disclaimer.
Below is a shortened version of our latest quarterly letter to clients. You can read our thoughts on one of our largest positions—Mastercard/Visa—that trailed the S&P by over 25 percentage points. We also introduce a more recent holding that had outstanding performance last year. If you'd like the full letter, please contact us.
Dear Friends,
For the year of 2021 Andvari was up 11.0% net of fees while the S&P 500 was up 28.7%.i Andvari clients, please refer to your reports for your specific performance and holdings. The table below shows Andvari’s composite performance against two benchmarks while the chart shows the cumulative gains of $100,000 investments.
ANDVARI’S HOLDINGS
After outperforming the market by a wide margin in 2020, it is hard not to feel disheartened when we underperformed by a wide margin in 2021. Out of the positions we started the year with and which we still own, 2 in our top 5 largest trailed the S&P 500 by more than 25 percentage points during 2021. These two positions were Liberty Broadband and Mastercard/Visa.
We must remember our goal is to outperform the market, net of Andvari’s fees, over the long term. We pursue this goal by concentrating our money in our best ideas. Andvari currently has nine equity positions (some positions are comprised of two stocks, such as Mastercard/Visa). Our top five positions account for more than 70% of net assets under management. There are two notable side effects to this style of investing. One is increased volatility and the other is inevitable periods of underperformance relative to the market.
…
MASTERCARD & VISA
Mastercard and Visa (“MA&V”) enable the majority of non-cash payment transactions that occur throughout the world. Importantly, they do not issue credit or debit cards. They do not extend credit. They do not dictate or receive revenues from interest rates or other fees that issuing banks charge their card holders. MA&V revenues come from taking a tiny cut of each debit or credit card transaction that passes through their networks.
MA&V’s share price performance lagged the market this year by over 25 percentage points each. Shareholders seem to have several worries. First, Amazon.com has publicly complained about the interchange fees Visa has set for credit card transactions in the United Kingdom. Amazon warned it would stop accepting Visa credit cards for its U.K. business starting in January 2022. With a contract between Amazon and Visa up for renewal, Andvari believes this is simply a negotiating tactic by Amazon. It is still in the interest of both parties to ensure consumers have a variety of ways by which they can pay for goods.
Another worry for MA&V shareholders has been the fast-growing “buy now, pay later” (BNPL) tech companies. The BNPL companies (e.g., Affirm, Klarna, Afterpay) give merchants the ability to offer customers the choice of paying over time for a purchase via a short-term loan. These companies have been growing extraordinarily fast. For example, in Affirm’s most recent quarter, growth in payment volume was 84% over the prior year. Although the total volume of the BNPL crowd is still a small fraction of the volume going through MA&V, some still worry the BNPL companies are stealing business from MA&V. There are three reasons not to worry.
First, BNPL users can choose to use a debit or credit card as the way to make their scheduled payments. If a BNPL customer uses a debit card for 4 smaller transactions instead of 1 big transaction, that is good for MA&V. Second, MA&V both have their own BNPL offering that merchants can use. BNPL has been another way to expand the use of credit and debit cards.
Third, we simply do not believe BNPL is taking customers away from MA&V and credit card issuers. Most of the new BNPL customers were never credit card users to begin with. Oppenheimer’s Chris Kotowski recently wrote about the ability of the BNPL companies to grow like weeds: “Giving credit to those who generally can’t get it has a way of doing that.”
To illustrate why BNPL is not taking much business from MA&V and the card issuers, let’s look at JPMorgan Chase’s $143 billion credit card loan portfolio. 88% of the value of its portfolio is associated with a FICO score of 660 or greater. These are consumers with above average and higher credit. It’s unlikely people who are already credit-worthy need an installment plan to buy a new pair of sneakers.
The last thing to weigh on MA&V has been depressed levels of international travel and tourism. MA&V earn higher fees on cross-border transactions relative to local transactions. Cross-border revenues have been slower to recover (relative to local transactions in the U.S.) for MA&V due to COVID-related worries and travel restrictions. However, they will eventually recover. It’s just a matter of time.
With MA&V as a top position in Andvari portfolios, their poor share price performance during 2021 was a big hit to Andvari’s overall performance. Going forward, we expect this position to outperform the market as Amazon resolves its issues with Visa, as shareholders worry less about BNPLs, and as international travel returns to normal.
NOVANTA
Andvari started a position in Novanta within the last two years. We’ve allowed it to fly under the radar. However, with Novanta being a top performing position in Andvari’s portfolio during 2021, it’s appropriate to introduce you to the company.
Novanta is a company in a similar vein as Danaher and Roper. The company acquires niche businesses that make highly engineered solutions based on proprietary technology. These solutions are typically embedded in customer products for about ten years and provide enormous value for their cost. For example, Novanta’s subsidiaries provide the sub-systems that enable the precision motion required by robotic surgery or the proper functioning of high throughput DNA sequencers.
Novanta has also developed its own program of continuous improvement and growth: the Novanta Growth System (NGS). There is still ample room to apply NGS across current subsidiaries as well as all future acquisitions.
From 2012 to the last trailing twelve months (as of 9/30/21), Novanta has grown adjusted revenues at a 13% annualized rate. Adjusted EBITDA has grown at a 14.9% annualized rate. The company has achieved these growth rates by divesting and acquiring several businesses since 2012. Importantly, the company has acquired businesses using its cash flows and debt, not by issuing equity and diluting current shareholders.
As of the last twelve months, Novanta earned about $650 million in revenues with EBITDA margins in the high teens. With a focus on acquiring niche businesses and applying NGS, Novanta is still in the early stages of compounding value at high rates.
ANDVARI TAKEAWAY
After outperforming the market for a string of years, Andvari underperformed the market by a wide margin in 2021. Our results were to be expected given our concentrated style of investing. However, we still earned a return that is above the long-term market averages. With many of our largest holdings underperforming the market in 2021, we believe Andvari’s portfolio is ready for a rebound.
As always, I love to hear from clients and interested parties about anything on your mind. Please contact me with your thoughts, comments, or questions.
Sincerely,
Douglas E. Ott, II
DISCLOSURES AND END NOTES
[i] Andvari performance represents actual trading performance of all, actual clients beginning on 4/12/13. Performance from 12/31/12 to 4/12/13 is actual performance of proprietary accounts, namely the accounts of Andvari’s principal, Douglas Ott. Andvari believes including Ott’s performance figures for the first 4 months and 12 days of 2013 is fair as he managed those accounts similarly to Andvari’s first clients. All performance, including the initial proprietary period, are net of management fees (assumed to be 1.25% per annum, paid quarterly, as currently advertised), net of brokerage commissions and expenses, time-weighted, and includes all cash and other securities. Performance includes realized and unrealized returns and excludes the effects of taxes on incurred gains or losses. Andvari does not certify the accuracy of these numbers. Performance data quoted represents past performance and does not guarantee future results.
The indexes are listed as benchmarks and are total return figures and assumes dividends are reinvested. The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. The Russell 2000 Index is an index of 2,000 U.S. small-cap stocks. It is not possible to invest directly in an index. Because Andvari client portfolios are non-diversified, the performance of each holding will have a greater impact on results and may make them more volatile than a more diversified index. Andvari also engages or may engage in strategies not employed by the S&P 500 or the Russell 2000 including, without limitation, the use of leverage.
One may request a list of all securities mentioned or recommended for the preceding year as of the date of this letter. You may contact Andvari using the information below. Actual client results may differ from results depicted in this letter. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the loss of principal. Investment strategies managed by Andvari Associates LLC may have a position in the securities or assets discussed in this article. Securities mentioned may not be representative of the Andvari's current or future investments. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
The discussion of Andvari’s investments and investment strategy (including, but not limited to, current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) represents the views and opinions of Andvari’s portfolio managers and Andvari Associates LLC, the investment adviser, at the time of this report, and can change without notice.
This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the affiliates of Andvari.
The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. Any or all of Andvari’s forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties, and other factors, most of which are beyond Andvari’s control. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision.
One of Andvari’s largest and longest-held investments is Charter Communications, which we own via Liberty Broadband. On the back of several recent sell-side downgrades, shares of Charter have declined from all-time highs of $821 on 9/2/21 to $606 as of 12/13/21. Fears related to slowing customer additions and increasing capital expenditures are overblown. Charter is a high quality business and now is not the time to cut the cord on this investment.
Charter is the second largest cable company in the United States. It serves more than 31 million customers in 41 states through their Spectrum brand. Its network passes over 54 million households and businesses. Some of the qualitative features of Charter’s business include…
PREDICTABLE, RECESSION RESISTANT REVENUES
Customers sign up for one- or two-year contracts and pay on a monthly basis. This is also a recession resistant business. Internet, TV, and mobile phones are three things most people cannot live without. Thus, revenues and profits are extremely predictable.
