Earlier this month, I made my third consecutive journey to Omaha, Nebraska to attend the Berkshire Hathaway annual meeting, hosted by legendary investors Warren Buffett and Charlie Munger. For six hours – at ages 86 and 93, respectively – Buffett and Munger accept and graciously answer questions lobbed at them by journalists, analysts and shareholders. It’s an incredible feat of endurance – even more so because they deliver doses of wisdom in their responses, all while munching on peanut brittle and sipping Cokes.
Once held in a tiny hotel conference room, the Berkshire meeting has become a spectacle with more than 30,000 attendees, souvenirs and overpriced arena food. Yet I’ve never regretted making the trip. Yes, you can now watch the meeting via webcast, but, as with a music concert, there’s something special about attending in person.
One of my biggest takeaways from this year’s meeting was Buffett’s emphasis on waiting patiently for the right pitch (ie investment opportunity) and then, when it arrives, being sure to swing hard.
“Great,” you might be thinking, “but how do we know a good pitch from a bad one?” There are two equally important factors to consider: the first is business quality; the second is valuation. The ideal “fat pitch” opportunity is a great company trading as if it wasn’t a great company, but these tend to be rare occurrences. More often than not, the market is aware of the best companies and they consequently trade at a premium.
The purpose of the Supersize series of articles has been to focus on the first part of the “fat pitch” equation – business quality. Over the past four years and five iterations, I’ve sifted through the thousands of smaller companies in the US, UK and Europe to identify a few that I believe to have durable competitive advantages. These advantages, often called “economic moats” – a term coined by Buffett to describe a company with a defensible business model – can be a sign of a truly excellent business.
Why do moats matter? In capitalism, high returns on invested capital (ROIC) attract competitors the way honey attracts flies. If a company doesn’t possess at least one of the following moat ‘sources’, it will have a hard time keeping competitors at bay, and robust margins and ROICs will erode.
■ Network effects. Facebook is a classic example of a network effect moat source. As the Facebook platform adds new participants, it attracts other participants, and consequently makes the platform more valuable. Further, the more posts you engage with, the better Facebook understands your likes and dislikes, which in turn helps it better understand which advertisements to send your way.
■ Intangible assets. This bucket includes patents (GlaxoSmithKline), brands (Unilever) and even strong customer relationships (BAE Systems). The key question to ask when evaluating an intangible asset moat is, ‘Does the patent/brand/relationship allow the company to charge higher prices than competing products?’ For instance, Ferrari can charge a huge mark-up on its supercars because of the luxury image and scarcity factor associated with the brand. Ford, on the other hand, cannot, even though it is also a globally recognised brand.
■ Low-cost advantage. Some companies can produce goods or provide services at a much lower cost than their competitors. When its peers are aware of this advantage and struggle to replicate it, that’s a good sign the company in question has a low-cost production moat. For a long time, Wal-Mart (Asda’s parent company) maintained a low-cost position compared with retail peers in the US and elsewhere due to efficient supply chain management and tight store expense controls. These systems allowed Wal-Mart to price products below its competitors and take market share while maintaining attractive returns on invested capital.
■ Switching costs. RELX Group is a great example of a company that delivers mission-critical products entrenched in its customers’ work flows. One of its products, LexisNexis, offers a massive research database widely used in the global legal and risk management industries. If a customer wanted to switch providers, it would cost a lot of time and money retraining employees on another database. Additionally, the cost of a LexisNexis subscription is usually small relative to the important role it plays at a firm. As such, RELX Group should be able to maintain pricing power on LexisNexis subscriptions year after year.
Of course, moats are just one part of quality analysis. We also want to look at factors such as management, financial health and cash flow consistency, but I believe that if you’ve figured out the moat, you’re more than halfway toward discovering a high-quality business. Here are three new US small-caps that I think fit the bill.
Primo Water (PRMW)
Share price: $11.14
Market cap: $321m
Dividend yield: na
Trailing PE: na
In March, consultancy Beverage Marketing reported that in 2016 Americans drank more bottled water than carbonated soft drinks for the first time on record. The shift appears to be more secular than cyclical, given increasing concern about the potential health impacts of sugary drinks. This trend has been a tailwind for non-carbonated beverages such as iced teas, juices and plain old water. Moreover, headlines about compromised water quality in some American cities – most notably Flint, Michigan – has led some to question the safety of their kitchen tap water.
These trends appear to be beneficial to Primo Water – the largest water dispensing and bulk water provider in the US.
