Interesting Reading – January 20, 2017

In this series, we suggest worthwhile reading material on a variety of topics of general interest.

What to Make of the ‘Davos Class’ in the Trump Era – The New York Times, January 16, 2017.  Andrew Ross Sorkin reports on the mood of the “Davos Class” as the World Economic Forum got underway earlier this week.  This annual gathering has long been known as a setting where leaders from politics, business, and non-profits congregate to discuss important issues of the day with a focus on the benefits of globalization.  Those benefits are increasingly not apparent to many ordinary people throughout the developed world as we have seen with the Brexit vote and Donald Trump’s election as U.S. President.  With Marine Le Pen now leading in the polls in the race for the French Presidency, one wonders whether Davos attendees are taking that possibility more seriously than they took Donald Trump’s chances at this time last year.

Expert Opinion – Memo to Oaktree Clients by Howard Marks, January 10, 2017.  Howard Marks is well known for his timely memos to Oaktree clients which are also made available to the general public.  His latest memo contains a number of observations regarding the folly of believing in “expert” predictions on various subjects.  The most salient example is, of course, the recent U.S. Presidential election.  Something clearly went wrong in the expert polling that overwhelmingly predicted a Hillary Clinton victory.  Furthermore, the predictions regarding the market reaction to a Donald Trump victory were also wrong.  Howard Marks is the author of The Most Important Thing, one of the most illuminating books on investing published in recent years.

Warren Buffett in New HBO Documentary:  ‘I’m Getting Down to Salvage Value’ – The Wall Street Journal, January 11, 2017.  A new HBO documentary examines Warren Buffett’s life with a focus on his family relationships and the personal sacrifices he had to make in order to build Berkshire Hathaway.  Apparently, most of the details are already well known to people who have studied Warren Buffett’s life, particularly to those who have read Alice Schroeder’s lengthy biography of Mr. Buffett.  The idea that Mr. Buffett is down to “salvage value” is amusing for those who have owned Berkshire Hathaway for a long time.  Mr. Buffett reached normal retirement age in 1995 and has continued to run Berkshire ever since.  Berkshire Hathaway shares closed at $25,400 on August 30, 1995, Mr. Buffett’s 65th birthday, compared to $240,280 today, representing a compound annual return of about 11 percent.  The vast majority of Mr. Buffett’s wealth has been generated as a senior citizen.

Inside Sears’ Death Spiral:  How an Iconic American Brand Has Been Driven to the Edge of Bankruptcy – Business Insider, January 8, 2017. This is a long (and depressing) account of the failure of Sears and Kmart as viable retailers in the United States.  Through a series of transactions, Chairman and CEO Eddie Lampert has delayed the final day of reckoning for the retail business and there may yet be value to be extracted from the various remaining brands and real estate owned by the holding company.  However, it is quite clear that it is past the point where a retail turnaround can be reasonably expected.  John Huber of Base Hit Investing has also written an interesting mini case study of Sears: Importance of Knowing Your Investment Boundaries (Sears Mini-Case Study)Eddie Lampert and Bruce Berkowitz are both very smart investors but one has to wonder whether they got in over their heads in this situation and what the end game will look like.

Struggling Hedge Funds Still Expense Bonuses, Bar Tabs – Reuters, January 19, 2017.  Hedge funds, in general, have not been performing very well in recent years and active strategies of all kinds have been losing assets to passive investment vehicles.  One reason is that hedge funds charge high fees.  The 2 & 20 model (2 percent of assets and 20 percent of investment gains, sometimes over a hurdle rate) is obviously expensive but apparently it gets worse in situations where funds “pass through” additional expenses to clients.  For example, Millennium, a $34 billion hedge fund, charged its clients the “usual fee” of 5 or 6 percent of assets and 20 percent of gains in 2016, which left investors in their flagship fund with a net return of just 3.3 percent.