Although Charter is a capital intensive business, we love that each new customer it signs up is more profitable than the prior one. This occurs naturally with a high fixed cost network. More customers means lower costs on a per customer basis. Spreading costs—that are relatively fixed—among a greater number of customers leads to profits growing faster than revenues over time.
CAPITAL ALLOCATION AND STRUCTURE
Because of the predictability of its revenues and its growth, Charter has taken on debt that it has used to repurchase its own shares. This is the heart of its levered equity return framework. Thus, as Charter has grown its revenues at mid-single digit rates and profits at high single-digit rates, on a per share basis these have grown at much higher rates.
Also, Charter’s capital structure is efficient and optimal. As of 9/30/21, the company has a leverage ratio of 4.32x (over the last twelve months, Charter has $20.25 billion of adjusted earnings before interest, taxes, and depreciation and amortization that supports a net debt load of $80 billion). The weighted average cost of debt sits at 4.5%. The weighted average life of its debt is 14.1 years.
HIGH QUALITY AND ALIGNED MANAGEMENT
Tom Rutledge took over as CEO of Charter on February 13, 2012. During Rutledge’s tenure thus far, Charter’s cumulative share performance is 831% versus 320% for the S&P 500.
Rutledge has been richly rewarded for achieving excellent performance for all shareholders. He now owns shares of Charter worth $1 billion. CFO Chris Winfrey owns shares worth $370 million. We believe they have every desire and incentive to continue growing shareholder value over the long run.
ANDVARI TAKEAWAY
Andvari remains a shareholder of Charter through Liberty Broadband because of the quality of the business and a superb management team that is aligned with shareholders. We particularly like the predictability and resilience of the business. Given the decline in share price since September, we expect Charter to outperform the market over the next five years. If you'd be interested in a more detailed report on Charter, please contact us.
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IMPORTANT DISCLOSURE AND DISCLAIMERS
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of publication of this blog, Andvari clients had a position in Charter via its ownership of Liberty Broadband. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results.Full Disclaimer.
Self storage companies have been some of the best-performing real estate companies over the last decade. UK-based Safestore particularly stands out. Spurred by a recent In Practise interview, Andvari delved deeper into Safestore and discovered it exhibits many of the features for which Andvari looks in a high quality business.
LONG-TERM GROWTH TAILWINDS
Safestore was founded in 1998 with just a handful of locations and has grown to be the largest self storage company in the UK. Safestore has 126 wholly owned sites followed by Big Yellow with 75 wholly owned stores. Safestore has also ventured into Europe in the last few years.
With Safestore, there’s still opportunity to grow the business. The company will continue to consolidate a highly fragmented market and will continue to grow organically. In terms of fragmentation, there are roughly 1,900 storage sites in the UK. However, the six largest operators own just 352 of these, barely 20% of the total UK market.
In terms of organic growth, there remains a huge opportunity for the self storage industry to continue growing in the UK and Europe. First, according to Dave Davies, a former Operations Director at Safestore (see the In Practise interview), the UK has 0.7 square feet of self storage per capita compared to nearly 10 square feet in the US, 1.9 in Australia, and only 0.2 throughout Europe. Second, surveys indicate that roughly half of consumers in the UK either knew nothing about the service offered by self storage operators or had not heard of self storage at all.
PREDICTABLE REVENUES, RECESSION RESISTANT
Although customer churn is high at 100% to 120% per year (meaning Safestore must replace all its customers every year), revenues are still steady and predictable. For example, customers that existed prior to the start of 2020 contributed 70% to 80% of Safestore’s 2020 revenues.
Andvari also likes that the self storage business is recession resistant. Births, marriages, deaths, divorces, and downsizing happen regardless of the economy. All these life events drive the need for storage space. (See also Andvari’s blogs on other recession resistant businesses like Chemed's Roto-Rooter and Water Intelligence).
COMPETITIVE MOAT
The self storage industry cannot be disrupted by tech companies. If you need physical space to store physical items, a self storage company is the only option outside of moving into a larger home or office. Another barrier to entry that is specific to Safestore is that the majority of its revenues come from its locations in London and Paris. Both are densely populated areas where land is scarce and land values are high. This means extremely limited availability for new sites. Safestore also enjoys the protections of city planning regulations as well as laws that strongly favor the rights of leaseholders.
LOW CAPEX REQUIREMENTS
Capital expenditures to maintain Safestore’s current business are small relative to total revenues at just £7 million on £162 million of revenues. This allows Safestore to allocate generous cash flows towards building or buying new stores. This will in turn provide more fuel for Safestore to buy and build a greater number of stores each year.
ANDVARI TAKEAWAY
Safestore’s qualitative features combine to create a high margin, resilient business with a high probability of many decades of growth left ahead of it. Andvari believes Safestore and its peers are worthy of addition to our investment watch list.
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of publication of this blog, Andvari clients had no position in Safestore or Water Intelligence. Andvari clients do have a position in Chemed. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results.Full Disclaimer.
Andvari has found yet another highly profitable and fast-growing services business. The business is Water Intelligence plc. It’s based in London, but it’s core subsidiary, American Leak Detection (“ALD”), does business in the States. ALD is a franchise business and a leader in using technology to pinpoint and repair water leaks without destruction. ALD possesses several attributes of a high quality business. In fact, ALD shares many of the same qualities of Chemed’s Roto-Rooter business (see "How a Boring Service Business Produced Tech-Like Returns"). The qualitative features of the business has led to astounding share price performance: 3,700% cumulative returns over the last decade.
RECESSION-RESISTANT AND HIGH MARGINS
ALD's purpose is to help find and repair water leaks without tearing open walls, ceilings, or floors. Leaks and water damage happen regardless of whether the economy is good or bad. Finding and repairing the leak is something a homeowner must do. Further, because these situations are non-discretionary and somewhat urgent, the consumer is less sensitive to price. This is very similar to the situation of a Roto-Rooter customer. Thus, ALD currently has operating margins in the upper teens and there is still room to increase these margins.
REACQUIRING FRANCHISEES
Over the last decade, ALD has reacquired the operations of its franchisees (also similar to Roto-Rooter). This has unlocked significant value as it transforms indirect royalty income to higher margin direct corporate income. To illustrate, if ALD’s $17.4 million of revenues (as of 2020) from corporate-operated locations were executed by franchisees, ALD would only receive $0.27 million of pre-tax profit instead of $3.8 million. Although ALD certainly seeks to grow the number of franchisees, the selective reacquisition of these franchises to operate them internally has created tremendous value.
MANAGEMENT WITH SKIN IN THE GAME
Patrick DeSouza is the current Executive Chairman of Water Intelligence. He also is the largest shareholder of the company, owning 28.19% of outstanding shares. With the market cap at about $270 million (USD), DeSouza’s shares are worth $76 million. Andvari always appreciates management with a lot of skin in the game. This makes it more likely a manager will invest for the long-term. It also aligns the manager’s interests with all other shareholders. By doing well for himself, DeSouza has done well for all other shareholders.
OPPORTUNITIES FOR CONTINUED GROWTH
There is still a long runway for growth. First, Water Intelligence is still a small business. Reported annual revenues are just now approaching $35 million. However, the gross revenues have passed $140 million million. This gross revenue figure includes the indirect sales by franchisees from which ALD’s franchise royalty income is derived.
Second, as noted in the above paragraph, there is a huge opportunity to reacquire franchisees. There is nearly $100 million of revenues ALD can acquire from which it can earn greater profits.
Finally, Water Intelligence is in the beginning innings of expanding internationally. Although they are starting from a low base, operations in the UK, Australia, and Canada grew at a combined rate of 27% during 2020.
ANDVARI TAKEAWAY
Although Water Intelligence currently trades at a very high multiple of earnings, there are many reasons why it should. It’s a profitable, growing, and recession-resistant service business run by an owner operator with skin in the game. Finally, the corollaries to Chemed’s Roto-Rooter business, or even Rollins with their Orkin pest control business, should give a potential shareholder conviction Water Intelligence deserves to be highly valued. Water Intelligence is a recent, and well-deserved addition to Andvari’s watch list. We look forward to keeping tabs on this company in the years to come.
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IMPORTANT DISCLOSURE AND DISCLAIMERS
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of publication of this blog, Andvari clients had no position in Water Intelligence or Rollins. Andvari clients do have a position in Chemed. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results.Full Disclaimer.
CCC Intelligent Solutions (“CCCS”) is a company that is recently public. The company helped pioneer Direct Repair Programs for the auto insurance economy in 1992. Since then, CCCS has built a software platform and network that solves the needs of auto insurance companies and auto collision repair shops. Andvari has added CCCS to its watchlist as it has many of the hallmarks of a high quality business for which we always seek.
SOLVING PROBLEMS FOR HIGHLY COMPLEX AND REGULATED INDUSTRY
How an auto collision is handled by all industry participants is highly complex. A single collision event can require the resolution of hundreds of transactions and decisions. Who will be the best repair facility and part supplier? What local rates and prices apply? What local regulations apply? What’s the damage to the vehicle and what is needed to restore it? The slide below shows all the different variables that must be considered.