Here’s how it works. Primo’s customers purchase a water dispenser, which varies in style and range from $9.99 to $279.99. With a dispenser fit snugly into the kitchen or pantry, customers then purchase water either through a refill station or jug exchange found at a local retailer such as Home Depot, Lowe’s or Wal-Mart. Following Primo’s acquisition last year of a major competitor (Glacier), its refill stations and exchanges are now in more than 46,000 retail locations across the US.
The Glacier deal may have widened Primo’s economic moat. First, the refilling stations and exchanges take up valuable space on retailer floors. As such, store owners aren’t likely to allow competitors to add new equipment. This makes it difficult for upstart water distributors to match Primo’s scale advantages, which are a significant barrier to entry. Second, because it’s not economical for customers to drive around town looking for water, they are more apt to choose the water supplier with the most convenient refill stations. This is favourable to Primo, which has the most locations of any water exchange company. Finally, the Glacier deal dramatically reduced its reliance on the three US retailers mentioned above, which together once accounted for more than 70 per cent of Primo’s refill and exchange locations. Post-Glacier, Home Depot (US:HD), Lowe's (US: LOW) and Wal-Mart (US:WMT) represent about 38 per cent of the footprint. The merger reduces these retailers’ bargaining power over Primo to cut prices for their customers.
Encouragingly, Primo’s management has plenty of experience with this razor-and-blade business model. Its founder, chairman and chief executive Billy Prim previously founded and subsequently sold Blue Rhino – a propane cylinder exchange business – to Ferrelgas in 2004. Primo’s chief finance officer held the same role at Blue Rhino before the sale, and other executives have experience at Redbox and Coinstar – a DVD exchange business and coin-to-cash converting kiosk, respectively. Insiders own about 18 per cent of the company, as well, which should align their interests with long-term investors.
Despite Primo’s strong advantages in the water exchange business, there are obvious substitutes, such as bottled water, at-home water filtration systems (pitchers, refrigerators etc), and plain tap water. On a per gallon basis and over time, Primo’s water is considerably cheaper (and possibly more environmentally friendly) than buying bottled water or expensive filters. The biggest hurdle from a consumer standpoint is hauling a heavy jug of water around the store and then driving it home. One risk is that Primo’s water offerings stay niche and never catch on in the mass market.
Still, Primo could become an attractive acquisition target for a large beverage company looking to expand its water offering and capitalise on Primo’s valuable dispensing network at retail locations.
Stock Yards Bancorp (SYBT)
Share price: $38.75
Market cap: $868m
Dividend yield: 2%
Trailing P/E: 21x
One of the unique aspects of the US market is that there are hundreds of publicly traded local and community banks to sort through. These banks serve a small region of the country and compete with national banks on customer service and local underwriting skill. Economic moats are typically non-existent in smaller banks, however, given that most banking products like checking (current) accounts and mortgages are commodities.
There are some exceptions, and Louisville, Kentucky-based Stock Yards Bancorp might be one of them. As its name implies, Stock Yards got its start serving the local livestock industry more than a century ago (I just love that fact – and even more so because they held on to the name through the years!).
In the past decade, Stock Yards gained traction outside of its core Louisville area market, expanding into the surrounding Cincinnati and Indianapolis markets. There are two good reasons for its success. First, national banks acquired a number of competing community banks during and after the financial crisis, leaving many of the acquired banks’ customers frustrated with the lack of attention they received from the bigger banks. Stock Yards benefitted by remaining a ‘local’ bank.
Second, during the financial crisis Stock Yards continued to lend to small- and medium-sized businesses, while the national banks went into hiding (remarkably, Stock Yards didn’t need to cut its dividend as many other banks did in 2008 and 2009). Stock Yards’ ability to lend in such adverse circumstances endeared them to local business leaders.
And it’s precisely those business leaders that Stock Yards wants to attract into its customer ‘funnel’. The logic goes that if Stock Yards can win over a small company’s banking services, the company’s executives are more likely to follow suit. Stock Yards has a full suite of products designed for these high-net-worth clients, including trust services and asset management. These offerings increase the ‘stickiness’ of client relationships. Put another way, clients aren’t likely to switch banks to get another 0.25 per cent on their savings account the way customers might at mass-market banks. The value they receive from Stock Yards’ services more than outweighs any benefits from changing banks.
Stock Yards is led by chairman and chief executive David Heintzman, who has been in his role since 2005 and with the bank since 1985. Chief financial officer Nancy Davis has been in her role since 1993. Both of them deserve a lot of credit for the bank’s 8.5 per cent book value per share growth rate over the past nine-and-a-half years. Insiders own about 14 per cent of the bank, as well, so they should be financially motivated to act like long-term owners of the business.