The Great Unbundling – Stratechery, January 18, 2017.  This is a great article outlining the way in which the internet has changed the media business over the years.  The “media business” is obviously divided into a number of different categories (print, music, television, etc) , most of which have vastly different economics.  The internet has had different impacts on each category.  One of the most important developments in recent years is the manner in which services that used to be delivered as bundles are being broken apart into much more granular components.  A good example involves cable television and the erosion of the traditional huge cable bundle.  Stratechery has been around for a number of years but might not be well known in the value investing community.  Much of the content is offered under a subscription model but there is also very worthwhile free content such as The Great Unbundling.  

What Not to Eat:  ‘The Case Against Sugar’ – The New York Times, January 2, 2017.  The New York Times reviews a new book, The Case Against Sugar, which presents the logic that has led an increasing number of local governments to impose “soda taxes” on carbonated beverages such as Coca-Cola.  The book apparently makes a comparison between smoking and consuming sugar.  This seems absurd, but the author insists that “sugar kills”.  Is a calorie just a calorie?  Or is there something about sugar that is especially bad in terms of promoting obesity and the litany of related illnesses plaguing the United States?  While we must keep an open mind, even if the case against sugar is as solid as the author claims, the idea that only soda should be taxed rather than sugar itself seems politically opportunistic.  Why target only soda rather than sugar laden drinks such as a Starbucks Vente Frappuccino?  At a time of frustration among those who feel economically left behind, perhaps taxing the construction worker’s Big Gulp while exempting the $5 luxury drink of office workers isn’t the most intelligent (or fair) political move.

Under One Roof:  What Can We Learn From the Mayo Clinic? – Farnam Street, January 17, 2017.  With the inauguration of Donald Trump as President of the United States, the subject of health care reform is again on the minds of Americans, particularly those who are currently covered under “ObamaCare”.  In light of this attention, it was interesting to read Farnam Street’s discussion of how the Mayo Clinic has been able to earn its sterling reputation for quality health care over the years.  The incentive structure that the Mayo Clinic has put in place, along with the multi-disciplinary approach that encourages teamwork and treats all of the patient’s conditions in a unified manner, clearly makes an enormous difference when it comes to clinical outcomes.  Donald Trump has made some big promises when it comes to the level of quality Americans can expect from his upcoming health care reform plan.  One would hope that the lessons of systems that have worked well are studied in some detail, especially when it comes to incentive systems.

Marcus Aurelius on Business, Investing, and Modern Life

“Treat what you don’t have as nonexistent.  Look at what you have, the things you value most, and think of how much you’d crave them if you didn’t have them.  But be careful.  Don’t feel such satisfaction that you start to overvalue them — that it would upset you to lose them.”

— Marcus Aurelius

It is easy to imagine that we live in a unique era where human beings face challenges and opportunities that no previous generation experienced.  The tendency to focus on, and sometimes celebrate, our position in history is reinforced by rapid advances in technology that actually have changed the human experience in important ways.  At the same time, we face terrifying risks to the continued existence of civilization that few people living even a century ago would have contemplated.

Intuitively, it seems almost certain that the lives we lead today have very little in common with the experience of a person living a century ago and almost nothing in common with someone living a few thousand years ago.  This is true of certain practical aspects of our day-to-day existence but we must remind ourselves that even a few thousand years is almost nothing in the context of human evolution.  From a psychological perspective, have we really changed very much at all?  Or do we face many of the same problems and suffer from the same biases and human misjudgments as our ancestors?

Nassim Nicholas Taleb, author of the Incerto series, recently published an article on the Lindy Effect.  The basic premise of the Lindy Effect is that the future life expectancy of certain non-perishable things is proportional to their current age.  For example, a book that has been in print for fifty years and has retained wide readership has a much longer future life expectancy compared to a book that has been on the New York Times bestseller list for a month.  Ideas expressed in a book that has survived for 100 years will have a still longer life expectancy, and so on.  The individuals who developed ideas hundreds of years ago were all perishable but their ideas are not — if the ideas have merit.  A physical book is perishable, but the ideas contained within the book are not.  This is how Nassim Taleb hopes to be judged long into the future:

And as an essayist, I am not judged by other writers, book editors, and book reviewers, but by readers. Readers? maybe, but wait a minute… not today’s readers. Only those of tomorrow, and the day after tomorrow. So, my only real judge being time, hence future readers; it is the stability and robustness of the readership that counts. And as a risk taker, only time counts –for I could fool my accountant with steady earnings with a lot of risk, but time will eventually reveal the properties.