Building a system to handle such complexity has taken decades and hundreds of millions of dollars. The time and money it would take a new competitor to effectively compete against CCCS is substantial. Andvari views this both as a formidable moat for the company against new competition and as the source of CCCS’s attractive financials.
NETWORK AND ECOSYSTEM EFFECTS
More than 300 insurers and over 26,000 repair facilities are connected to CCCS’s network. Parts suppliers, auto OEMs, and financial institutions are also connected. This network creates value for all connected parties by enabling collaboration, streamlining of operations, and the reduction of claims management costs.
Andvari always appreciates how network effects can strengthen business. A strong network effect helps retain customers and increases the likelihood of adding new customers. This makes revenue growth stronger and more certain. A company with a dominant network, which CCCS might have, is a moat that a competitor usually has low odds of duplicating.
TREASURE TROVE OF DATA
CCCS has processed $1 trillion of historical data through its network. It is now processing $100 billion of transactions annually. They use the data to help reduce costs for insurance carriers and drive revenues to repair shops. This treasure trove of data will be extraordinarily hard for any other company to replicate and acts as another barrier to new competition.
STICKY CUSTOMERS AND PREDICTABLE REVENUES
CCCS’s business model enables sticky customer relationships and highly predictable revenues. Average contract length is around 3-5 years in length. 96% of revenues are recurring software revenues. As of 2019, gross dollar retention was 97% while net dollar retention was 107%. Given its customer-centric approach to business, it’s not surprising CCCS has a high net promoter score of 80. For comparison, Starbucks has an NPS of 77 and Apple has an NPS of 47.
Another awesome data point is that 70% of CCCS revenues come from accounts that are 10 years or older. Furthermore, the average revenue per long-term insurance customer has risen 80% from 2010 to 2019.
CAPITAL EFFICIENT BUSINESS MODEL
With gross margins in the mid 70s and adjusted EBITDA margins in the mid-30s, the company spits out cash. Andvari loves software businesses like CCCS as they require little capital to grow. CCCS aims to have capex as a percent of revenue in the 4-7% range and working capital as a % of revenue in the low single-digits. A capital efficient business enables higher cash flows that can be used to reinvest in the business, acquire other businesses, or else be returned to shareholders. Cash can compound at a higher rate in businesses like this.
MANAGEMENT WITH SKIN IN THE GAME
Githesh Ramamurthy is the Chairman and CEO of CCCS. He’s been with the company for 29 years and is the beneficial owner of a little over 33.5 million shares (5.6% of outstanding shares). At a share price of $11.53, Githesh’s stake in CCCS is worth nearly $390 million. As a group, directors and executives own 6.2% of shares outstanding. We believe this is more than enough motivation for them to continue to create value for themselves and all other shareholders.
ANDVARI TAKEAWAY
From a high-level view, CCCS possesses many of the characteristics of a high quality business. It has a deep understanding of a highly complex and highly regulated industry. It’s software platform benefits from network effects and has an enormous treasure trove of historic data. Revenues are sticky and predictable, margins are high, cap-ex is low, and the CEO and Chairman has an enormous stake in the company. CCCS is worthy of addition to any watchlist as it has high potential to grow and compound shareholder value for years to come.
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of publication of this blog, Andvari clients had no position in CCCS. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results.Full Disclaimer.
Below is a selection from Andvari's latest quarterly letter. Please enjoy.
Dear Friends,
For the first nine months of 2021 Andvari is up 6.5% net of fees while the S&P 500 is up 15.9%.[i] Andvari clients, please refer to your reports for your specific performance figures. The table below shows Andvari’s composite performance against two benchmarks while the chart shows the cumulative gains of $100,000 investments.
ANDVARI HOLDINGS
During the third quarter, one of our largest and longest-held investments—“Company A”—announced the largest acquisition in its history. Company A will increase its revenue base by about 40% by acquiring “Company B”. Company B has a set of genetic analysis products that enable labs and pharmaceutical companies to perform certain types of diagnostics more quickly and at a lower cost.
Andvari believes the best is still yet to come with our investment in Company A. Depending on the size and pace of future acquisitions, this serial acquirer can grow revenues 4x–5x over the next ten years while maintaining high margins and cash flows. As Company A grows, it will have ever-increasing cash flows to allocate to larger and larger acquisitions. Cash flows will compound. At a minimum, Andvari expects over the long run to earn annualized returns in the low-teens as shareholders of Company A.
A new entrant to Andvari’s portfolio is Chemed. We sold our investment in a large, customer-focused enterprise software company to make room for this overlooked holding company based in Cincinnati, Ohio. Chemed’s two subsidiaries are Roto-Rooter (plumbing and drain cleaning) and VITAS Healthcare (hospice care provider). Chemed checks many of the boxes within Andvari’s qualitative-based investment framework:
Stable and predictable revenues from two recession resistant businesses;
Low capital expenditure requirements;
Roto-Rooter and VITAS have good organic and inorganic growth opportunities as both are the largest players in markets that are still highly fragmented and populated mainly with “mom-and-pop” competitors;
Management has demonstrated excellent capital allocation skills; and
Management is long-tenured and highly aligned with shareholders.
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ANDVARI PARTNERS LP
In the prior quarter’s letter we mentioned the launch of Andvari Partners LP, Andvari’s first investment fund. The fund’s track record officially started in early August. For more information we urge you to contact us at info@andvariassociates.com.
ANDVARI TAKEAWAY
For the first nine months of 2021, Andvari still trails the market by a wide margin. However, we’ve caught up a bit in the third quarter. Looking at our collective performance over the past three and five years, Andvari has outperformed the market net of management fees. This outperformance is in spite of the fact that Company A—our largest holding now—has significantly underperformed against the market this year. Finally, we are strong believers in Company A and in our new Chemed investment.
As always, I love to hear from clients and interested parties about anything on your mind. Please contact me with your thoughts, comments, or questions.
Sincerely,
Douglas E. Ott, II
DISCLOSURES AND END NOTES
[i] Andvari performance represents actual trading performance of all, actual clients beginning on 4/12/13. Performance from 12/31/12 to 4/12/13 is actual performance of proprietary accounts, namely the accounts of Andvari’s principal, Douglas Ott. Andvari believes including Ott’s performance figures for the first 4 months and 12 days of 2013 is fair as he managed those accounts similarly to Andvari’s first clients. All performance, including the initial proprietary period, are net of management fees (assumed to be 1.25% per annum, paid quarterly, as currently advertised), net of brokerage commissions and expenses, time-weighted, and includes all cash and other securities. Performance includes realized and unrealized returns and excludes the effects of taxes on incurred gains or losses. Andvari does not certify the accuracy of these numbers. Performance data quoted represents past performance and does not guarantee future results.
The indexes are listed as benchmarks and are total return figures and assumes dividends are reinvested. The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. The Russell 2000 Index is an index of 2,000 U.S. small-cap stocks. It is not possible to invest directly in an index. Because Andvari client portfolios are non-diversified, the performance of each holding will have a greater impact on results and may make them more volatile than a more diversified index. Andvari also engages or may engage in strategies not employed by the S&P 500 or the Russell 2000 including, without limitation, the use of leverage.
One may request a list of all securities mentioned or recommended for the preceding year as of the date of this letter. You may contact Andvari using the information below. Actual client results may differ from results depicted in this letter. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the loss of principal.
The discussion of Andvari’s investments and investment strategy (including, but not limited to, current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) represents the views and opinions of Andvari’s portfolio managers and Andvari Associates LLC, the investment adviser, at the time of this report, and can change without notice.
This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the affiliates of Andvari.
The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. Any or all of Andvari’s forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties, and other factors, most of which are beyond Andvari’s control. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision.
Imagine a company. It's not based in or anywhere near Silicon Valley. It's enterprise value is $7.5 billion and has revenues of $2 billion. It doesn't have a sexy, fast-growing tech business. It clears drain pipes and provides hospice care. Yet the shares of this company have achieved "tech-like" returns over the last decade.
Chemed, the owner of Roto-Rooter and hospice care provider VITAS, has many qualities that Andvari finds attractive in an investment. The main four are:
Being in steady, recession-resistant service businesses that require little capital;
Being a large player in markets that are still highly fragmented and populated with "mom-and-pop" competitors;
Excellent capital allocation; and
A long-tenured management team that is in alignment with shareholders.
ROTO-ROOTER AND VITAS
Roto-Rooter is the largest provider of plumbing and drain cleaning services in North America. It has a presence in 127 company-owned territories and 369 franchise territories. EBITDA margins are in the mid-20s. VITAS Healthcare is the largest hospice services in the U.S. with a presence in 14 states and the District of Columbia. EBITDA margins for VITAS are in the high teens.
Slide from Chemed's June 30, 2021 investor presentation showing Roto-Rooter's presence and strategy.
