Volatility picked up in September and we used the market swings to continue adding to our portfolio. We are extremely sensitive to valuation and maintain high standards for adding new and existing positions.
A volatile flat market like the one we experienced in September plays to Somar’s strengths. Virtually all of our performance in September came from stock selection. Since inception more than two thirds of our profits came from stock selection while the rest of the profits came from market appreciation1.
Last month’s discussion of the secular change opportunities focused predominantly on the long book. However, in a low-growth economy if some businesses are benefitting from strong secular growth, those sales are coming from other companies. So to complete the discussion from last month we will emphasize our short book this month.
As you may remember from our pre-launch meetings, our holding period on short positions is typically less than one year. Since inception we have already harvested a few short positions. Today we want to briefly discuss one of these. The name of the specific company will be protected as we may get involved with the company again in the future.
The company (“Company A”) is a national general merchandise retailer that sells to consumers through TV infomercials and a nationally distributed catalog. It has operated with mild competition until recently. It reaches about 80% of American Households and has a trusted and respected brand.
Company A has grown historically in the mid to high single digits by catering mostly to married women with kids who enjoy discovering new products and buy in a community setting. It has a strong following among the baby boomer generation. Limited competition on TV and an established client base allowed the company to achieve operating margins ranging from 8% to 10.5% and a return on invested capital ranging from 40% to 80% over the last 5 years.
This attractive position is now under attack from two secular changes we have done detailed research on:
- Growing retail share from internet and mobile-based retailers
- Move of TV subscribers away from complete bundle of Pay TV channels towards skinny bundles or even no Pay TV service at all (so called “cord-cutters”)
The emergence of players like Amazon, eBay, Jet.com and the online efforts of general retailers like Target and Wal-Mart brings households in the US quick access to a wide assortment of products at extremely competitive prices. These emerging competitors also offer consumers rich product data, including videos, which encroach into Company A’s traditional advantage of offering fun product discovery to its customers2. These competitors are happy to operate with margins below 5%. They are well funded and have been taking market share. Their growth is putting increased pressure on company A’s margins which peaked above 8% in 2013 and since then have steadily declined.
Another Company A advantage is its wide reach. Company A got “free” entry into about 80% of American Households by being included in the standard pay TV bundle. This advantage is also being eroded. US consumers are steadily moving towards skinnier bundles of channels that don’t include Company A’s channel. Critically, this behavior is more prevalent among millennial consumers including young moms, a key constituency for Company A’s present and future growth.
Emerging competition has put pressure on Company A’s sales. Sales growth has decelerated from slightly above 5% in 2014 to flat growth on the trailing twelve months3. Management has blamed the deceleration on cyclical and temporary issues such as: poor merchandising options, weak customer confidence and product mix. We interviewed competitors and customers and found more permanent impairment in Company A’s consumer value proposition. Somar’s work revealed it would be extremely difficult for the company to keep both its current customers and its high operating margins.
Trading at more than 15x the trailing 12 month earnings, the stock valuation didn’t account for any of these challenges. We found at least 30% downside potential if either the market share or the margins came under pressure. If the turnaround went according to management’s expectations the stock offered less than 15% upside according to our judgement. We shorted the stock given the favorable asymmetric risk/reward exceeded our minimal standards. After we took our position, Company A reported a sales decline of 3.5% and an operating margin contraction vs. the previous year. The stock declined more than 15% as investors recognized the more permanent nature of Company A’s challenges. After the drawdown, we chose to cover, take our profits and redeploy the capital in other more attractive risk-rewards in the portfolio.
We don’t believe in staying in our short positions until the last potential dollar is made because the risk-reward becomes less compelling as the stock goes lower. Also, lower valuations increase the odds of an acquisition from a competitor. Therefore, we are happy to capture a majority of the expected profits and rotate the capital to other more compelling risk-rewards on the short book.
1Source: Northstar Risk Corp (Internal Risk Manager)
2In addition, new players have emerged that leverage mobile platforms to shoot and distribute infomercials. See for example MikMak at https://www.mikmak.tv
3To March 2016.