Bonhoeffer Fund commentary for the first quarter ended March 31, 2020, provind a case study on Combined Motor Holdings Limited (JSE:CMH).

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Q1 2020 hedge fund letters, conferences and more

Dear Partner,

The Bonhoeffer Fund returned -33.7% net of fees in the first quarter of 2020, compared to -23.1% for the MSCI World ex-US, an international benchmark. As of March 31st, our securities have an average earnings/free cash flow yield of 26.5% and an average EV/EBITDA of 3.7. The MSCI World ex-US has an average earning yield of 7.9%. The difference between the portfolio’s market valuation and my estimate of intrinsic value is still large (greater than 100%). I remain confident that the gap will close over time and continue to monitor each holding accordingly. I am also expanding my toolbox of value investing tools to enhance fund performance which I look forward to detailing in this letter.

Bonhoeffer Fund Portfolio Overview

Bonhoeffer’s largest country exposures include: South Korea, Italy, South Africa, Hong Kong, United Kingdom, and Philippines. The largest industry exposures include: distribution, consumer products, telecom, and transaction processing.

Since my last letter, we have added to one position in the US pipeline space. Our two positions provide exposure to a recurring revenue stream from a large market (natural gas) that has been hurt by the current glut of oil where natural gas is a free byproduct of oil production. Given the current crash of oil prices, supply destruction is currently going on in the oil industry, thus pulling low-cost supply off the market. Many people have given up on the oil and gas market but the infrastructure will reflect its economic value once the market adjusts to new levels of supply and demand.

The portfolio’s investments in infrastructure are in a senior position with recurring revenue in a sector that is hurting. However, I anticipate a speedier recovery than many equity holders who may be wiped out with reorganization of many capital structures.

I remain excited about some firms we are investigating in Canada, Mexico, Georgia, South Korea, and South Africa and from a strategy perspective described below.

Risk vs. Uncertainty

The COVID-19 pandemic is an event which revealed that the world is more uncertain than we previously thought. This was the message from great investors like Warren Buffett, Howard Marks, and Sam Zell. Uncertainty does not necessarily mean values decline, but it does make the range of outcomes wider. Wider outcomes mean higher risk spreads for risky assets like stocks and real estate. This increase in uncertainty has been accompanied by lower interest rates and widespread credit availability (via the Federal Reserve and SBA programs) which should make the better outcomes worth more and buffet the effects of the downside liquidity scenarios.

I am of the opinion that this crisis should be analyzed in two phases—a financing panic followed by a fundamental reckoning. The financing crisis occurred in March and early April as some of the mortgage and high-yield financing markets froze. This was caused by some margin-call-induced selling amongst some of the mortgage REITs. The Fed stepped in and provided government, investment-grade, and previously investment-grade funding (exchanged cash for securities) to firms. This provided a put for these securities and facilitated the market opening for less-than-investment-grade firm borrowings.

The fundamental reckoning is beginning now. In this phase, a company-by-company “work out” of debt and equity financing needs will be occurring. At this point, prices reflect this, as firms directly or indirectly experience this supply and demand shock (airlines, travel, and restaurants) and are valued much lower than those not affected or whose position is enhanced due to this pandemic (software, internet, and staples). If you look at the various stock markets around the world, you can see this too. In emerging markets, you see markets with weak currencies (Brazil, Mexico, Russia, and South Africa) suffering both large equity and currency declines. Markets with strong currencies (South Korea, Hong Kong, Philippines, and Peru) are experiencing more modest equity declines. In my opinion, it is a time to sift through the firms and countries that have been hit hardest and see if their value is higher than the current market price if the optimistic scenario plays out since the downside is already reflected in most of their prices. In most cases, these are priced correctly but, in some cases, there are some hidden treasures. One example is auto dealerships. Both US and developed-market dealerships are trading at discounted prices. Comparatively, the market in China, which is further along the COVID-19 timeline, is booming higher than pre-COVID-19. Examples in our portfolio include Cambria Automobiles in the UK and Combined Motor Holdings in South Africa, as compared to China MeiDong in China.

As described by Howard Marks in a recent letter, confidence can be challenging in the face of uncertainty. We need to be open to changes in our mental models as new data arrives. As a result of the drastic changes and disruptions experienced in the first quarter, I offer my thoughts on some strategic framework models that I am incorporating into my thinking as I continue to analyze and manage the Bonhoeffer portfolio.