Both VITAS and Roto-Rooter have grown annual revenues in the 5–6% range for many years. Both require little capital expenditures—capex as a percent of revenues has ranged between 2–3%. Both are recession resistant. The state of the economy has no bearing on the decision of anyone with a plumbing emergency or anyone with a terminal illness who needs or desires hospice care.
From Andvari's perspective, steadily growing, and recession-resistant businesses are great qualities to have in an investment. These businesses ought to deserve a premium valuation due to their greater ability to make it through an economic downturn and little need for capital to continue growing.
LARGEST PLAYER IN HIGHLY FRAGMENTED MARKETS
Roto-Rooter and VITAS are each the largest players in highly fragmented markets. Roto-Rooter has an estimated 15% of the drain clearing market and a 2–3% share of the same day service plumbing market. VITAS has about a 7% share of the U.S. hospice market. This positioning allows both ample opportunity to grow organically and by acquisition for decades to come.
Furthermore, because Roto-Rooter and VITAS have greater scale, and the competition for both are coming from "mom-and-pop" organizations operating on thinner margins, both can spend more on branding, advertising, training, and offering new services. This gives both Chemed companies a solid advantage over their competitors.
A HISTORY OF CAPITAL ALLOCATION
Another quality for which Andvari always looks is a management team skilled at capital allocation. The first proof of Chemed's seriousness about capital allocation comes straight from its 2020 form 10-K (emphasis Andvari's): "Chemed purchases, operates and divests subsidiaries engaged in diverse business activities for the purposes of maximizing shareholder value. The Company's day to day operating businesses are managed on a decentralized basis."
Screenshot of front page of Chemed website. A little more pizzazz than Berkshire Hathaway's, but it's still an outdated design. Perhaps an indication the company is focused on more important things?
In Andvari's words, Chemed views itself as a pure allocator of capital seeking to maximize long-term shareholder value. Furthermore, Chemed's head office does not meddle too much in how its subsidiaries run their respective businesses. Both qualities—excellent capital allocation and decentralized operations—could make Chemed a good candidate for a second Outsiders book.
More proof of Chemed's dedication to maximizing shareholder value is evident from the extraordinary action it took in 1999. The company announced they'd be cutting their dividend from a quarterly $0.265 per share to $0.05 per share. The dividend yield on their shares went from over 7% to 1.4%.
The reason for the dividend cut was to have more resources for internal growth and acquiring more Roto-Rooter franchises. Companies rarely cut their dividend. When they do it's usually forced upon them by awful capital allocation decisions from prior years. A company with the fortitude to make an unforced decision that is unpopular in the short-term, yet could ultimately create more value in the long-term, will always be worth Andvari's time to investigate.
ALIGNED AND LONG-TENURED MANAGEMENT
Chemed has a management team with long tenures and who are aligned with Chemed shareholders. Importantly, Chemed executives have significant personal wealth tied to the long-term performance of the company. Yet another important quality for which Andvari always looks.
Kevin McNamara has been with Chemed since 1986. He has served as President since 1994 and CEO since 2001. He is a beneficial owner of shares worth over $93 million.
David Williams has been with Chemed since 1990. He has served as CFO since 2004. He is a beneficial owner of shares worth over $43 million.
For long-term compensation, management is compensated based on a combination of: 3-year adjusted earnings per share growth and 3-year total shareholder return as compared against their peer group. This incentive plan combined with management’s already significant shareholdings means that management is well-aligned with all other Chemed shareholders (see also Andvari's "Quick Guide to Executive Comp").
HISTORICAL FINANCIAL RESULTS
Chemed's intangible qualities have coalesced into the production of excellent financial results. The chart below shows steady growth of revenues and adjusted EBITDA.
The next chart shows growth of revenues and adjusted EBITDA on a per share basis since Chemed's acquisition of VITAS (acquired February 2004). Given Chemed's large and continuing share repurchases, adjusted EBITDA per share has grown at an annualized rate of nearly 20% since 2003.
Finally, Chemed shareholders have enjoyed exceptional cumulative performance over the last 10 years. Chemed has outperformed the S&P 500 and NASDAQ 100 indices. The company has also kept up with or outperformed several other tech and software businesses (like Salesforce and Autodesk) that are all wonderful in their own right.
ANDVARI TAKEAWAY
A decidedly non-tech business with annual revenues growing at "just" a 5–6% pace can still outperform an index of tech stocks. A combination of important qualitative factors are the necessary ingredients for success. Chemed's two service businesses will always be in demand regardless of the economy. Roto-Rooter and VITAS have low capital requirements. Both businesses are the largest in highly fragmented markets which gives them the opportunity to gain more scale through acquisitions. Finally, Chemed's management team are skilled allocators of capital and are well aligned with other shareholders given their large holdings of Chemed shares.
Chemed fits squarely within the framework of Andvari's qualitative-focused investment process. This unassuming and under-the-radar company is well worth a look for inclusion in any long-term investment portfolio.
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IMPORTANT DISCLOSURE AND DISCLAIMERS
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of publication of this blog, Andvari clients had a position in Chemed. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results.Full Disclaimer.
Andvari has recently discovered SDI Group, a company that could become the next great U.K.-based serial acquirer. Over the last decade, this small company has grown revenues nearly five-fold. SDI has done this organically and through over a dozen acquisitions.
Andvari’s Interest in Serial Acquirers
Good companies with management teams skilled at capital allocation have historically greater odds of producing market beating returns. Andvari recently studied a short list of serial acquirers. We analyzed how long it took these companies to reach various revenue thresholds. Many grew rapidly through acquisition, while some grew at a more moderate pace. The one thing nearly all of them had in common was superlative performance during these periods, both in absolute and in relative terms.
Fitting the Mold
SDI seeks to buy and build niche businesses in the life science and technology markets. They have a variety of businesses in the digital imaging and sensing and control sectors. For example, SDI’s Synoptics Health manufactures ProReveal, a test to detect residual proteins on surgical instruments using fluorescence. SDI also owns Opus Instruments, a world leader in the field of Infrared Reflectography cameras for use in art conservation.
Acquisition Criteria
SDI has positioned itself as a sort of permanent home for niche businesses in the life science and technology markets. The company prefers to fund acquisitions from the cash flows of their existing businesses where possible. After acquisition, SDI implements financial controls and objectives, but otherwise allows the acquired business to run autonomously. The goal is to focus on the long-term and to “create an environment for the businesses to grow and develop with investment if required.”
Skilled Management
Regarding management, Mike Creedon has helmed the company as CEO since August 2011. Since then, Creedon has overseen the dramatic growth of the company. He has made over a dozen acquisitions. Annual revenues have grown from £7.2 million in 2012 to £35.1 million in 2021. Gross margins also grew from the high 50s to the mid-60s during this period. SDI’s share price has thus far reflected these excellent long-term results.
Andvari Takeaway
SDI Group appears to have the basic characteristics of a young serial acquirer that can produce excellent returns for shareholders (see our prior post on M&A wisdom from Halma plc). SDI’s management has proven to be capable over the prior ten years by acquiring good businesses at fair prices. Furthermore, with just £35 million in annual revenues, to say there is still room for SDI to grow would be a vast understatement. Based on Andvari’s study of other successful serial acquirers, it is certainly possible for SDI to grow revenues to £100 million within the next 7 years. If this turned out to be the case, we think it is likely shareholders will be quite happy.
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IMPORTANT DISCLOSURE AND DISCLAIMERS
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of the conversation and as of the publication of this transcript, Andvari clients had no position in SDI Group. Furthermore, Andvari clients have not had a position in SDI Group in the past.Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results. Full Disclaimer.
The following article contains selected highlights from a live Q&A on August 10, 2021 between Douglas Ott, founder and CIO of Andvari Associates, and Catherine Corrigan, President and CEO of Exponent (NASDAQ: EXPO). At the time of the conversation and as of the publication of this transcript, Andvari clients had no position in Exponent. The transcript has been edited for clarity. Please read the full disclaimers at the end of the PDF transcript via the link below.
I come from a family of engineers and technical people. My father, he has a PhD in electrical engineering from Cornell. He had a career at Bell Laboratories. My older sister went into engineering. She’s a mechanical engineer at Penn and at MIT. My mother went back to school later in life and became a network software manager. The culture of my immediate family was really around technology, and science and engineering.
A Desire to Provide Immediate Solutions to Problems
At that point in time [having just completed a PhD], I would not have imagined myself in the seat that I’m in right now. It’s interesting. As you go through a PhD program, particularly on the engineering side, so much of what you see in terms of your faculty and your mentors, and what folks are doing there, they’re continuing on to do research. They’re going into postdoctoral fellowships, and then they’re becoming assistant professors, and then they’re getting tenure. This was the sort of traditional path. I applied for some of those and I followed that path. I had some opportunities along those lines, but it just wasn’t what I really thought I would be passionate about.
