These are humbling times to be an investor. It wasn't that long ago that you could still throw money at stocks, practically randomly, and earn quick double-digit returns. Now it's double-digit losses. You used to check your portfolio three times a day and each time it was bigger than the last. Now you avert your eyes when you see a ticker tape on TV. It's enough to make you pack up your toys and go home.
Don't do that though. The value mavens are busier than ever. This is their time, buying precisely when the rest of us feel like running. So let's check in with value picker Ming Lam, of Toronto-based Silver Heights Capital, to see what he's up to and why.
Q: You've taken a shine to U.S. auto retailing. Why is that a good move given that the consumer is becoming an endangered species?
A: We've been following the auto retailing sector for many years but the stock prices were never attractive enough. In the past year or two, the sector has declined a lot. While the consumer may be experiencing difficulty, the stocks are being priced as if that difficulty will last forever.
Q: What is it about auto retailing that you find attractive as an investor?
A: The business produces good cash flow. People will always need cars and a place to get them serviced. They will need a place to buy them: We don't think people will buy cars sight unseen and without a test drive (unlike online book retailing). In a nutshell, we don't think that bricks-and-mortar auto retailing will disappear.
Q: Is it growing?
A: Auto retailing is a huge and fragmented market, one that lends itself to economies of scale. There are a number of publicly traded auto retailers, but combined, they have less than one-fifth of the total market.
Q: Give us a couple of names.
A: We recently purchased two companies in the auto retailing sector: CarMax (KMX-NYSE), a used-car retailer, and Lithia (LAD-NYSE), a traditional new-car retailer.
Q: Let's start with Lithia. Doesn't it sell Big Three cars, and isn't that kind of risky?
A: It also sells cars from virtually all the other auto manufacturers as well. They have over 100 dealerships, with a focus on non-urban areas. Contrary to what most people think, the new-car retailers make more of their money from the parts and service business than from the sale of new cars. That's a far less volatile stream of revenue. And, it's much higher margin than what they make on the sale of a new vehicle. The new-car OEMs [manufacturers] have a far more volatile business than do the retailers of those vehicles [see table].
Q: How's the balance sheet?
A: It has debt but we don't think the business is overleveraged. The bulk of the debt is against the inventory of cars.
Q: The stock has been clobbered and hints at solvency problems. How does the valuation look if you assume it survives?
A: This company has a long track record of profitability. It was started in 1946. It has survived two previous oil shocks and a period of 20-per-cent interest rates. For the past 10 years, they've earned between $1.14 (U.S.) and $2.37 a share. While it may have a bad quarter, or even year, or two, the business is fundamentally a good one. If you were to show that EPS history to people, you wouldn't suspect that the stock would be $4.
This is one of the common opportunities in the stock market. I call it "time arbitrage." It's when stock prices are set according to short-term conditions. In circumstances like these, you can acquire an attractive long-term holding at prices that reflect only negative short-term conditions.
Q: Let's talk about CarMax. You think it's actually a better business? Why is that?
A: For traditional auto retailing, the profit from the new-car sales stems from three sources: the margin on the new car, the trade-in and the financing. It's hard for the consumer to win. If he brings a trade-in, he won't get great value for it, or he'll pay a higher price for the car or financing or whatever. At CarMax, there's no-haggle pricing, they'll buy your car whether or not you buy a car from them. And the price you pay is not dependent upon whether you use their financing.
Q: And it's more flexible?
A: Right. CarMax is not tied to any manufacturer. They buy most of their cars from the public so they can quickly fine-tune the inventory. If consumers want small cars or big cars, foreign cars or domestic cars, Toyotas or Hondas, or blue cars or red cars, CarMax can adjust its purchases to meet this demand. This flexibility is one of its greatest advantages over new-car retailers.
Q: The earnings per share have grown nicely for the past eight years or so, yet the stock was pretty volatile and it's down about 50 per cent from its high. Why is that?
A: The stock was quite richly valued a few years ago, so despite having produced good profits and growth, those results may have been short of what investors had expected at the time. However, I can never tell you for sure why a certain stock gyrates in the very short term.
Q: How about a word on valuation?
A: It's trading at a mid-teens forward P/E. However, the current and near-term earnings are below normalized levels because of: (a) current economic conditions, and (b) significant and continued investments they are making for the long-term growth of the business.
One of the most appealing attributes about this company is the long growth runway it faces. With $8-billion in revenues last year, KMX is already - by far - the largest used-car retailer in the U.S., but had less than 3-per-cent market share.
Q: Do you worry that the company is expanding in what is likely a recession?
A: No, we're pleased that it plans to keep investing for the long term. It would be easy to succumb to Wall Street's pressure by curtailing investment, but it wouldn't be in the best interests of long-term shareholders.
Q: Stocks that are falling have a tendency to keep falling, especially after we buy them thinking they're cheap. What does it take to succeed as a bottom feeder?
A: A huge part of what dictates an investor's success (or failure) is their temperament. Do they have the intestinal fortitude to do their own thinking and not be swayed by common "wisdom." Patience goes hand-in-hand with temperament. It's virtually impossible to predict short-term stock prices. However, with proper due diligence, you can gain an understanding of where a business may be headed over five or 10 years.
© The Globe and Mail