Value Investing and Strategic Framework Investing

Value investing is investing in securities that are trading for less than they are worth. It is interesting to examine the historical evolution in valuation techniques to estimate the fair value of firms at different stages of their life cycles (young growth, growth, mature, and declining).1 Valuation models have evolved over time from valuation multiples—which work well with mature companies (Graham)—to discounted cash flow models—which work better for growth companies (Buffett)—to distress-weighted models for declining businesses (Damodaran), and finally to strategy/business models—which focus on market size, growth (including network effects), customer lock-in, economies of scale, and probability of survival for young growth companies (venture capitalists).

Historically, value investing has been practiced by purchasing stocks with low valuation multiples compared to either similar firms or in relation to their expected growth rates or below their estimated value using DCF models. Business models in this context were used to identify similar firms or estimate future growth rates, along with determining the durability of the competitive advantage or “moat.” Many of the investors using these techniques (such as Buffett) would limit their exposure to mature or growth business where the comparable multiple or DCF techniques work best.

Another model to examine businesses is the 7 Powers model2. This model focuses on identifying the barriers to entry, scale, and adoption as important differentiators of whether firms will receive the benefit from a new business model or whether they will be arbitraged away by incumbents or competitors. Barriers to scale include scale economics, switching costs, and network economics. Barriers to entry include cornered resources (like drug patents), process power, and brands. Barriers to adoption include counter-positioning. Counter-positioning is when a new business model would be detrimental to a business’ current business model and thus is not adopted by the existing business. An example is digital photography technology and Kodak, who at the time of the innovation was the largest and most profitable chemical photography firm.

With the introduction of disruptive internet capital-light models by young growth companies, current profitability (under the assumption of the presence of either large unreproducible investment or network effects) has been less important than future profitability supported by a business model that can generate strong customer growth, recurring revenue with small amounts of customer attrition due to customer lock-in and/or creating network effects. The key parameters for this model are the lifetime value (LTV) of a customer and customer churn and customer acquisition costs (CAC).

The increase in CAC over time for new entrants versus existing firms can create a scale moat for the first company to scale. If scaling happens quickly, then incumbents do not have the time to react to the threat. Thus, there is a requirement for rapid investment, and even more so if the firm is not profitable. The lack of time, the increased supply of “free” content, and relatively expensive way to deliver similar content is why the internet has destroyed the newspaper business and cash flows. If firms have time and can reduce the cost structure of their business models (via economies of scale), then they can adopt the innovation and have a fighting chance, like what is happening in the TV business currently.

One issue with these new business models in a good number of situations is the LTV, customer churn, and CAC parameters can be challenging to estimate. Some of the business models are dependent upon outside financing when they are in the growth phase of development, especially if they are ramping up customer acquisition faster than their current cash flow can support.; the assumption being that the customer lock-in will reduce CAC versus competitors and thus recurring revenues can be stacked on top of each other to generate recurring growth rates. In software and other industries, where switching costs can be high and there is low customer-revenue churn, the stacking of recurring revenue can be sustainable. This model is also effective when more products and services can be sold to an existing customer, like Amazon, as the CAC approaches zero.

Recently, this model has been tested in markets with less stickiness, lower customer switching costs, and weaker network economics. The question is whether this model, which works with locked-in customers and high switching costs, can be as successful in these markets. Some examples or participants in these markets include Uber, Door Dash, and Carvana. Today many of these businesses are the darlings of Wall Street.

Testing of the young growth business models focused on specific market segments (for firms such as Trip Advisor or Yelp) is occurring with the current stoppage/slowdown of travel, leisure, and lodging services over the next few months/years. As the large platforms’ (Google, Amazon, or Facebook) growth rates decline in their core businesses, the young growth firms will be challenged by larger platforms who want to increase their exposure in specific vertical to maintain growth. The larger platform firms have the ability to subsidize losses to establish scale in targeted segments. Amazon is an example of this in grocery.

One approach to investing in disrupted markets is to buy the young growth disruptor. In the past, this has been successful with technology companies that have been able to secure lock-in due to high switching costs or standard setting.3 If you invest in cheap hardware technology stocks (low P/E), then you typically buy a disrupted company that has a real probability of distress (bankruptcy) that has to be factored into the valuation model. Examples of these gorillas include Microsoft, with its office suite, and Cisco, with its networking routers.