I really had a desire to be not doing basic research that might not see an application for 20 years or 30 years. I was much more interested in immediate solutions to problems that are happening right now. And really practical and applied solutions. I recognized I had a postdoctoral fellowship all queued up and I said, “Well, there’s this company called Failure Analysis [Exponent's former name] that looks sort of interesting.” They had come to campus at MIT to do some interviews. And so I did that interview, and the rest is history.
On Exponent's Culture of Scientific Excellence
Well, our culture around scientific excellence has been a constant throughout that time. That is a core value of the organization that has been in place and has been a foundation for the business. Our clients recognize that we are bringing the most advanced science, the most critical eye, that level of independence. That has always been there.
The company has certainly evolved over the course of time. When I started, I would say probably 85% or 90% of the portfolio of the company was this failure analysis, reactive type of business. And the nature of those engagements is very different than the engagements that we now have on the proactive space. The collaborative nature of our workplace has steadily increased over the course of time.
We have recognized the degree of differentiation that we have as a company, because of not only the critical mass of expertise, but our ability to form these interdisciplinary teams, literally at the at the snap of a finger in order to solve a client’s problem. So it’s this sort of culture of collaboration, this culture of bringing diversity in all its dimensions. Technical disciplines, years of experience. We need the industry expert who has 20, 30, 40 years of experience, but we also want the new PhD who worked on the leading edge technology, right? We can bring those together. And I really do think that that interdisciplinary collaboration that we’ve been able to foster in our culture over time, has been a big driver of the company’s success.
Data on Exponent's consultants
Exponent's Competitive Moat: Multiple, Premium Services Under One Roof
I would describe the competitive landscape as fragmented. We have competition in everything that we do. But there isn’t a single entity that’s going to have the depth and breadth that we cover. If I look at our chemical regulatory folks—we’ve got that group in both the U.K. as well as in the U.S.—they’ve got competitors in that regulatory space. But those competitors are not going to crossover into some of the reactive kind of work that we get into with chemicals.
Or if I look at our vehicle engineering practice, there are boutique accident reconstruction firms out there that are very good, that I would consider to be premium service firms. But they’re going to have a single discipline. Or maybe they’re just doing accident reconstruction and they can’t go next door to bring that human factors expert in, to be able to talk about that human operator error and operator distraction side of the equation, right?
If there’s an explosion of an oil refinery, we can handle the root cause of that explosion with our thermal scientists. But then we’re also going to look at the chemistry issues of what’s being discharged both into the air as well as into the ecological environment. And then further downstream, what are the health effects of that? And how do you monitor that? So it’s very much a soup-to-nuts kind of coverage that we have. Whereas if you went elsewhere, you you’d have to patchwork together maybe five different boutique firms.
We could be a much, much bigger company, if we decided to pursue more commodity-level professional services work. Lower costs, lower rates, lower margins: it’s just a race to the bottom. That’s not what we’re about. We want to solve the problems that only we can solve. I think our competitors have been just amazed at how much of a proactive portfolio we have been able to build. We charge the same rates for proactive work as we do for our reactive work. One person, one rate is our philosophy.
On Being "Defender-in-Chief" of Exponent's Reputation
One of my jobs—and I didn’t list this when you asked me what I spend my time on—but I am certainly the Defender-in-Chief of Exponent’s reputation. Our reputation for scientific excellence, for objectivity, independence, all of those things. The way the regulators view us, the way the scientific community views us are foundational to our success. Maintaining that reputation through the quality of the people that we hire, and through our quality management system to ensure we’re not making errors in our work, and all those sorts of things that we have in place, is incredibly important to maintaining that absolutely top-level reputation.
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. At the time of the conversation and as of the publication of this transcript, Andvari clients had no position in Exponent. Furthermore, Andvari clients have not had a position in Exponent in the past.Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results. Full Disclaimer.
Doma is a recently public company that is taking on the most antiquated portion of the home purchase market: the title, escrow and close portions. Doma has some excellent qualities Andvari likes to see in a potential investment. It's founder-led and it's the founder's second act. Incumbent competitors are at a disadvantage having prospered too long based on inertia rather than innovation. Finally, the financials can scale extraordinarily quickly as Doma gains name recognition, takes market share, and expands into adjacent lines of business.
What Does Doma Do Exactly?
Doma has created a platform that "seeks to eliminate all of the latent, manual tasks involved in underwriting title insurance, performing core escrow functions, generating closing documentation and getting documents signed and recorded." The platform accomplishes this by using data analytics, machine learning and natural language processing. Looking at just the title portion of Doma's services, Doma can underwrite title insurance in mere minutes as opposed to the usual 3–5 days it would take one of its legacy competitors. If a lender uses all of Doma's services, the typical 40 to 50 day mortgage closing time can be shortened by 15 to 25%.
Max Simkoff founded Doma in 2016 and remains the CEO. However, this is not the first company he founded. Max previously co-founded Evolv in 2006 and sold it in 2014 to Cornerstone for over $40 million. Evolv used similar technology as Doma, but instead applied it to evaluate the skills, work experience and personalities of a company's employees and job candidates. The fact that Simkoff has experience creating a successful business based on similar technology increases the odds he will be successful in this second act.
Fat and Lazy Incumbents
The big four legacy providers of title & escrow services are Fidelity National Financial (FNF), First American Financial (FAF), Old Republic (ORI) and Stewart Information Services (STC). The four have 80% market share in the US. For the past few decades they have just coasted on the benefits they've accrued as they consolidated the market.
These legacy providers have had little incentive to invest to the extent Doma has. Trying to catch up to Doma now would mean spending upwards of $65 million over many years. And even if they were successful in catching up in terms of technology, they'd still have to lower their fees to match Doma's level. This is a "high risk, low reward" proposition from the perspective of the incumbents.
One great piece of advice that applies to life, sports, and investing: "Go to where the competition isn't." Looking at the competitors Doma has, it's as if they don't have competition. From Andvari's perspective, we like situations where there is little to no true competition as it increases the odds of success.
Growing Revenues and Capturing Market Share
Another great thing about Doma is they operate in a large and steadily growing U.S. residential real estate market. In 2020, there were nearly 6.5 million homes sold. There were also 12 million mortgage originations with 40% from purchases and 60% from refinancings. Virtually all these mortgages required the services (title insurance, escrow, and closing) that Doma can provide.
Slide 8 from 4/16/21 Doma Analyst Day presentation
Scaling the Business
As the disruptor in their small, $23 billion section of the nearly $320 billion home ownership market, Doma has grown and can continue to grow quickly. They will do this organically, through acquiring other small title agencies and plugging them into their platform, and by expanding into adjacent services like appraisal and warranty. It seems highly likely that Doma can meet their goal of doubling revenues in the next 3 years. In the process, their market share will go from 1–2% to nearly 5%. Given their tech advantage, it also seems highly likely Doma will eventually be as or more profitable than their legacy competitors.
Slide 40 from 4/16/21 Doma Analyst Day presentation
Andvari Takeaway
Doma has some great qualities that Andvari believes can make for a potentially good investment. This company is founder and CEO Max Simkoff's second act. He built and sold a company before which makes it more likely he can do it again, perhaps with even greater success. Doma has created a much better service that is both cheaper and higher quality. Finally, the incumbent competitors have been lazy and it seems inevitable they will cede more market share to Doma.
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IMPORTANT DISCLOSURE AND DISCLAIMERS
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. Andvari clients do not currently have a position in Doma. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results. Full Disclaimer.
EverArc Holdings, the special purpose acquisition company (SPAC) co-chaired by Nick Howley and Will Thorndike, announced last month it will acquire Perimeter Solutions for $2 billion. Howley founded and led TransDigm, a company which has delivered a >35% IRR since 1993. Thorndike, aside from being the well-known author of The Outsiders, is a founding partner of successful private equity firm Housatonic Partners.
As they write, Perimeter is a "leading global manufacturer of high-quality firefighting products and lubricant additives." Given the success of both Howley and Thorndike in their respective careers, and the acquisition criteria they laid out, Andvari believes EverArc found a quality business.
EverArc Acquisition Criteria
EverArc laid out five criteria they wanted in a business:
Recurring and predictable revenue streams
Long-term secular growth tailwinds
Products or services that account for critical but small portions of larger value streams
Significant free cash flow generation with high returns on tangible capital
Businesses in industries with potential for opportunistic consolidation
Andvari believes Perimeter and its Fire Safety segment (which accounts for 80% of total EBITDA) meets EverArc's criteria. Fire Safety revenues are recurring and predictable and the segment has secular growth tailwinds. The following charts are from a recent webinar presentation by Perimeter's CEO Eddie Goldberg.
Spending to suppress forest fires has steadily increased over the decades. Acres per fire has steadily increased. The length of the fire season has also increased over time. Andvari then looked at data from California Dep't of Forestry and Fire Protection ("Cal Fire"), a state that has been plagued with costly fires in the last several years. Fire suppression expenditures in California have increased over a hundredfold in the last 40 years.
