Someone emailed me this question:
“What are some of the most interesting investments in particular classes such as deep value, quality/moat, cheap cyclicals or special situations that would be interesting to recount? How do you position your own portfolio? Do you solely invest in moat businesses?”
I don’t have a rule where I only invest in moaty businesses. I’d be willing to invest in other kinds of businesses if I have confidence that the investment would work out. My style doesn’t have to do with moat specifically. I don’t consider myself either a high quality or a deep value investor. I don’t consider myself mostly a Warren Buffett (Trades, Portfolio) or Ben Graham type investor. I just think in terms of 1) What will the business look like in five years? And 2) What would an acquirer pay for the business at that time? A value stock could qualify under this approach. I definitely look at companies that most people don’t consider “high quality.” Although, to be honest, the lack of quality usually has to do more with the lack of growth or with being in a “buggy whip” type industry. It rarely has to do with having a poor competitive position, being a marginal player in the industry, etc.
Let me give a few examples. I owned shares of Barnes & Noble (BKS, Financial). The company with the best position overall in book retailing (both printed and e-book) was probably Amazon (AMZN, Financial). This was back in 2010 that I made the investment, therefore the situation was somewhat different than today. But, still, I’d say that Amazon had the best future in book retailing and Barnes & Noble had the second-best future. There were companies in a much worse competitive position. For example, I expected Borders to end up in bankruptcy and close most of its stores. That’s what happened. Overall, I expected the total amount of shelf space dedicated to selling books would decline over time. I didn’t expect people to buy more books in the future than they had in the past. But, I did expect Barnes & Noble to be one of the biggest - along with Amazon - sellers of books five years down the road.
This investment didn’t work out for me. The biggest reason for that was my miscalculation regarding capital allocation. I had valued Barnes & Noble by putting a positive value on the free cash flow that the stores would produce over the next five years or so - while I expected to hold the stock. I added up the amount of free cash flow I expected the company’s stores to produce - in aggregate - over the next five years. I tried to guess how much the company’s stores would still be producing in five years. Or would they be bleeding cash? That’s the calculation I did. The answer I came up with was that the retail stores were capable, even with declining sales of print books, of producing free cash flow that would add up to more than the market cap of the company. In other words, if Barnes & Noble wanted to, I thought it could simply pay out more in dividends to shareholders from 2010 through 2015 than new shareholders (buying into the stock in summer 2010) would have to pay for the entire company. So, over five years, you could get paid back everything you put into the stock and you’d have this leftover bookseller who I thought would still have market share behind only Amazon in the U.S. book business.
What went wrong? Barnes & Noble took the free cash flow from the cash cow stores it was milking, and then invested that milk in the Nook. The Nook was a failure that lost a lot of money. The free cash flow from the declining print book business was never used to the benefit of shareholders. Instead, the company could have just had a bonfire and set all that cash from the stores aflame. The result would have been about the same for shareholders. Did Barnes & Noble have a moat? I wouldn’t say so. But, I’m not sure thinking about moat mattered much here. I didn’t expect anyone to seriously want to enter the print book business, and I didn’t expect anyone who wanted to enter the e-book business without being in the print book business to have success. I figured that Amazon and Barnes & Noble had a lot of the total market - print and digital - for books in 2015 and that Amazon and Barnes & Noble would have a lot (maybe more in fact) of a market that could be smaller in 2015.
Here, it might help to make a distinction between “moat” and “competitive position.” I don’t necessarily care about moat. I certainly don’t care about the concept of “barriers to entry” as being the only way a company can be successful. In the case of books, I felt the market was settled and it wasn’t attractive to new entrants. Was there a moat? I didn’t think that mattered. It’s not like Barnes & Noble or Amazon could open a new store and get a decent return on their investment. Capital wasn’t going to be added to this business. I thought the print book retailing business wasn’t going to become more competitive in the future and that it might become less competitive.
A current example of this is Staples (SPLS, Financial), a stock I don’t own. But, it’s a stock I’ve followed. I’ve been very interested in the company. Why? Because I think the amount of selling space dedicated to the sale of office products will decrease. Staples wanted to merge with its next biggest competitor. This was banned by the government. But, it shows this is an industry that the main players want to see consolidate. They aren’t focused on growth. They’re focused on reducing costs and reducing competition. Staples has this idea that it can reduce the size of each of its stores by a lot, almost 50% in terms of square footage. Yet this should still allow them to capture 90% of the sales they were making before. If that’s true - and I think it might be - that’s great for the per store economics. A lot of the sale of office products has already gone online. A lot of Staples' profit already comes from a combination of two activities that are different from what other retailers do.
