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Breaking the mould

Todd Wenning highlights how businesses that think differently can turn into highly profitable opportunities
April 25, 2019

Sorting is one of the first things we teach children – put the green colours together, the circle shapes together, and so on. Comparing objects with similar and dissimilar characteristics is a foundational life skill. Classification helps us to quickly organise information, understand complex systems and make decisions.

Naturally, classification is also prevalent in the investment industry. Indeed, a paper by Blue Mountain Capital Management’s Michael Mauboussin explored how the investment world makes comparisons. More specifically, Mr Mauboussin shows how professional analysts and investors do a poor job comparing companies. He concludes that: “Comparing, essential to effective decision-making, comes naturally to humans. But our basic approach of relying on analogy can limit our ability to compare effectively. In particular, we fail to incorporate sufficient breadth and depth into our comparisons, and we can be easily swayed by the presentation of information or the allocation of our attention.”

Why might this be? Let’s consider how the industry is set up. Fund managers often employ in-house ‘buy-side’ analysts who cover entire sectors (eg, healthcare) and outsource third-party ‘sell-side’ analysts who cover specific sub-sectors (eg medical devices). The buy-side analyst provides breadth of research while the sell-side analyst provides depth.

Organising research in this way usually makes sense. Companies in a given sector or sub-sector typically have common characteristics: operating metrics, macroeconomic sensitivity, valuation ratios, and so on. Accordingly, most sell-side analysts’ price targets are determined by a comparison of price/earnings (PE) ratios or a regression analysis of two metrics for all the companies in the sector.

This valuation approach, called relative valuation, is not valuation at all. It’s instead a pricing of the security. Put another way, they’re saying: ‘Here’s what we think the market is willing to pay’ rather than ‘here’s what the company is truly worth’. This may sound subtle, but it’s a critical difference. New York University professor Aswath Damodaran estimates that almost 85 per cent of equity research reports are based on relative valuation and that “rules of thumb based on multiples are not only common but are often the basis for final valuation judgements”.

There’s nothing inherently wrong with relative valuation and it can be useful as a data point for consideration. And it’s great for the analyst because, by definition, there’s always something that’s relatively attractive to recommend as a buy or sell.

 

 

However, sloppy relative valuation – and by extension poor classification – done by sector specialists, can create buying opportunities in ‘idiosyncratic’ companies. Idiosyncratic companies are those that do not fit the mould, so to speak. Here are five common traits of idiosyncratic companies:

  • They are playing a different game to their peers. Idiosyncratic companies often measure success differently from competitors or take a different path to the mountaintop.
  • They trade at much higher multiples than their peers. A high valuation itself is not indicative of a special company, but idiosyncratic companies often appear expensive. You’ll often hear analysts and investors saying they cannot understand how the company continues to outperform while trading with high multiples relative to their (likely misclassified) peer group.
  • They straddle two or more industries. Idiosyncratic companies are often a combination of multiple industries, such as technology and finance, which makes it challenging for specialists to cover the company properly.
  • They have high returns on invested capital (ROIC) or returns on equity (ROE). By playing a different game and dominating a niche, idiosyncratic companies enjoy less direct competition and therefore generate superior ROIC or ROE.
  • They are slowly but surely taking market share. They address an important customer need that incumbents have failed to satisfy. Incumbents are often legacy businesses that can be culturally unwilling or unable to make the necessary changes.

Idiosyncratic companies have unique fundamental characteristics and do not compare well with their assigned peers. In fruit terms, they are tangerines among oranges – both from the citrus family, but different species. 

Consider that when Amazon (US:AMZN) went public in 1997, it was assigned to analysts following bricks-and-mortar booksellers such as Barnes & Noble and the now-defunct Borders. Even if we try to set aside what we know happened in the subsequent 22 years, reading through the 1997 annual reports of Barnes & Noble and Amazon shows these were companies with different strategies and business models. The former used bricks, the latter used clicks. Barnes & Noble was laser-focused on selling books; Amazon saw books as just the first of many products to be sold online.

Might a technology-focused analyst have been a better assignment to cover Amazon in 1997? Perhaps, but there were also retail factors beyond a tech analyst’s expertise. There were no good industry comparables for Amazon in 1997, and you could even argue the same holds true today. Amazon is still considered a consumer discretionary company even though its cloud business, AWS, accounts for more than half of its operating profits.

