At Global Quality Edge Fund we prioritize time speaking to senior management. It is precisely on these calls where we get better insight to clarify and find answers to these possible accounting risks.
In one of his famous letters to shareholders, Warren Buffett once said “…trouble awaits managements that paper over operating problems with accounting manoeuvres. [They achieve] the same result as the seriously-ill patient who tells his doctor: “I can’t afford the operation, but would you accept a small payment to touch up the x-rays?”
Another renowned American investor, Thornton O’Glove, would explain it through the following
example: “If we assume that company reports earnings per share of $2, would there be a reason
for the CEO to undervalue this number? Surely not but he could have inflated it from $1.5 to $2 to give the appearance that it is greater than is really is.” These two stories serve as a reminder to investors that companies massage their accounts, preferring in some cases illusion over reality.
Do you have an example of a business that initially looked interesting, but turned out to have accounting issues?
Yes, halfway through 2017 I came upon Mitie Group (MTO), a leading British outsourcing service company, which provides facilities management, office cleaning services, waste management, security and document management.
A typical and very boring business made interesting because of the specialist services they offered. Mitie managed almost always to renew all their service contracts, enjoyed high retention rate due to high switching costs, economies of scale and attractive returns on capital. Once I began to review their annual statements, I found what I had initially presumed would be a ‘red flag’ when they purchased Enara, a leading home care service provider in 2012. When analyzing the deal, I realized Mitie was assuming very high forecasts for their care service unit that could force a negative goodwill adjustment and subsequent losses on their P&L. Goodwill represented 45% of Mitie’s market cap of which Enara contributed more than 20% to the total value. Under note 31 from the 2012 annual report, you could see how the amount paid to complete the acquisition was £115.7 million of which £94 million was allocated to Goodwill; in other words, more than 80%!
In addition to this, note 13 from the 2016 annual report showed how Mitie was aggressively
forecasting total revenue growth rates of 20% when the underlying business was running on a loss. The years that followed, the pharmaceutical line of business began to deteriorate, and yet senior management chose not to write-off the goodwill although they did explain they would be open to it if the business did not improve. Eventually what I anticipated became a reality. Mitie announced their exit from the pharmaceutical business and recorded an impairment charge of goodwill, generation losses due to discontinued operations worth £132.4 million.
On 19th September 2016, after hosting an earnings call with analysts, the share price quickly dropped by 28.8%. Today, the stock is 50% below its yearend 2015 price.
In conclusion, whenever a company acquires and merges with another business, and the total value of the deal is significant, it is essential to analyze all of their accounting reports in greater detail.
You also like to talk to management as part of your invest process. What qualities are you looking for in the management teams you invest alongside?
I can think of many but we generally begin by asking ourselves what type of manager leads the organization and what is his or her degree of independence when it comes to decision making.
(1) Bank of the Ozarks, now known as Bank OZK, is lead by Georg Gleason, CEO and founder of the company in 1979. The passion that George transmits when running the day to day business is undeniable and far-reaching throughout the entire company. All his decisions are long-term and never influenced by what the competitors may be doing, proved recently by giving up growth in his CR&E division to avoid compromising the quality of OZK’s loan portfolio at a time when there is certain pricing pressure. In our teleconference calls with Tim Hicks (CFO), he told us that OZK only approves between 5-7% of applicants out of all the offers they study and will only do so when there is an imbalance between supply and demand.
Another important indicator to look out for is managers with low salaries, low stock-option compensation schemes and high stock ownership.
(2) Christian Canty is president and CEO of Installux, and his base salary is not even 0.5%
of total sales, does not offer option linked compensation, and he’s the owner of more than 50% of the company.
An interesting characteristic that’s often not reflected in the market is how senior management values its employees.
(3) Employees of Holland Colours own 25% of the company, which impacts the profitability of the business both directly and indirectly.
In another conference call with Neurones (NRO) the colouring company’s CEO, Luc de Chammard, explained how their decentralized business model helps improve profit growth and retain talent. The company’s level of talent retention is amongst the highest in the industry
It is also relevant to know if the CEO and CFO are making good decisions when allocating capital.
(4) Inchcape plc (INCH) is a good example. Their investments, working capital, M&A, dividend payments and timely share repurchasing programs have all added value for shareholders.
Share repurchase agreements are worth understanding and seeing if their timing is opportunistic or not.
(5) O’Reilly Automotive (ORLY) has a long history repurchasing shares. In May 2017 when the stock was trading at 15x earnings, O’Reilly announced it was boosting it by back facility by $1 billion raising the total to $9 billion, which represented 50% of its market cap.
(6) Straco Corporation (S85) announced a share repurchase program last April of at least 10% of shares outstanding, at which point the stock price was close to SGD 0.75 with a cash P/E of 10.5x and an average daily volume of 100,000 shares.