If higher switching costs or standard setting are not present, then you get new firms disrupting existing firms with each new generation of hardware/software. In these industries, a firm’s advantage only lasts if there is product generation. Many of these cheap technology firms are in markets where there are short product technology cycles, low switching costs, and there are barriers to adoption by the incumbent. One key to look for here is whether the incumbents adopt the innovation without destroying the ecosystem they have developed for business operations (i.e., do they have a barrier to adoption?). If they can adopt the innovation, then they can become competitive. Recent examples include Walmart and Target in e- commerce competing with Amazon.

Valuation Multiple Investing

Traditional value multiple investing is dependent upon mean regression. Mean regression is based upon firms in a given industry having similar economics. Historically, this has been the case for most firms and thus firms with a lower multiple would approach the multiple of a higher value in the same industry. In cases like these, P/BV, P/E, or P/FCF can be used to buy the cheaper firms in an industry. These multiples are most useful in slow-changing businesses where market share is steady.

Company-specific intangible assets like patents, local economies of scale, and network economics in combination with barriers to entry and adoption can upset the mean regression assumption. In these cases, the company possessing these assets (the advantaged firms) should sell at higher multiples than firms who do not possess these assets, as the possessors will be either protected by barriers to entry, scale or adoption, and be taking market share from the non-possessors. Examples of these types of assets can be seen in the drugs, software, distribution, media, and transaction processing businesses. In these industries, possessing the intangible asset (business model) can be more important than valuation based upon historical multiples. In these situations, the value of the advantaged firms needs to incorporate the growth from more market share, and the disadvantaged firms needs to incorporate the decline in market share. The possibility of the disadvantaged firms slowing the disruption—or adopting the disruption itself—also needs to be considered.

Network economics can have exponential growth as customer adoption increases and the network becomes larger versus the linear growth in models of the past. Networked assets can create exponential economics but, to be sustainable, they typically are associated with high switching costs and scale economics to prevent competitors from competing the profits away. Another more general question is whether these advantages allow a firm to generate successful economics. In many cases this is not the case, as either the advantages are weak or the customers and competitors prevent the successful economics.

History of Valuation Multiple Mean Regression

Valuation multiple mean regression can be looked at in a historical context associated with technological revolutions and the technology adoption lifecycle over time, as described by Perez.4 She lays out five technological revolutions since the 1770s. These revolutions are divided into two phases—installation and deployment. The installation phase is kicked-off by a new innovation, followed by an interruption period, and then a frenzy period. In the current revolution (information and telecommunications), the innovation was the development of the microprocessor in 1971. The interruption period transitioned into the frenzy period in the 1990s, as the new-age firms based upon digital technologies were formed. Many of these were little more than business plans (similar to the railroad mania in the 19th century, where lines were financed based upon future capital calls) to which some folks attributed values as though they were generated profits, thus creating bubble prices in these firms. The turning point was the popping of the bubble that was created in the frenzy period, and the technology is adopted on mass scale across existing firms. In the current cycle this occurred in the dot-com crash (2000-2002). We are currently in the synergy period, with the innovation being adopted across most industries. The key to surviving these revolutions is for the incumbent to adopt the innovation. Some examples include trains adopting diesel engines (versus steam engines) to remain competitive with trucking or incumbent utility firms investing in wind and solar to remain competitive with independent alternative energy firms. In some cases, this does not make sense economically, as the innovative product will cannibalize an existing product’s profit as described in The Innovators Dilemma5 and in the 7 Powers framework described above. This is especially true if the existing product is highly profitable. This can be seen in Kodak and the adoption of digital technology (the current technology revolution) and in Walmart’s use of local economies of scale versus a traditional discount store (like K-mart). Value multiple investing should work for disruption survivors but not for the disruption victims.

One approach for value investors is to avoid those industries being disrupted. This is followed by investors such as Warren Buffett. You can see this in Berkshire’s largest allocation of capital to businesses with long average lives like insurance, banking, regulated utilities, and consumer products. However, I think as time goes on, this approach will work for smaller and smaller groups of companies. Alternatively, the focus could be on incumbents that can adopt the innovation that the challengers have used. We see this in a few of our telecom holdings (Telecom Italia and KT Corporation).

Conclusion

Over time, I am confident that more opportunities will present themselves associated with this strategic framework theme. Using this theme in combination with Bonhoeffer’s three frameworks (compound mispricing, mischaracterized companies, and public LBOs) should provide some nice opportunities and diversify the portfolio from the primarily emerging market, small-cap value current composition. An area we are now examining is firms incorporating the internet into their existing business models.