The first profit source is its business customers who get deliveries from Staples directly (instead of shopping at the company’s stores) under a contract. This isn’t quite an MRO type business like Grainger (GWW, Financial), MSC Industrial (MSM, Financial) or Fastenal (FAST, Financial), but it isn’t exactly just a pure in-store retail business either. The second profit source is people who go to Staples stores but just place their order at a Staples kiosk - basically an online order - instead of buying the product and checking out physically in the store. Now, if you are doing deliveries and kiosks, you don’t need a lot of square footage. If you are one of the strongest competitors in a shrinking market, you are going to have competitors closing their stores in your area. You'll have these forces at play that should help you increase sales per square foot.
There are few trends that benefit a business more than the ability to increase sales per square foot. So, if I really believed that Staples was going to have higher (real) sales per square foot in 2021 than it does today, I’d be very interested in buying the stock. If you look at recent free cash flow results at Staples and the company’s enterprise value, you could be talking an adjusted P/E of 9 to 11. The company might be trading pretty close to a 10% free cash flow yield already. If that’s true, you don’t need any growth to do well in the stock. Now, you do need to avoid any sales shrinkage that would cause deleveraging in the operations of the business such that earnings declined faster than sales. If you could have sales at around 0% growth and costs actually declining by a percent or two a year - well, then, you could justify an investment in the company over the next five years. If earnings had been growing over the last five years, even while sales were not, and the company had a solid financial position, I could imagine a private equity or other acquirer being interested in the company in 2021 at a fair multiple. In that case, Staples would meet my criteria.
The Staples situation is a little trickier than I just laid out. The biggest issue here is, of course, capital allocation. Staples has done some things recently that make me think they are doing the things I’d do if I controlled the business. When I was writing the newsletter, my co-writer Quan and I talked about what we wanted to see from Staples. It was pretty simple. We wanted them to merge if they could. We wanted them to stop opening stores. We wanted them to shrink the size of existing stores and/or move them to lower rent locations wherever possible, and we wanted them to exit all the non-U.S. businesses.
Staples has some big advantages in the U.S. Three of the biggest advantages are: 1) a great national distribution footprint (very few companies have distribution centers around the country), 2) a large number of contracted business customers and 3) a website that is already doing a huge amount of sales relative to competitors. If Staples.com was its own business, it would actually be one of the bigger e-commerce sites around. The company doesn’t have these advantages in other countries. We really wanted to see them exit the U.K., continental Europe, etc. Recently, Staples has moved in that direction. It looks like it has been planning to exit those businesses.
The other thing we wanted to see Staples do is pile up some cash and not have any debt so that it was financially sound despite declining sales. Then the company could focus on paying out everything it could in dividends. We really didn’t want to see Staples acquire any other businesses outside of office products in some sort of attempt to stay relevant with retail stores that weren’t going to be obsolete. We didn’t want to see that because we think all retailers - or almost all retailers - are subject to much the same risks Staples has already survived. Almost all other retailers are in more competitive markets than office products. In the long-run, I expect all retail products to see the same erosion of their business that office products saw first. Yet there are many more players in other retail fields. Staples is more similar to Barnes & Noble. It dominates what is left of the office products industry. So, I’d much rather Staples return free cash flow to shareholders or - and this is by far my second choice - simply buy back its own stock. I’m very scared that Staples will actually use free cash flow from its office products retail business to buy other types of retailers. That’s something I don’t want to see.
It’s the main reason I’ve never invested in GameStop (GME, Financial). GameStop is comparable in some ways to both Barnes & Noble and Staples. It’s a business that would catch my attention. But, my fear with GameStop is that it will take the free cash flow from its video game retail business (where it has a strong competitive position) and invest either through acquisitions or through opening new stores, remodeling old stores, into other businesses like AT&T stores and those sorts of things. Here, the company’s capital allocation history has me worried. That doesn’t mean GameStop is making a mistake. It just means GameStop is moving out of something that seems more settled, even if it’s doomed to shrink, and where it’s clearly the leader into other stuff where I’m less sure what the competitive situation will be.