The essence of the Lindy Effect is that short term success can be due to a variety of factors, many of which have little to do with the long term value of what has been produced.  But for something to survive over centuries, it must provide actual value.  If not, it will be relegated to the ash heap of history, both literally as physical manifestations of an idea deteriorate, and literally as the idea retreats from human consciousness and is never discussed again.

The Longevity of Self Help Books

The dwindling number of people who still browse physical bookstores are well aware of the large number of shelves devoted to “self help” books of various types.  These books seek to present new and interesting perspectives that “speak to” modern human beings and address our very unique problems and challenges.  How many of these books will be in print in five years?  How many will be stacked on portable shelves placed outside used bookstores and sold for $5 or less as they physically deteriorate while exposed to the elements?  It is safe to assume that the vast majority of these books will not survive the next few decades, let alone be read by people in a few hundred years.  Some will fail due to a lack of merit and others might just have gone unnoticed.  But all will be subject to the Lindy Effect.

Approaching the category of books known as “classics” can be quite an intimidating experience, especially for those of us who were educated in systems that did not make it a priority to expose students to these works at a relatively early age.  However, one of the many benefits of reading what are known as the Great Books is that we begin to gain an appreciation for the fact that the underlying elements of human nature have not necessarily changed very much over the centuries.  Many of the fundamental problems we face today were encountered by people living thousands of years ago and they struggled then just as we do today.  Rather than be intimidated by the classics, it is best to jump in and start reading.  Of course, we have a limited amount of time to read and many seek practical knowledge they can apply right away.  If the dual goal is to learn from the classics and obtain practical knowledge, one could hardly do worse than to start by reading Meditations by Marcus Aurelius.

The Lindy Effect – An Extreme Example

Marcus Aurelius was born in 121 A.D. and was the Roman Emperor from 161 until his death in 180.  The story of his childhood and the sequence of events that led him to become the heir apparent gives us a sense of the type of person he was, which was obviously far removed from the experience of ordinary people at the time.  The introduction to Meditations by Gregory Hays provides the background a modern reader needs to put the book into context.  As an adherent of stoicism, Marcus adopted a philosophy of life that was already centuries old at the time — meaning that Marcus himself looked to the classics of his day as he formulated his world view.  Stoic philosophy was not merely an academic discipline to be studied but a blueprint for living one’s life.  Central to this world view is the concept that the world is organized in a rational and coherent way, as must be our interactions with the world.

Although he is probably best known for Meditations, it is interesting to note that Marcus never intended to write a book for publication, let alone put forth a philosophy of life that others would try to emulate thousands of years later.  The book we have today was written as a compilation of personal reflections with references that sometimes would only make sense to its author.  Mr. Hays characterizes the book not as a personal diary but as a personal self help book, one that Marcus himself could refer to in the midst of the stress and demands of his everyday life as Emperor.

The Hays translation is modern enough to be very intelligible to today’s reader while, in places, retaining the ambiguity one would expect from a 1,800 year old set of personal reflections.  The topics Marcus addresses are wide ranging, with the most profound relating to matters of life and death, and in particular the manner in which human beings should view their place in the world and the unjustifiable anxiety surrounding death.  Most of these topics, although very worthwhile to read, fall outside the scope of our concern in this article where we instead focus on Marcus’s views regarding topics that have contemporary applications to business, investing, and human psychology.  We aim to take selected excerpts from Meditations and relate them to contemporary life.