As always, if you would like to discuss any of the philosophies or investments in deeper detail, then please do not hesitate to reach out. Until next quarter, thank you for your confidence in our work and have a safe and fruitful spring season.

Warm Regards, Keith D. Smith, CFA

Case Study: Combined Motor Holdings (CMH)

Combined Motor Holdings is an automotive dealership group located in South Africa. Combined Motor Holdings has 68 dealerships. Fourteen are considered premium/luxury brands and 46 are volume brands. Automobile dealerships are really four businesses in one: new car sales, used car sales, service and parts, and financing and insurance (including leasing). Disruption is occurring in the dealership industry via channel compression and disintermediation.

Combined Motor Holdings’s management has a returns-oriented framework, having delivered an average return on equity of 30% over the past eight years. Organic growth is more important than acquired growth, as management has much more control over the business model and customer experience. CMH has grown over the past few years despite the decline in units since 2013. In 2019, industry car sales declined 1.9%, but CMH units sold increased by 1.3%. It is the third largest—but fastest growing—car dealer in South Africa, with 14% earnings per share growth over the past seven years, higher RoE (31%) versus larger competitors (Motus (13%) and Super Group (9%)), and 65% of profit from new and used cars sales and service and 35% from car rental/leasing and financing.

Auto dealerships are really four types of businesses: new car sales, used car sales, service and parts, and financing. New car sales are cyclical based upon OEM new car sales. Used car sales are less cyclical, as consumers will purchase used cars when there is a downturn for economic reasons. Service and parts are more defensive, as service is required on a regular basis for automobiles. Financing is dependent upon new and used car sales and is a high-margin add-on to these types of sales.

The South African auto dealership market is less competitive than the UK’s. The result is higher margins for most dealerships in South Africa, thus leading to higher returns on capital in the mid-double digits versus mid-single digits or higher for UK dealer groups. CMH is the highest-return dealer in SA and has higher inventory turns and margins than other South African dealers. This is due in part to the ability to turn cars quickly, with inventory turns of 8.5x, the highest amongst traditional car dealers outside China.

The integrated auto dealership market is being disrupted by new business models and technology. The used-car superstore is a new business model where disruption is occurring. Examples in the US include Carmax and Motorpoint in the UK. These firms sell cars at lower prices and have higher inventory turns versus the traditional integrated dealer models. They also attract a value-oriented car buyer who buys used versus new cars. Technology is also facilitating the selection and purchase of used cars. In the UK and SA, there are used-car marketplaces led by Autotrader, where auto dealers can list and sell their used car inventory across the country to other buyers. Another disruption is the larger independent automobile service providers like Monro Muffler in the US. Luxury car dealers are more immune from price competition than the volume dealers, superstores, and independent automobile service firms present. Most of Combined Motor Holdings’s sales are currently in the volume market (72% of dealerships).

The auto dealership model is also subject to local economies of scale. In a local market, a dealership, like other retailers, can take advantage of economies of scale (density) associated with advertising, logistics, and local oversight. If you look at CMH’s geographic footprint, then you notice two clusters—one around Durban and the second around Pretoria/Johannesburg representing 57 of the 60 dealerships.

SA Auto Dealership Business

Sources of growth for Combined Motor Holdings include service and parts growth, used car sales growth, new dealerships, and acquisitions. The South African new-car market has been declining in the past five years, with new car sales declining. CMH has been able to increase sales over the past five years. CMH’s smaller size also allows it to maintain revenue growth by adding a relatively modest number of dealerships versus competitors who need to add a larger number of dealerships to maintain their revenue growth rates.

Combined Motor Holdings has utilized the local scale model to generate comparable margins (5.0% EBITDA) with less than 20% of the revenue of the other South African automobile dealers (Motus and Super Group). The higher margins are in part due to the focus on primarily two markets versus the other SA dealerships. Inventory turns are also important in the auto retailing business. CMH has the highest inventory turns of 8.5 times amongst the SA car dealers which range from 4.6 to 5.6 times. Quicker inventory turns mean that the dealer is matching the customer to cars more quickly than its competitors. This allows CMH to either sell fewer cars or sell for lower prices than competitors while obtaining the same return on invested capital. CMH has a higher return on equity than South African competitors from both higher margins and inventory turns.

Downside Protection

Auto dealer risks include both operational leverage and financial leverage. One way to measure operational risk in automotive dealerships is the “absorption” ratio, which measures how closely the firm’s gross profits (assuming no new car sales) cover the firms selling, general, and administrative costs. Unfortunately, the SA car dealers do not provide the revenue and cost breakout to determine their absorption ratios.