Small, But Critical Component
With the federal government regularly spending over $1.5 billion a year on suppressing fires, Fire Safety's retardant products are a small but critical component to these efforts. EverArc writes that fire retardant "consistently represents only approximately 2–3% of suppression costs in the US." This feature should allow the Fire Safety segment to operate with above average margins and a greater ability to raise prices.
Attractive Financials
Lo and behold, Perimeter indeed has extremely attractive financials. EBITDA margins are in the 40% range. Capital expenditures as a percent of revenue is ~2%. Even more interesting is EverArc's statement that Perimeter’s products enable value-based pricing. This means Perimeter can price its products based on the economic value it offers to the customer and not just the cost of the product. Nick Howley's TransDigm has expertly used value-based pricing as a way to continually raise prices on the thousands of different aerospace parts they sell to their customers.
Extensive Qualification of Products
Also similar to TransDigm, whose parts must undergo extensive testing and qualification by the Federal Aviation Administration, Perimeter's Fire Safety products must also undergo "extensive performance, safety and environmental testing." The Wildland Fire Chemicals Test Procedures section of the Forest Service website has a very long list of the tests that must be performed. Only after a fire chemical has successfully completed all the required tests will it gain listing on the Forest Service Qualified Products List (QPL). A chemical’s presence on the QPL is what allows federal agencies, states, and others to purchase it. This constitutes an effective barrier to entry for would-be competitors.
Sierra Hotshots Captain directing crew members during a burn operation near Jerseydale; Ferguson Fire, Sierra Nat’l Forest, CA, 2018. (Forest Service Photo by Kari Greer)
Potential for Consolidation?
Andvari does not have a great sense if there is an opportunity to consolidate parts of the fire suppression industry. Whether the industry is fragmented is a question a potential investor will have to answer through their own efforts. However, a good place to start would be looking at the QPLs of the Forest Service.
On the other hand, the QPLs for Class A Foams and Water Enhancers have a longer list of products that compete with Perimeter's products. There might be consolidation opportunities in these two categories. There might also be opportunities for Perimeter to acquire makers of equipment used to store, transport, and disperse firefighting foams.
Andvari Takeaway
Perimeter checks off many boxes in terms of business quality. Its products are small, yet critical parts to the end product or service. It has secular growth winds at its back. The financials of the business are excellent. Finally, we believe Co-Chairmen Howley and Thorndike will be excellent stewards of capital. Whenever Perimeter becomes publicly listed in the U.S., Andvari believes it is a company worthy of addition to any investor’s watch list.
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IMPORTANT DISCLOSURE AND DISCLAIMERS
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. Andvari clients do not have currently have positions in EverArc Holdings or Perimeter Solutions. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results. Full Disclaimer.
For the first half of 2021 Andvari is up 2.9% net of fees while the S&P 500 is up 15.3%.[i] Andvari clients, please refer to your reports for your specific performance figures. The table below shows Andvari’s composite performance against two benchmarks while the chart shows the cumulative gains of $100,000 investments.
ANDVARI HOLDINGS
Andvari's largest positions continued to lag the market and remain a drag on performance year to date. The holdings that worked well in 2020 are not working as well so far in 2021. However, just because a company's share price has declined does not mean that the value of its business has also declined. We are extremely bullish on the long-term prospects for our holdings that have lagged the market this year.
LATENT VALUE
Andvari's second largest holding has now lagged the market over the last twelve months and over the last three years. Still, we remain confident there is tremendous potential for the company and its shareholders. There is enormous latent value that has yet to surface.
This is a company with a market cap of $1.4 billion, revenues approaching $150 million, and over $250 million of cash on its balance sheet. Importantly, over the last several years this company has upgraded the quality of its management team and its board of directors. The management team now includes a handful of former Danaher employees. The new directors on the board have experience leading business units with billions of revenues.
It is hard to overstate the significance that the managers of our company have Danaher on their résumés. Danaher is a company that has built enormous wealth for its shareholders over the last 37 years. From 1995 to 2020, Danaher shareholders enjoyed a total cumulative return of 7,801% versus 880% for the S&P 500 index. Danaher did this by using its cashflows to acquire dozens of companies and instituting a culture of continuous improvement.
Knowing what Danaher was able to achieve gives us confidence in the latent value of our investment. It took Danaher eight years (12/31/85 to 12/31/93) to grow revenues from $100 million to $1 billion. During this phase of Danaher's growth, their shareholders vastly outperformed the market. Although nothing is certain, the odds are skewed in our favor that our holding, run by former Danaher managers, can grow quickly over the next decade and deliver outstanding returns to shareholders in the process.
LAUNCHING ANDVARI PARTNERS LP
After starting Andvari in 2011 with just $3.5M of "friends and family" money, it is a pleasure to share some exciting news. Andvari’s first investment fund, Andvari Partners LP, has been launched.
The philosophy underpinning the fund strategy is identical to Andvari's existing approach. We intend to invest in nearly all the same names we currently own. Just fewer of them. Owning fewer names and managing fewer separate accounts is something we have long sought. Our progression towards fewer names has been careful and measured given the significant retirement assets we manage.
We strive to invest in the way we think will lead to the best, long-term outcome. High concentration mixed with our qualitatively-driven selection process and our long holding periods is how we get there. The new structure gives us the increased freedom to make that happen. For more information on Andvari Partners LP, please contact us (info@andvariassociates.com).
ANDVARI TAKEAWAY
Andvari remains steadfast in our investment approach and philosophy. We wrote last quarter about continually looking to be invested in fewer and better companies. These are companies that can compound our wealth at above average rates for decades rather than several years. When the market ignores the latent value of one of our holdings for too long, we usually view this as an opportunity to add to that holding.
This is exactly what we have done over the last six months. We have added to this already sizeable holding. With the effects of the COVID global pandemic subsiding, our holding will find it easier to do business and close new sales. We also expect our holding to put its cash pile to work by announcing a large acquisition in the next 6–12 months. These both will be catalysts for future increases in its share price and the intrinsic value of the business.
As always, I love to hear from clients and interested parties about anything on your mind. Please contact me with your thoughts, comments, or questions.
Sincerely,
Douglas E. Ott, II
DISCLOSURES AND END NOTES
[i] Andvari performance represents actual trading performance of all, actual clients beginning on 4/12/13. Performance from 12/31/12 to 4/12/13 is actual performance of proprietary accounts, namely the accounts of Andvari’s principal, Douglas Ott. Andvari believes including Ott’s performance figures for the first 4 months and 12 days of 2013 is fair as he managed those accounts similarly to Andvari’s first clients. All performance, including the initial proprietary period, are net of management fees (assumed to be 1.25% per annum, paid quarterly, as currently advertised), net of brokerage commissions and expenses, time-weighted, and includes all cash and other securities. Performance includes realized and unrealized returns and excludes the effects of taxes on incurred gains or losses. Andvari does not certify the accuracy of these numbers. Performance data quoted represents past performance and does not guarantee future results.
The indexes are listed as benchmarks and are total return figures and assumes dividends are reinvested. The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. The Russell 2000 Index is an index of 2,000 U.S. small-cap stocks. It is not possible to invest directly in an index. Because Andvari client portfolios are non-diversified, the performance of each holding will have a greater impact on results and may make them more volatile than a more diversified index. Andvari also engages or may engage in strategies not employed by the S&P 500 or the Russell 2000 including, without limitation, the use of leverage.
One may request a list of all securities mentioned or recommended for the preceding year as of the date of this letter. You may contact Andvari using the information below. Actual client results may differ from results depicted in this letter. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the loss of principal.
The discussion of Andvari’s investments and investment strategy (including, but not limited to, current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) represents the views and opinions of Andvari’s portfolio managers and Andvari Associates LLC, the investment adviser, at the time of this report, and can change without notice.
This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the affiliates of Andvari.
The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. Any or all of Andvari’s forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties, and other factors, most of which are beyond Andvari’s control. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision.
To understand the possibilities for new, emerging serial acquirers, Andvari has studied the financial history of the great serial acquirers. The greats are companies like Danaher, Roper, HEICO, and Constellation Software, all of which have acquired dozens of companies over the decades.
In our small sample size, we focused on how quickly these serial acquirers have been able to grow their revenues. In nearly every case, and in spite of the risks involved with M&A transactions, Andvari found that these companies outperformed the market for each period of their revenue growth.
QUANTIFYING PERIODS OF OUTPERFORMANCE
Our basic question is how quickly have the great serial acquirers grown from $100 million in revenues to $500 million? From $500 million to $1 billion? Below is a table of Andvari’s findings. We chose the first fiscal year end during which a company achieved a particular revenue number as the start or end date as the case may be.
WHAT IS BASELINE GREATNESS?
The findings are instructive as to what is possible. By knowing what is possible, it will be less likely for Andvari to dismiss an emerging serial acquirer on concerns the current valuation multiple might be way too high.