Stock Yards has a track record of strong loan underwriting quality, as evidenced by the bank’s resilience during the financial crisis. It is also well capitalised, with a Tier 1 capital ratio of 12.1 per cent. Conservatively managed, the bulk of Stock Yards growth has come from organic sources rather than from acquisitions. This is uncommon in the small bank arena. In fact, Stock Yards has only made two deals in the past 20 years. Indeed, one of the warning flags I have with Stock Yards is if it starts making aggressive acquisitions outside its core regions of Kentucky, Ohio and Indiana.
Overall, there seems to be adequate organic growth potential through expansion into the cities mentioned above. Local business owners in those towns should be thrilled to have a reliable, business-focused lender enter their markets.
Trupanion (TRUP)
Share price: $16.84
Market cap: $512m
Dividend yield: na
Trailing PE: na
According to the American Pet Products Association (APPA), Americans are expected to spend $69.3bn on their pets in 2017. Incredibly, this figure is more than double that of 2004.
There are myriad explanations offered for this pet spending surge. One is that millennials are deferring household formation (ie getting married, buying a house, having children) and thus have more discretionary income to spend on pets. But it’s not just a millennial trend – the baby boomer generation spent more on their pets in 2016 than all other generations combined. Whatever the reasons, the trend shows few signs of slowing.
The APPA survey also estimated that about $16bn of the $69.3bn total spending would go towards veterinary care. As we become increasingly attached to our pets, surgery, medicines and treatments for our furry friends have become far less discretionary than they once were. As baffling as the human healthcare industry is in the US, veterinary care is relatively straightforward. At present, insurance companies are not heavily involved. Indeed, only 1 per cent of American pet owners have pet insurance, compared with over 25 per cent in Europe.
Why hasn’t pet insurance caught on in America? Frankly, it’s because earlier forms of pet insurance here were terrible. It was expensive, didn’t cover much, and you risked being kicked off the policy if you did file a claim.
Thankfully, pet insurance has started to change for the better, as newer pet insurance companies like Trupanion have introduced simpler, more comprehensive policies for American pet owners. Given rising veterinary costs and the changing roles of pets within families, an increasing number of American employers are offering pet insurance as part of their employee benefits packages.
Although insurance is typically a commodity product, Trupanion separates itself from competitors in some meaningful ways.
First, Trupanion has aggressively pursued relationships with veterinarians alongside the obvious marketing toward consumers. Specifically, through its Express program, Trupanion allows veterinarians to process insurance claims immediately through its proprietary app. The process allows vets to get paid ahead of the procedure and the consumer doesn’t have to stress about coming up with what may be a large upfront payment. It’s a win-win situation for all parties as there’s no need to defer treatment for economic reasons. It also creates some switching costs at the vet office. As office staff get more accustomed to the Express system, they could be less inclined to take on additional insurance claim apps, as it would require extra training time and expense.
Next, Trupanion has been underwriting pet insurance since 2000 and has an extensive data set for dogs and cats of all ages and breeds, including veterinary costs by postal code. An insurance company starting from scratch would likely struggle to obtain similar data with which they could properly underwrite pet insurance. This advantage provides Trupanion with at least a few years’ head start on a brand new competitor.
Finally, Trupanion is led by its founder, Darryl Rawlings – a surfing serial entrepreneur, who was inspired to start Trupanion by a bad childhood memory of losing a beloved family dog for economic reasons. Today, Rawlings owns about 8 per cent of the company and writes some of the more transparent and engaging shareholder letters in the US market.
Trupanion has yet to turn a profit, as it’s heavily reinvesting in the business. The rapid reinvestment approach can make sense, however, if you’re trying to get well ahead of the new competition that will inevitably enter if and when pet insurance demand accelerates in the US. To its credit, Trupanion has generated positive free cash flow, although some investors may understandably balk at investing in an unprofitable company. Optimists in the business – myself included as a shareholder – might reframe it as a “moat in the making”.
Final thought
Please remember that before deciding to invest in any business – high quality or not – it’s important to determine whether or not you think the share presents an attractive value today. So as you evaluate the ideas presented in this series, be sure to do your valuation homework before considering an investment.
Todd Wenning, CFA is an equity analyst based in the United States. He owns shares of Berkshire Hathaway and Trupanion. His opinions stated here do not reflect those of his employer. A full disclaimer can be found at cleareyesinvesting.com