Lastly, insider trading is a key indicator to buy stock whenever the CEO drastically increases his or her stake in the company.
(7) In June this year, Walgreens (WBA) CEO, Stefano Pessina, bought 1.7 million shares valued at $109 million, increasing his stake to 15%.
You also employ a tail risk strategy. Can you give us some insight into this strategy and why you’ve decided to implement it?
The idea behind hedging through options is to protect the tail-risk of the market, a practice that is also known as tail-hedging and was mainly developed by value investor Mark Spitznagel.
Throughout history, most drops in equity indices above 20% have been recorded when the economy enters into a recession. Our most recent evidence of this is the dot-com bubble in 2000 and the financial crisis in 2008. To avoid or diminish the drop, we buy out-of-the-money put options on market indices to protect our fund from market downturns greater than 20-25% whenever there is a significantly high chance of this occurring by closely monitoring Conference Board indicators (Leading, Coincident and Lagging indicators) for US and Europe.
We classify the business cycle in four phases based on the rate of change of the US Conference Leading Indicator, on a year-on-year basis and year-on-year three month moving average. We believe the business cycle in the US is now in the expansion phase where (along with the recovery phase) is where we see higher returns for equities. We expect that towards the end of 2018, the business cycle in the US could move into the deceleration phase where stock returns will still be positive but not as high as the previous cycles.
Global Quality Edge: Stock Idea One
Your first stock pick is Israeli company Ituran Location (ITRN). How did you first discover this business?
I discovered Ituran in a forum on American listings which I never miss; they are always a great place to learn about lesser known companies. Ituran was one of them and despite going public in Tel Aviv in 1998, it wasn’t until 2005 that this Israelibased company began trading on the Nasdaq.
Even though it has several years of history behind it, it is largely unknown to American investors. Less than five analysts cover the stock; they’re all local and the company itself never attends investor conferences.
What does the company do and what is its market size or potential for growth?
Ituran is a leading provider of location-based services, consisting primarily of stolen vehicle recovery (SVR-most important), fleet management services and tracking services. Ituran principally operates in Israel, Brazil and Argentina, has more than 1 million subscriptions.
The SVR business consists of locating, tracking and recovering stolen vehicles through a subscription fee service.
Ituran installs the AVL tracking unit in the car and has a network of transmission and reception stations for monitoring and a 24-hour control and customer service centre on standby. In the majority of countries in which it operates, the Ituran security staff is in direct communication and coordination with local police. Most of the company’s customers are individuals, insurance companies and agents, OEMs (original equipment manufacturers) and industrial fleet management companies. Another line of business within Ituran is their Wireless Communication which encompasses all the AVL technology products, making up 25% of total sales.
Demand for SVR products is strongly linked to crime and motor vehicle theft rates within a country. Brazil ranks at the very top in both categories. According to recent figures from Interpol, 557,000 vehicles were stolen in Brazil in 2017, of these case, 70% involved violence. The number of stolen vehicles secured by insurance companies is growing at a double-digit rate. Regardless of how you calculate it, this South American country is perhaps one of the worst places to own a car and the best for Ituran to do business. If the income per capita continues to increase among middle classes, demand for vehicles will rise, theft rates will also grow and demand for Ituran’s services is almost guaranteed. We forecast a market share in Brazil of about 25% (precise figures are hard to come by) and believe it will continue growing in what we see as a fragmented market with tiny players and potential for future inorganic growth for Ituran.
What makes Ituran an “extraordinary” business in your view?
There are two reasons. Firstly, a competitive advantage in the form of a ‘network effect’ and the second one being its size or scale. In a rapidly growing market, like Brazil, its high market share allows it to have a higher degree of control on market trends.
A network effect exists when the value of a service is increased by the number of users who; in turn, attract more users, creating a virtuous cycle that displaces smaller networks giving way to more dominant ones. Over time, the increase in the user-base makes the marginal cost of adding one subscriber decrease and contributes to the overall sustainability of the network business model. In Ituran’s case, their recurring sales (>80%) from their SVR line of business is one of their most exciting features. Their consistency in successfully increasing the number of subscribers year-on-year since going public 1998 is exemplary, leading them to surpass the one million subscriber milestone by the close of 2017. Most of the users are located in Israel and Brazil and pay an average $200 subscription fee.
One of the reasons why Ituran is unknown in the US market is because their total revenue figure is impacted by foreign exchange rates when converting sales from their local markets in Brazil and Israel to US Dollars. During 2015 and 2012, the Israeli Sequel and the Brazilian Real depreciated considerably against the US Dollar, giving the appearance of a drop in sales of 3 and 6%, despite the double-digit growth in the user base.