In a recent note to my investors, I described three different categories of investments. I’m going to describe an investment idea from the third category very briefly at the end of the post, but first I’ll describe these three types of investments. From a note I sent to clients:
When I look back at our fund’s historical investments, I can group them in three broad categories, which I’ll call: Dominant Moats, Emerging Moats, and Bargains.
I think of the portfolio using the barbell metaphor: our biggest positions tend to be in the dominant moats on the left side of the barbell. These are very high quality businesses with high returns on capital and leading positions in their markets. They might still have above average growth rates, or they might be mature businesses with excess free cash flow that can be used for buybacks. In either case, they are very durable businesses with predictable recurring revenue. They have a resilience that might stem from the value they provide to customers, a culture that adapts to change, a desirable place to work which attracts valuable human capital, a network effect that gains strength as it grows, or a valuable brand, to name just a few. These companies are the household names like Amazon, Mastercard, Tencent, and Apple, but also include firms like Copart, the dominant marketplace for auto salvage auctions, or Verisign, which collects annual royalties for each and every .com and .net domain names, effectively a “toll road of the internet”.
Sometimes a “dominant moat” comes not from a traditional competitive advantage, but from what I call a behavioral edge. NVR is a company that has a very valuable moat despite operating a commodity-like business (homebuilding). I briefly summarized NVR’s model last year:
Homebuilders tend to have cash flow statements that look a lot like energy producers: they earn cash from the sale of a finished home, but that home sits on land that has to be replaced, and so the profit has to be constantly reinvested into new land. Like an oil well that slowly bleeds dry and requires a new well to maintain production levels, builders are constantly pouring their cash flow back into the ground in order to stay in business. NVR gets away from this depletion problem by utilizing a different business model that avoids land development (the segment that consumes cash) and focuses on building and selling of homes (the business that produces cash).
In theory, competitors could copy NVR’s model, and some have been attempting to do this, but it’s a hard transition because it means leaving gross profit dollars on the table. If you’re used to these dollars, it’s hard to give them up, even if it means making less efficient use of capital. NVR made the decision long ago to swap lower gross margins for far greater returns on capital and much lower risk. This capital light model also has much lower risk to housing downturns because NVR is never left with lots of excess land (funded by debt) when a housing downturn comes. NVR doesn’t have to sink money into land, which means much more accounting profits convert to excess free cash flow, which is used to buy back shares:
NVR is consistently profitable, even making money during the greatest housing downturn since the Great Depression. Its free cash has been used to reduce shares outstanding by 80% since the late 1990’s. Why wouldn’t other builders just copy NVR’s superior model? Many are trying, but one hurdle has proven hard to overcome: incentives.
I recently reviewed every public homebuilder’s proxy statement and noticed a vast majority of the industry’s compensation structure involves bonuses based on the growth of EBITDA, revenue, volume of homes sold, or some other metric involving a gross level of dollar volume. As Buffett says, the simple way to grow earnings in a savings account is to add more money to it, even though that won’t improve the returns on your invested capital. If you’re compensated based on the amount of interest the account generates, then you’re highly motivated to add more money to the account. Builder executives can do this by buying land (which allows them to keep the developer’s profit) and by taking on more debt to increase the amount of land. Returns on capital are what drive economic value, and they involve a numerator (earnings) and a denominator (capital deployed). NVR looks at both sides of the equation, but most of the industry thinks only of the former. NVR is a very simple business, which has pros and cons. It still has to compete very hard on costs, labor, and quality of materials, and it still has to continually source new land for development. It is still a commodity business, but it has found a model that generates value within a tough business and they’ve achieved a track record that I think is likely to continue.
These are great businesses that compound value for owners over time. Usually about 60-80% of our fund is invested in these dominant moats.
On the other side of the barbell are what Peter Lynch used to call “fast growers”. These companies often share some of the same qualities of the dominant moats, but just aren’t as established. They are in the building phase of their growth cycle, often reinvesting heavily into their own businesses, with a long runway ahead. The reinvestment sometimes is part of the income statement through research and development or sales and marketing, and sometimes its listed as capex through expanding locations or building new production capacity. In either case, these businesses are sacrificing current earning power for much greater future earning power. The range of possible outcomes is greater, and the uncertainty is higher, but the upside potential in certain cases is significantly greater than the risk.
Examples from looking at Saber’s Emerging Moat watchlist include Domino’s Pizza, Heico, Trade Desk, Pool Corp, and Floor & Décor. There are also a number of much younger companies that I’m watching and studying to see how they develop. The beauty of this category is that latching onto just one of these can make your career. O’Reilly Auto Parts has been reinvesting in its growth for decades, and is one of the biggest winners in the stock market, growing 64x since 2000 (23% annual return), a compounding rate which approximates the after tax return on investment that the business was able to earn on each new store it opened. Emerging Moats can be game changers.