Financial leverage can be measured by the Debt/EBITDA ratio. Combined Motor Holdings has a lower Debt/EBITDA than other SA dealers (1.5x EBITDA versus 2.3 to2.7x for the other SA dealers). In addition, all of CMH’s debt is associated with its rental operations. CMH has also done well in the SA auto recession of FY2015-2019. Over these four years, CMH’s revenues were up 3% and net income was up 33%, while total car sales volumes were down.

The historical financial performance for CMH is illustrated below:

Management and Incentives

Combined Motor Holdings’s management has been focused on increasing efficiencies by merging small franchises into larger regional operations and reducing overhead. The CEO currently holds 26 million shares (R250 million) which is more than 26 times his 2019 salary and bonus. The CEO’s total compensation is about 50% salary and 50% bonus. The bonus is based 70% upon financial KPIs (EPS growth, return on equity, and rental profit growth) and 30% upon nonfinancial KPIs.

Valuation

The key to the valuation of Combined Motor Holdings is the expected growth rate. The current valuation implies an earnings/FCF decline of 1.2% into perpetuity using the Graham formula ((8.5 + 2g)*(4.4/AAA bond rate)). The historical ten-year earnings growth has been 19% per year including acquisitions and the current return on equity of 31%. The historical revenue growth rate has been 6% per year over the past nine years.

South African new car sales declined by 3% per year over the past five years, while Combined Motor Holdings’s revenues have increased by 1% per year, 4% in excess of the SA automotive market growth rate. Over the past five years, CMH has grown EPS by 21% per year, 14% due to increased net income growth and 7% from share repurchases. The increase in net income is due to cost efficiencies. Over the next five years, the automobile market is expected to grow by 2.2% per year in new units. If we assume the excess growth going forward, then we arrive at a revenue growth rate of 6%. Given this, a 10% earnings growth is conservative given the 2.6x multiple of earnings/revenue growth over the past nine years and the historical RoE of 29%. The resulting current multiple is 14.0x, while CMH trades at an earnings multiple of 3.0x. If we look at firms in different markets (Motus and Super Group) with similar growth prospects, they have earnings multiples of around 5.0x. If we apply 5.0x earnings to CMH’s estimated 2019 earnings of R3.29, then we arrive at a value of R16.45 per share, which is a reasonable short-term target. If we use a 10% seven-year growth rate, then we arrive at a value of R45.42 per share. This results in a five-year IRR of 36%.

Comparables

Below are the South African and international firms engaged in the car dealership market that have high returns on equity.

Benchmarking

Compared to other SA automotive dealer groups, Combined Motor Holdings has the highest inventory turns and return on equity. The Blue Sky value is based upon multiples paid for branded dealerships over the tangible book values of those dealerships. The methodology for the multiple determination is described in the Year- end 2019 Haig Report. CMH, like other auto dealers, has significant upside based upon the Blue Sky methodology. CMH differs from the other SA dealers in return on equity and runway for growth, as it is smaller than the other dealers and thus can more easily focus on niches that will have a smaller impact on larger firms.

Risks

The primary risks are:

• lower-than-expected growth in sales/earnings; and
• a lack of new investment opportunities (merger and acquisition or new dealership).

Potential Upside/Catalyst

The primary upsides/catalysts are:

• a resolution of COVID-19 in South Africa;
• more share repurchases; and
• increased local scale or purchase of local scale in new

Timeline/Investment Horizon

The short-term target is R16.45 per share, which is almost 75% above today’s stock price. If the economic recovery thesis plays out over the next five years (with a resulting 10% FCF/earnings per year growth), then a value of R45.42 could be realized. This is a 36% IRR over the next five years.

1 Aswath Damodaran has a nice framework for business valuation by development stage of business that is described in detail in his The Little Book of Valuation.

2 This model is described in Hamilton Helmer’s 2017 7 Powers: The Foundation of Business Strategy, as well in a May 19, 2020, “Invest Like the Best” podcast by Patrick O’Shaughnessy.

3 As described in The Gorilla Game, Moore, Johnson, and Kippola, 1998. This book was the first to describe how network economics are achieved through the technology-adoption lifecycle by firms that can provide products ahead of competitors in markets where participants have customer lock-in due to high switching costs, such as Microsoft.

4 Technological Revolutions and Financial Capital, Carlota Perez, 2002

5 The Innovator’s Dilemma, Clayton Christensen, 1997

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