For example, Danaher took just 2 years to go from 100 million to 500 million in revenues while it took 6–8 years for most of the others. For the longer term view of growing revenues from 100 million to 2 billion, Danaher, Constellation, and Open Text achieved this feat in 11–12 years. Other companies in our list took (or will take) 20 years or more to go from 100 million to 2 billion.
With a baseline for what is possible for revenue growth, how did shareholders of these companies fare? Any management team can grow their company via acquisitions, but it’s a special management team that doesn’t destroy value along the way in this process. Below we see the returns of each of these well-managed companies compared to the S&P 500 during each phase of their revenue growth.
With few exceptions, shareholders of these serial acquirer companies outperformed the market in all revenue growth phases. The companies that underperformed the market all shared one trait: proximity to the dot com bubble.
Roper underperformed in their 100 to 500 million phase. This was from 1993 to 2000.
Ametek underperformed in their 500 million to 1 billion phase. This was from 1984 to 2000.
Open Text underperformed in their 100 million to 500 million phase. This was from 2000 to 2007.
Watsco underperformed when they grew revenues from 500 million to 1 billion in less than 2 years from 1997 to 1998.
ANDVARI TAKEAWAY
In Andvari’s ongoing quest to outperform the market over the long term, we are always on the hunt for small and mid-sized companies that can become the next great serial acquirer.
Occasionally, Andvari might find a company we believe to be a nascent serial acquirer and also looks very expensive. Having studied the history of older serial acquirers, we appreciate that growth can come much more quickly than anyone can imagine. We also understand the historical returns shareholders have achieved with these types of companies.
Armed with an understanding of the range of outcomes a serial acquirer can achieve, Andvari hopes to never immediately dismiss such a company based purely on traditional valuation metrics. The potential returns are hard to ignore.
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IMPORTANT DISCLOSURE AND DISCLAIMERS
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. Andvari clients currently have positions in HEICO and Constellation Software. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results. Full Disclaimer.
The picks-and-shovels investing theme is a favorite of Andvari’s. The theme takes its name from the California Gold Rush. Prospectors were not guaranteed to find gold but the people selling the picks and shovels earned a good living. Suppliers of goods and services that are essential to the creation of another finished product are fertile grounds for prospective investments. MSA Safety is one company that fits the picks-and-shovels theme—and several others—and has turned into a 100-bagger over the last 33 years.
Originally named Mine Safety Appliances, the company was formed in 1914 after a spate of terrible coal mine explosions. Dozens or even hundreds of miners died in these tragic accidents when an open flame lamp ignited methane gas or coal dust. The Monongah Coal mine was the site of the largest coal mine disaster in U.S. history in 1907 with 362 deaths. Thus, MSA enlisted Thomas Edison to help create an electric cap lamp to replace the open flame lamps used in mines. Over the next 25 years, MSA’s lamps helped reduce mine explosions by 75%.
LIFE SAVING, MISSION CRITICAL PRODUCTS
Although not literally selling picks and shovels, the MSA product range includes breathing apparatus products, fixed gas and flame detection instruments, portable gas detection instruments, and firefighter helmets and apparel. These products are all essential to the safety of miners and others working in hazardous environments. Also, these products are often mandated by government and industry regulations. The life saving, mission critical qualities of MSA's products enables high margins and affords them the ability to more easily raise prices.
EXEMPLARY FINANCIALS
MSA’s financials are quite good despite them being a manufacturer of physical products. This is because MSA’s products are: (1) essential to safety; (2) are highly-engineered; (3) are mandated by regulations; and (4) are a small part of the total costs borne by the end users. MSA’s revenues are also more stable compared to the industries to which they sell.
LEADING MARKET POSITIONS AND VALUE-CREATING M&A
There are two other factors contributing to MSA’s success. One is that most of their products occupy the #1 position in their categories. Having the best brands allows MSA to charge more and raise prices more easily. The other factor is MSA’s excellent track record of value-creating acquisitions. Although not quite a serial acquirer like Constellation Software or Halma, from 2010 through 2020 MSA has acquired 5 companies for a total consideration of $716 million. It’s acquisition program has succeeded because MSA has stayed inside its circle of competence. They’ve only acquired manufacturers of mission critical products that help protect the lives of people working in dangerous environments.
ANDVARI TAKEAWAY
Although MSA does sell to cyclical industries Andvari categorically dislikes—mining and oil and gas, for example—it would be wrong to totally dismiss MSA as a potential investment. It has many attractive qualities that we look for. It’s products are highly engineered, have leading positions in highly regulated markets, and are non-discretionary purchases that protect the lives of people. Whether it's miners, firefighters, or chemical plant employees, none of them can do their jobs without products from MSA. This all adds up to a company whose shareholders have enjoyed a 100-fold return since 1988.
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. In the instance of MSA Safety, Andvari and its clients have never owned shares prior to publication of this educational blog. Andvari may re-evaluate its holdings in any mentioned securities and may buy, sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results. Full Disclaimer.
McCormick, the seasoning and spice company, is an outstanding business with several of the qualitative traits we seek. Spices are a small, but essential part of end products that consumers often grow to love. It has dominant positions in its markets and its CEO is highly aligned with shareholders. The combination of these traits have enabled McCormick shareholders to outperform the S&P 500 over the long term.
SMALL AND ESSENTIAL
According to McCormick, spices are typically 10% or less of the cost of a meal, yet provide 90% of the flavor and satisfaction. Andvari has written about this concept before in “Robertet Groupe: Accounting for Good Taste”. Being a small part of the total cost while also being an essential component gives a company pricing power. This allows the company to more easily raise prices over time, an especially important quality in times of inflation.
MARKET DOMINANCE
Further, the majority of their products and brands are #1 in their respective categories. Market dominance generally leads to higher margins and more stable revenues due to less intense competition. Andvari likes to see this in all companies.
Dominance of McCormick’s type can often come with the price of increased scrutiny from the Federal Trade Commission (FTC). This can be both a good and bad thing. Good because it’s a high-value indicator of a company’s strength but bad because the company may be forced to divest assets to restore market competition (see “The Fertile Ground of Forced Divestitures”).
RELIABLE SIGNALS OF STRENGTH
In the case of McCormick’s proposed $605 million acquisition of Lawry’s and Adolph’s consumer brands in 2007, the FTC alleged McCormick would control 80% of the $100 million U.S. market for branded seasoned salt. To complete the deal, McCormick had to (1) sell it’s Season-All business to Morton and (2) abstain from acquiring another seasoned salt brand for 10 years. Despite the divestiture and 10-year ban, McCormick’s share price continued to produce savoury returns with its consumer segment leading the charge.
VALUE-CREATIVE M&A IN A HIGHLY FRAGMENTED MARKET
McCormick has created value through an effective M&A program. It has acquired dozens of brands and products in the flavors, spices, and condiment categories. It has stuck to acquiring businesses it knows well, one of the key reasons why it's M&A efforts have succeeded (see “M&A Wisdom from the U.K.”).
Despite a robust M&A program, McCormick still only has a 20% market share. A highly fragmented market like this gives a company a very long runway for both organic and inorganic growth. As of 2017, the company’s SVP of Corporate Strategy & Development said they had a list of 1,000 assets it could potentially acquire under the right conditions. Significant opportunities for growth reinvestment are two other qualitative factors Andvari likes to see.
ALIGNED CEO
Finally, McCormick’s current CEO is Lawrence Kurzius. He was CEO and President of Zatarain’s for 12 years when McCormick bought the company in 2003. Since then, Kurzius steadily acquired and retained McCormick shares as he climbed through the ranks of leadership.
In 2016 Kurzius took over as CEO of the entire company and now owns 5.8% of McCormick’s voting class of shares. These shares are worth roughly $100 million. Kurzius has skin in the game, has an excellent track record, and it's highly likely he will continue to maximize his and shareholders’ wealth over the long run.
ANDVARI TAKEAWAY
Whether a company sells spices, software, or rents out space on cell towers, Andvari always seeks out the qualitative factors that increase the likelihood of earning above-average returns over the long run. We like to see a company selling a highly valuable product that’s just a small part of the customer’s total cost. We like market dominance, value-creating M&A, and consolidation of fragmented markets. We like highly aligned CEOs. In the case of McCormick, the returns to shareholders from this recipe have been extremely satisfying.
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IMPORTANT DISCLOSURE AND DISCLAIMERS
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. Andvari may re-evaluate its holdings in such positions and sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results. Full Disclaimer.
In his speech, Barber described the reasons behind the success of Halma. Although there are several, Andvari focuses on the criteria Halma used in its highly effective M&A program. When nearly everyone agrees most acquisitions destroy value, we can learn much by studying a company with a track record of creating value through M&A (see our prior post, “The ‘Permanent Home’ Advantage”, on the same topic).
Barber’s guidance can be boiled down to four, key recommendations:
#1: USE INTERNALLY GENERATED FUNDS
Barber says the first factor that will improve the odds of an acquisition creating value is whether one funds the deal with surplus cash or by issuing shares. The idea here is if the acquired company was purchased at a fair price and performs well, the value creation will be greater if shareholders weren’t diluted in the process. Simple and logical.