 

 

Was using Barnes & Noble’s PE ratio a good comparison for Amazon? Of course not. Ultimately, a business’s intrinsic value is determined by its ability to generate distributable cash flow over time. But this is frequently ignored by analysts who prefer using rules of thumb and quick solutions.

For example, you’ll often read something like this in a broker report on an idiosyncratic company’s stock: “The stock trades at a large PE premium to the industry. Even though the business is growing at a faster rate, we can’t justify the current stock price. Our rating is ‘hold’.”

Alarm bells should go off when you read something like this. That’s because any discussion of relative value that focuses on growth with no discussion of ROIC is based on a faulty premise.

Consider two companies, each growing at 10 per cent a year. Company A generates ROIC of 50 per cent while Competitor B has a 20 per cent ROIC. While both companies generate the same amount of growth, Company A only reinvests 20 per cent of its earnings to sustain its 10 per cent growth (50 per cent x 20 per cent = 10 per cent) while Company B reinvests half its earnings to grow 10 per cent (20 per cent x 50 per cent = 10 per cent). Company A keeps 80p of every £1 of earnings, while Company B keeps 50p. Company A should be 60 per cent more valuable, all else being equal. Yet analysts frequently home in on growth alone and overlook cash generation.

Because idiosyncratic companies often have high ROIC and are not good apples-to-apples comparisons with their peers, they are doubly confounding to analysts and investors alike. 

A good candidate for an idiosyncratic company in the UK market might be Fevertree Drinks (FEVR), which makes premium drink mixes. At first glance, Fevertree seems like an obvious match for other consumer staples companies, but it checks off most of our criteria.

  • Playing a different game to peers. Most fizzy drinks companies built their brands on consumers’ non-alcoholic consumption. If some consumers happened to use their product as an alcoholic drink mixer, that was just a bonus. From its start in 2004, however, Fevertree Drinks has focused specifically on crafting premium tonics and mixes designed for alcoholic beverages, where consumer preferences are decidedly different.
  • Trades at much higher multiples than peers. In recent years, Fevertree has traded with a PE ratio anywhere between 100 per cent and 200 per cent above the consumer staples industry average.
  • Straddles two or more industries. Fevertree shares characteristics with traditional fizzy drinks companies, but arguably alcoholic beverage companies, as well. As Fevertree likes to say: “If three-quarters of your drink is the mixer, mix with the best.” In other words, to the drinker, there’s a mutual relationship between the alcohol and the mix. One doesn’t taste right without the other.
  • High returns on invested capital or returns on equity. Among the 347 publicly-traded European and North American consumer staples companies (excluding tobacco) valued over $100m, Fevertree has one of the top five ROICs over the trailing 12 months (37.57 per cent, according to Bloomberg). Higher than Clorox, Hershey or Unilever.
  • Slowly but surely taking market share. In Fevertree’s latest investor presentation, the company shows how it has steadily taken market share from Schweppes in the mixer category. Since 2013, Schweppes has gone from about 50 per cent market share to 30 per cent, while Fevertree has gone from about 5 per cent to 42 per cent.

We can debate the sustainability of Fevertree’s success, but it is clearly doing something different and has been executing it for some time. As such, any comparison with other fizzy drink competitors that does not acknowledge this is missing something important.

Two holdings in our portfolio also illustrate the concept of idiosyncratic companies: Ferrari (IT:RACE) and First Republic Bank (US:FRC).

 

For companies such as Fevertree, Ferrari and First Republic Bank relative valuation against peers doesn’t make sense

Ferrari

When Ferrari went public in 2015, there was some debate about who its direct competitors were. Should it be compared with other auto companies such as Volkswagen (Ger:VOW) and Ford (US:F), or luxury goods companies such as Hermes (Fr:RMS) and LVMH (Fr:MC)?

Some research companies assigned the company to its autos or industrials analyst; others to their luxury goods or consumer analyst. A few research companies smartly had joint coverage with an auto and luxury goods analyst, but even then, those are completely different industries. Auto companies are capital intensive, cyclical and trade at discounts to the market, whereas luxury goods companies are capital light, more defensive and trade at premiums to the market. Which analyst will take the lead opinion?

These are exactly the type of debates we like to see, as they offer up potential mispricings of attractive idiosyncratic businesses.