I felt our investment in Facebook a couple years ago was a hybrid between category 1 and 2, but in many ways fits the description of fast growth. The company is certainly dominant, but it grew its revenue at 27% last year, and there is a long runway ahead as it is helping create new advertisers who exist solely because of Facebook’s vast network users (potential customers). But one of Facebook’s most valuable intangible qualities, and one that I think is vastly underappreciated, is the company’s adaptability to change. My view is change is a constant in today’s world, and the best companies won’t be the ones who resist it the most, but rather the ones who adapt most effectively. One of the great (and undervalued) benefits of a network with 3 billion people is the likelihood of entering vast and potentially very profitable new markets like payments and ecommerce. Facebook’s investment in Jio, the dominant telecom and ecommerce company in India, is an example of the company’s adaptability to change (also an underappreciated intangible quality of Facebook). So is its new Facebook Shops and Instagram Shop, which works with vendors like Shopify to streamline the ability for small businesses to sell products directly on Facebook and Instagram. The global advertising and marketing industry is over $1 trillion, which is a market that Facebook’s dominant moat will monetize for many years to come, and I think the “fast growth” portion of the business could lie in some of the sizable new markets.
Tencent turned WeChat into a “super app” and Alibaba created Alipay to serve financial services to its network of buyers and sellers (a business that is planning an IPO at a value of around $200 billion), and I think Zuckerberg is probably looking East for ideas on what the potential for worldwide networks might be.
Finally, there are the bargains. These are businesses that are not necessarily the highest tier of quality, although our investments in this category are still good businesses. But they are mature businesses, and the primary reason for investing in companies in this group is simply the stock is very cheap. Special situations also fall into this category.
There is a current idea that falls into this last category, which I’ll describe briefly below.
Pershing Square Tontine Holdings
PSTH is a Special Purpose Acquisition Vehicle (SPAC). A SPAC is a so-called “blank check company”. An investor or group of investors (called sponsors) form a new entity and raise money from the public in an IPO. The money raised is placed in a trust and can’t be touched by the sponsors until a deal is approved. The sponsors then have two years to find a company to buy, at which point the SPAC investors get to vote for or against the deal. Investors in the SPAC have essentially no risk prior to the deal closing because if they don’t like the deal, they can elect to get their money back. Typically, the SPAC shares are actually structured as units that consist of one share of common stock as well as a certain amount of warrants (often 1/2 or 1/3 of a warrant per unit). The warrants are a kicker that are designed to entice people to invest in the IPO, and also provide upside if the sponsors are able to find a good deal. Investors pay $10 per unit and can get their $10 back for the common if they don’t like the deal while keeping the warrants (or sell those as well as they typically are publicly traded after a period of time). So SPACs are usually a low risk investment if you’re able to buy them around book value (the per share value of cash held in trust).
However, SPACs have historically been dreadful investments after the deal has closed, and for good reason. The sponsors are incentivized to do a deal, regardless of whether the deal is attractive to outside shareholders or not. This is because most SPACs are structured in a way that gives a large portion of the equity value (usually 20%) directly to the sponsors. These are called “founders shares”, and this is absolutely free money. If a sponsor has two years to do a deal and has $400 million in cash from the proceeds of the SPAC IPO, then even if they spend $400 million in cash to buy a business worth $200 million (in other words, they pay the seller twice what the business is worth; obviously a huge destruction of value for the SPAC shareholders)… even in this extreme case, the sponsors still walk away with $40 million in value (20% of the $200 million value). In other words, the stock might IPO at $10 (which is the price most SPACs IPO at), then fall to $5 once the market weighing machine correctly values the new business, meaning the sponsors destroyed $200 million in value but still walked away with $40 million in cash when they sell their founder shares for $5 a piece.
These deals are extremely misaligned at best, and borderline criminal at worst. It’s not that all SPAC deals are bad and of course the sponsor would prefer a good deal over a bad deal, but it’s just that the incentives are structured in such a way that if a sponsor can’t find a good deal, they’ll do a bad deal over no deal. Even in an extreme example of the $400 million SPAC above losing 80% of its value (i.e. the stock goes from $10 to $2 after the deal closes), the sponsor still walks away with $16 million in value (20% of the $80 million marked down value). This sounds extreme, but I’ve seen numerous SPACs that have performed this poorly or worse. The founder shares basically create a 20% hurdle for outsider shareholders (the first 20% of any value created goes to the sponsors before outside shareholders see any return on their investment).