This is what Coinstar, now Outerwall (OUTR, Financial), did. I owned stock in Coinstar when it was really just a coin counting kiosk company. I liked the business. I thought the product economics and competitive position were excellent. I had no idea where it could possibly spend all its free cash flow. And that turned out to be a problem. The company got involved in things with better growth prospects, notably RedBox. DVD rental became a huge growth business and then that business collapsed. DVD rental was supposed to be the new, durable route compared to coin counting. If you look at the Coinstar part of the business, it was always more predictable. It’s the same pattern, but leading to a less destructive outcome that we saw with Barnes & Noble.
I thought I understood how much free cash flow Barnes & Noble’s retail stores would produce over the five years I planned to own the stock. Then I thought I knew it would still be in the top two (along with Amazon) of booksellers at the end of those five years. I didn’t think there were going to be new entrants. I thought I knew who the leaders would be and that the leaders would still have a lot of market share. But, I didn’t predict that the free cash flow from the retail stores would go into Nook. Once I realized that was what was happening in a big way, I sold Barnes & Noble.
The same thing many years earlier happened with Coinstar. Once I realized it really was becoming a DVD rental company, I sold that stock. For shareholders, the outcomes were different. But, to me, both companies became “un-understandable” once they moved away from the original cash cow business I understood. I understood the competitive position of Barnes & Noble’s retail stores and Constar’s coin counting kiosks. I didn’t understand the competitive position of either the Nook or Redbox. So, I sold those stocks. I didn’t have a clue what those businesses would look like in five years.
So, would I buy GameStop or Staples? If I really thought I knew what they would look like in five years and what an acquirer would be willing to pay for that, yes, I would. I don’t need growth. For example, if Staples could pay out close to 10% of its share price in a combination of dividends and share buybacks over each of the next five years and then the multiple an acquirer (or the market) would pay for the company in 2021 was higher (something like 15 times earnings instead of 10 times), then you have a good, solid profit potential there. I don’t think other companies want to enter the office products retail business. Honestly, I don’t even think Staples or its next biggest competitor really want to grow their square footage. So, I think competition will be muted. The economics of the business could improve even if the size of the market is smaller in five years than it is today. So, here we have an example of a “decay” instead of a “growth” company. And yet, yes I’d be willing to buy it.
Do I think I will buy Staples? Probably not. The reason for this is that if I compare Staples to something like Howden Joinery - a U.K. building products retailer (for trade accounts only) - I’d say I like Howden better. Howden is more expensive, at least 50% more expensive by my math. However, I feel a lot more certain that Howden will be making more money in 2021 than it is today, than I am that Staples will be making more money. However, the reason for this isn’t industry growth. It’s just that Howden has 600 stores now and I believe them when they say they can reach 800. And then I know it takes a really long time for Howden locations to reach their full sales potential.
When I run those two assumptions through my model of what the company would look like in 2021, I get a much higher rate of growth in earnings per share than in total sales. As odd as it sounds, I actually analyze Staples and Howden the same way. Howden is a “growth” stock and Staples is a “value” stock in a buggy whip industry. Howden is 50% more expensive right now. But, my focus in both cases is really on what I think the companies will be earning in five years and what an acquirer would pay for a business earning that much in 2021. Howden is easier for me to see a path to 10% to 15% annual returns over five years. Staples might be capable of that. But, it really depends on capital allocation. With truly ideal focus and capital allocation on the part of management, Staples could be a good investment even though it’s in a dying industry.
But, remember, I felt that way about Barnes & Noble. I still feel that way about Barnes & Noble. If it had been more focused, more disciplined in capital allocation, and ignored e-books, I think it could have paid off for shareholders from 2010 to 2015. The price in 2010 was cheap and the retail stores produced good free cash flow. Barnes & Noble didn’t work out for me. But, that doesn’t mean I would never consider a situation like Staples. I am considering Staples. Right now, it’s just that I consider Howden Joinery to have an easier to foresee five-year future than Staples. Therefore, I’m more likely to buy Howden next rather than Staples. But, I’m definitely open to the idea of buying a retailer in a shrinking industry. I don’t require a growing industry. The good thing about a shrinking industry is that it’s often very settled competitively. Competition often decreases in a shrinking industry instead of increasing. I love investing in a business where I think competition will decrease over the time I own the stock.
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