We believe that Ferrari should be primarily viewed as a luxury product. Its cars are anything but practical. They are instead a Veblen good – a status symbol for an ultra-minority of individuals who can both afford $250,000-plus cars and appreciate the craftsmanship, the passion for racing, and the unique experience offered by a Ferrari supercar. Like other luxury companies, Ferrari intentionally undersupplies the market to create scarcity. The newest models and supercars, which carry price tags above $1m, are reserved for Ferrari’s best customers and by invitation only. Indeed, we think Ferrari ownership enables ambitious individuals to join an exclusive club of sorts that can lead to valuable business connections. Those with privileged access to new Ferraris also know that, given the scarcity and high demand, their car is immediately worth more in the secondary market.

These dynamics are simply not present at most car companies. Ford makes a fine car, but Ford owners aren’t flying across the world to test drive the latest Focus on a track outside Detroit.

Still, Ferrari ultimately makes cars and is therefore not immune to factors that impact the larger auto industry. Factors such as emissions regulations, electric-hybrid alternatives and the long-term threat of autonomous vehicles don’t impact other luxury goods such as handbags and couture. 

Because Ferrari makes a unique luxury product and is neither a traditional auto nor traditional luxury good, we do not believe relative valuation against either peer group makes sense. It is a prime example of an idiosyncratic business that the market will frequently misprice.

 

First Republic Bank

A unique feature of the US banking industry is the sheer number of banks and credit unions out there. While the four largest banks – Wells Fargo, JPMorgan Chase, Citigroup and Bank of America – dominate the national market, there are about 5,000 regional and local banks scattered across the 50 states, in addition to another 5,000 or so credit unions.

Consequently, banking in the US is commoditised – a deposit or loan relationship at one bank is like the others. This makes relative valuation a fair way to assess value among regional banks, as it’s as close to an apples-with-apples comparison as you’ll find. Most banking analysts regress a bank’s ROE against its price-to-book ratio to determine if it’s relatively over- or undervalued. And because US banking is so competitive, returns on equity hover around the cost of equity, producing a typical price-to-book ratio around one.

California-based First Republic Bank, however, currently trades with a price-to-book ratio over two times – a major premium. So, what’s going on?

First Republic is best thought of as a high-end retail/banking hybrid. To illustrate, its net promoter score – a measure of customer satisfaction – is more than double the US banking average and is on par with Ritz Carlton and Amazon. Fully half of its growth comes from existing customer referrals.

What First Republic’s targeted high-net-worth customers really need is time. The last thing a busy person wants to do is spend an hour with multiple customer service representatives to fix a minor problem. At First Republic, you have one point of contact for holistic financial solutions: loans, deposits, wealth management, and trust services. Simple.

In addition to leading with customer service, First Republic is also a solid bank. Over the past 17 years, its net charge-offs (similar to bad debt, where the lender declares – usually after six months of non-payment of instalments – that a debt is unlikely to be paid back)averaged 0.07 per cent per year versus 0.42 per cent per year for the top 50 US banks. Since it was founded in 1985, First Republic has originated over $230bn of loans and its cumulative net losses on those loans were $333m – just 0.15 per cent of the total.

Analysts covering First Republic have struggled to properly assess its true value since it came back to the public market in 2011. Over that eight-year period, the majority of analyst ratings have been ‘hold’ despite the fact the stock has about quadrupled.

Here’s an example of what I mean. This is from a November 2011 report by a well-regarded research firm: “We are impressed by the uniqueness and simplicity of the First Republic business model. Its focus on customer service goes above and beyond that offered by any other bank… What holds us back from taking a more constructive view is relative valuation.”

In other words, the analyst recognised First Republic’s unique franchise, but still valued First Republic solely against other banks. When the report was released, First Republic traded around $26 (dividend adjusted). It recently traded near $103.

As with Ferrari, the banking regulations by which First Republic must abide will never make it entirely comparable with customer-friendly retail or hotel franchises. As such, comparing it with other high-quality banks is a reasonable data point, but it misses a crucial piece of First Republic’s value proposition.

 

Bottom line

Because analysts and investors have a natural tendency to classify – and subsequently cling to that classification – there’s a good chance that companies with idiosyncratic business models will be misunderstood and therefore mispriced. Having a more generalist approach to investing can make it easier to spot these opportunities produced by the tunnel vision and impatience of other market participants.

 

 

Todd Wenning, CFA, is a senior investment analyst at Ensemble Capital Management in the US. As of the date of publication, clients invested in Ensemble Capital Management’s core equity strategy own shares of Ferrari and First Republic Bank. These companies represent only a percentage of the full strategy. Mr Wenning’s family owns shares in Amazon.