So I’ve always stayed away from SPACs, but I sometimes flip through the prospectuses just to see what the founders are paying themselves and how egregious the terms really are. And this brings me to Bill Ackman’s SPAC. Ackman is an interesting character. He’s in one sense a comeback kid of sorts. His Herbalife bet was a PR nightmare, and the Valeant debacle was extremely penalizing. Performance suffered for four straight years. But his fund had an incredible 2019 (up around 60%) and he has followed that up with an even better 2020. His well-timed hedge was prescient, but his portfolio has performed extremely well even aside from the profits he made on his credit short, and his fund is up nearly 50% this year.
He has taken advantage of the turnaround in his reputation as an investor, and has capitalized in a big way by raising the largest SPAC in history. Ackman’s firm is the sponsor of Pershing Square Tontine Holdings, the SPAC that raised $4 billion from the public. Also, Ackman’s funds have agreed to invest a minimum $1 billion more at the same terms as outside shareholders (with an option to invest as much as $3 billion), so the company has a minimum $5 billion (max $7 billion) to buy a company. Ackman’s plan is to actually bring a company public by taking a minority stake in a private firm, so the overall valuation could be much higher than the equity the SPAC currently has. Ackman has given a number of interviews discussing what he’s looking for, but in short, he’s looking for the same type of company that he always prefers, which is a quality business with a strong position that generates cash. He says he’s looking to bring a unicorn public, and firms such as Airbnb and Bloomberg, among others, have been thrown out as possibilities. (although Airbnb has recently filed to list its shares via the conventional IPO route).
But what is most interesting is this is no ordinary SPAC, for a few main reasons:
One, there are no founder shares. Ackman and his fund aren’t getting any compensation. They did invest $65 million to buy warrants on 5.95% of the future entity, but those warrants have a strike price of $24 (the IPO price is $20, not $10 like most SPACs), so the stock has to rise 20% before those warrants are money good, and expire worthless if Ackman does a bad deal. He also can’t exercise these warrants for 3 years.
Secondly, Ackman’s funds have committed to invest $1 billion, which is a big position for Ackman (his publicly traded fund has around $7 billion of capital). And this investment is in the same shares at the same terms as IPO investors received (no freebies, no special treatment, etc…).
Finally, this SPAC is very unique in another way. When you buy a unit of PSTH.U, you get a share of common stock plus 1/9th of a warrant (i.e. 1 full warrant for every 9 shares you own); but there is a big twist. Shareholders receive an additional 2/9ths of a warrant for each share if they choose to invest in the deal, and they also receive bonus warrants on a pro rata basis from a pool of warrants that are left over for any shareholders that choose to redeem their shares. (The name Tontine comes from a centuries-old insurance structure where a group of people would invest in a annuity pool and when anyone died, their share of income would be split among the remaining investors).
So if you invest in the deal, you get 3/9ths of a warrant, plus additional warrants that depend on how many people redeem.
This is a smart concept because it eliminates one of the drawbacks that a SPAC has, which is you never know as the sponsor if you’ll be able to get enough votes to close the deal, and if you come up short, you’re forced to raise additional financing, which often is further dilutive to shareholders.
Ackman’s SPAC really lowers the risk of requiring PIPE financing by a) sponsor agreeing to invest at least $1 billion and up to $3 billion, and b) disincentivizing shareholders to redeem their shares.
So to sum it up, when you buy a share (unit) of PSTH.U, you get a company with a $20 in cash that you can get back if you choose, plus 1/3rd of a warrant, plus potential for additional warrants, plus the upside of Ackman doing a great deal with a high quality company that you might want to invest in (not a given for sure, but still a nice call option). If Ackman announces a deal, it’s possible that the stock rises if the market likes the business, and this would give you the option of either holding your shares if you still like the valuation or selling into the market if you don’t. And if the deal is announced and you don’t like the deal, there is always the opportunity to redeem your shares for $20.
Shares are trading around $21.50 or so, which is around 7% max downside if you choose to redeem, but some of that downside will be offset by the value of the warrant that you’ll be able to sell when they get split off (the units will be separated into common stock and warrants sometime in the next few weeks).
This is a special situation investment (category 3), but one that might offer great risk reward (possible significant upside without much downside risk).
It’s the only SPAC I’ve ever come across that have fair terms and absolutely no freebies for sponsors.
John Huber is the founder of Saber Capital Management, LLC. Saber is the general partner and manager of an investment fund modeled after the original Buffett partnerships. Saber’s strategy is to make very carefully selected investments in undervalued stocks of great businesses.
John can be reached at firstname.lastname@example.org.