#2: FIND A REPLICA
Next is whether the acquisition target is a “replica” of one already owned by the purchaser. Anyone selling a business likely has more information than the buyer. The owner also wouldn’t be selling unless they thought they could get the better end of the deal. Thus, to reduce the risk stemming from a disparity in information, the buyer should be as much or even more of an expert in the field of the seller. The buyer of businesses should therefore be looking to purchase other businesses that are replicas of the ones they already own.
#3: PURSUE BOLT-ONS
The third way to reduce M&A risk is by seeking to acquire “bolt-ons”. Barber defines a bolt-on company as one that “when purchased can then be readily integrated into an existing Group company.” This necessarily means the target will be of a smaller size, which also usually means lower complexity, both of which increase the odds of generating value.
#4: DO NOT SACRIFICE EARNINGS QUALITY
The last predictor of value creating M&A is if the acquired company will improve the quantity and quality of earnings. From Barber’s perspective, “quality of earnings is paramount” and “you can never pay enough for a good acquisition and never pay too little for a bad one.”
ANDVARI TAKEAWAY
Thanks to the combination of sensible M&A criteria and a focus on quality, niche businesses with high returns on capital, Halma provided extraordinary returns to its shareholders. Furthermore, thanks to Barber cementing the strategy and culture into the business, shareholders have enjoyed great results even after his retirement in 2003.
A great deal of M&A is value destructive, but not always. Companies with excellent management and sensible M&A programs have beaten the odds. HEICO, Constellation Software, Roper, Danaher, Ametek, Teledyne, and Waste Connections are just a few examples of other companies that have similarly successful M&A programs. High-performing, serial acquirers that can compound returns for decades are exactly the sort of companies for which Andvari is continually on the hunt.
Investment strategies managed by Andvari Associates LLC ("Andvari") may have a position in the securities or assets discussed in this article. Andvari may re-evaluate its holdings in such positions and sell or cover certain positions without notice.
This document and the information contained herein are for educational and informational purposes only and do not constitute, and should not be construed as, an offer to sell, or a solicitation of an offer to buy, any securities or related financial instruments. This document contains information and views as of the date indicated and such information and views are subject to change without notice. Andvari has no duty or obligation to update the information contained herein. Past investment performance is not an indication of future results. Full Disclaimer.
For the first quarter of 2021 Andvari is down 5.2% net of fees while the S&P 500 is up 6.2%.[i] Andvari clients, please refer to your reports for your specific performance figures. The table below shows Andvari’s composite performance against two benchmarks while the chart shows the cumulative gains of $100,000 investments.
Compounding capital at high rates—especially in a taxable account—is a challenge with smaller turnaround investments. If and when the turnaround succeeds, the investor must sell their position and look for the next opportunity. Capital gains will be realized and the next opportunity might not even be immediately available, both of which reduce long-term performance.
We maintain that companies who engage with their shareholders in unique ways likely do so because there is something special about the company, its leadership, or both. This week we extend the theme by looking at a few companies that have taken relevant inspiration from Berkshire Hathaway.
To achieve results different than the average, one must actually do something different. One underappreciated way in which companies may differentiate themselves from their peers is in their approach to communicating with shareholders. The way a company tells its story might just be a sign that something special is going on.
AMT’s business model is one of the most competitively advantaged among publicly traded companies. The company has multiple characteristics, a number of which we have highlighted in past research reports, that make it a high quality and extremely valuable business.
Assessing management’s skill and integrity is a process that defies quantification. We have invested hundreds of hours reviewing proxy statements over the years. Many capable investors can and do get it wrong (we are guilty as charged). Our experience tells us the best protection from a poor management team is to ensure their compensation incentives are aligned to produce good results for shareholders.
With Robertet, we see a company run by owner-operators, that has pricing power, is a provider of “picks and shovels” to its customers, and that has annuity-like revenue streams. Companies that embody multiple investment frameworks like Robertet are always on our radar as potential, long-term investments.
For the full year of 2020 Andvari is up 31.1% net of fees while the S&P 500 is up 18.4%.[i] We are proud to finish another year of composite outperformance against the market. The numbers also do not tell the full story. Andvari manages separate accounts for individuals and institutions with diverse needs. Many clients require fixed income exposure and less concentration relative to other accounts Andvari manages. These factors all impact the firm’s aggregate performance.
Websites that have taken the place of classified newspaper ads can earn extraordinary EBITDA margins of 50% to 70%. Think of eBay (used items), StubHub (market for ticket exchange and resale), or Apartments.com (property listings for renters). Each platform's ability to generate extraordinary profitability, however, depends strongly on the level of market share it has relative to its next closest competitor.
The article which follows is a high-level summary of a deep dive we recently initiated into the history of the desktop publishing software market from its founding in 1984 until the 2000s. These are the software programs used to edit graphics and to lay out pages for documents ranging from brochures to newsletters to magazines. We work through the enduring lessons highlighted below, which are still applicable to investing today and to all businesses. But we certainly encourage our readers to 'go deeper' via our PDF if they are so inclined.
SS&C checks off many of the qualitative boxes on Andvari’s list. Bill Stone, the founder, is still running the business after more than 30 years. He still owns 13.3% of SS&C which now has a market cap of $16.5 billion. He has an extraordinary track record of capital allocation (including demonstrating talent as a serial acquirer, which we value). He is an intense operator and has created a culture that retains and attracts highly motivated people.
If Warren Buffett was 30 years old, all he’d be doing is buying software businesses. They have every attribute of a business he loves. They have incredible moats around them. You can raise prices every year. Your customers don’t leave. You can deliver value and that value is paid for and expected to be paid for.
For the first nine months of 2020, Andvari is up 13.0% net of fees while the S&P 500 is up 5.6% (see Disclaimers at bottom). The table below shows Andvari’s performance against two benchmarks while the chart shows the cumulative gains of $100,000 investments.
The servant leadership culture at Waste Connections (WCN) is a compelling case study for its effectiveness in empowering employees. This concept also allowed WCN to continue its rapid growth via consolidation of the solid waste industry. WCN shareholders since 2004 have enjoyed 10-bagger returns.
Investors may not remember Larry Bossidy, but he is one of the great business leaders of the 20th century. Bossidy worked at General Electric for over three decades where he ultimately became Vice-Chairman. He left GE in 1991 to become CEO of Allied Signal, a manufacturer that badly needed help. His story offers tangible evidence on the power of building strong internal culture, which is a practice we value at Andvari.
Tyler Technologies possesses many qualities that make for a high quality business. The first (and often loudest) criticism we hear about Tyler is related to Valuation. We agree it does have optically high valuation multiples based on current financials. There is also a narrow gap between Andvari’s estimate of fair value and market value. However, these facts mask the opportunity to earn good returns by investing in Tyler. At Andvari, we frequently emphasize that ‘expensive-looking’ stocks aren’t necessarily bad investment opportunities. This is often a function of one’s investment horizon, which, for us, is indisputably long.
Investors might think the purpose of a company is to continually maximize profits, but the process of deliberately lowering short-term profits to invest in a brand can sometimes create enormous value over a longer period of time. This “capacity to suffer” (a phrase I borrow from Tom Russo) during a period of heavy investment is also a sign of a differentiated management team, something Andvari is always eager to discover.
Large, growing markets present obvious appeal to business leaders and investors, but the pursuit of these shiny objects can be fraught with risks of lost time and money. The scenario reminds us what specific behaviors we value in our executives.
Within all industries there is the opportunity for companies to acquire their competitors or other companies in related markets. Some may naturally be better at it than others. Andvari acknowledges that M&A is unlikely to add value, yet we hesitate to say “all M&A” is bad. If a management team has the skills and track record of creating value through M&A, it’s a rare thing worthy of attention. Enter Constellation Software (CSU:CN), a brilliant example of a company that has become the acquirer of choice for owners and founders of software businesses.
For the first half of 2020, Andvari as a whole is up 4.2% net of fees while the S&P 500 is down 3.1%. Andvari clients, please refer to your upcoming reports for your specific performance.
Within a single FTC-forced divestiture, there’s potential to examine not one, but two investment opportunities. One is the company that must sell. If it was dominant enough to merit an FTC action, it's likely to remain the dominant one in its market post-divestiture. The other is the acquiring company because it might be picking up a high-quality asset at a cheap price. The forced nature of the sale is likely to make the price cheaper than it might be in market-driven environments (and, in reality, these types of assets would not come up for sale otherwise). In both cases, the forced divestiture can be fertile ground for finding excellent businesses.
Let’s imagine a contest between a relatively obscure company founded in 1969 and Google, both battling for supremacy in providing digital mapping services and software to enterprises. Google has the benefit of hundreds of billions in revenues and the ability to hire the best engineers in the world while the older company has zero recognition outside its industry and a fraction of the earnings power. Who wins and why?