On Distraction, Procrastination and Focus

It is probably fair to say that people have never faced more distraction than they do today, but Marcus found it difficult to focus and easy to procrastinate, and apparently this was a common enough problem at the time to warrant several observations:

“Do external things distract you?  Then make time for yourself to learn something worthwhile; stop letting yourself be pulled in all directions.  But make sure you guard against the other kind of confusion.  People who labor all their lives but have no purpose to direct every thought and impulse toward are wasting their time — even when hard at work. ”  — Book 2, Section 7.

It is, of course, easy to relate to the first sentence.  External factors distract us all the time, whether it involves coworkers, family members, television, the internet, or increasingly, the phone in our pocket.  This could have been written by a self help author last week or discussed on a morning talk show today.  As investors, we face distractions all the time.  Many of us have televisions tuned to CNBC all day, every day.  Marcus is encouraging us to turn off these distractions and focus on something “worthwhile”.  However, we must be sure that what we are focusing on is actually worthwhile rather than busy work that serves no real purpose.  We can feel busy all day but accomplish little, even when not distracted.

Distractions can often be an excuse to procrastinate:

“Remember how long you’ve been putting this off, how many extensions the gods gave you, and you didn’t use them.  At some point you have to recognize what world it is that you belong to; what power rules it and from what source you spring; that there is a limit to the time assigned you, and if you don’t use it to free yourself it will be gone and will never return.” — Book 2, Section 4.

That’s a pretty intense statement that goes beyond what we’re likely to read today.  It is even a little bit “judgmental”, which would be considered a sin in today’s “no judgment” self help culture.  Do not procrastinate because we’re working with a very limited amount of time on this earth and should make it count.  If we don’t make the time assigned to us count, we will never get it back.  That’s something to consider the next time we decide between watching a financial news entertainer and finishing up a 10-K.  If you waste your time, you will never get it back.  And if we choose to be entertained, maybe that is not a waste of time but should be recognized for what it is.

When we resist the temptation to procrastinate and get to work, we have to focus:

“Concentrate every minute like a Roman — like a man — on doing what’s in front of you with precise and genuine seriousness, tenderly, willingly, and with justice.  And on freeing yourself from all other distractions.  Yes, you can — if you do everything as if it were the last thing you were doing in your life, and stop being aimless, stop letting your emotions override what your mind tells you, stop being hypocritical, self-centered, irritable.  You see how few things you have to do to live a satisfying and reverent life?  If you can manage this, that’s all even the gods can ask of you.”  — Book 2, Section 5.

Admittedly, Marcus has something far more serious in mind here than focusing on finishing a boring proxy statement, but focusing on what’s in front of us has a great deal of merit.  If we free ourselves from distraction and focus on the work sitting in front of us, and if we do this on a consistent basis day after day, good things are likely to happen.  One very key point is that we must keep our emotions in check and let our rational mind dictate what we do.  So much of what takes place in business is driven by emotions — principally fear, greed, and envy — and we must guard against acting in irrational ways due to these emotional factors.

On Business Ethics and Buffett’s “Front Page” Test

Marcus knew nothing of modern business or the specific ethical situations facing us today, but he did have a sense of ethics that is timeless enough to be fully applicable today:

“Never regard something as doing you good if it makes you betray a trust, or lose your sense of shame, or makes you show hatred, suspicion, ill will, or hypocrisy, or a desire for things best done behind closed doors.”  — Book 3, Section 7.

This sentiment that Marcus expressed over 1,800 years ago is not very different from Warren Buffett’s famous “front page” test:

“I want employees to ask themselves whether they are willing to have any contemplated act appear the next day on the front page of their local paper, to be read by their spouses, children and friends, with the reporting done by an informed and critical reporter.” — Warren Buffett

In other words, never take any action in business that you would be ashamed of and only wish to be known behind closed doors.  Although acting in accordance with this ethical code might seem virtuous, it is really in our self interest in the long run.  Being known as a person who betrays trust and acts in hatred and out of ill will and hypocrisy is, quite simply, bad for business.  We can all identify businessmen and politicians who seem to have “gotten away” with terrible behavior but the high publicity surrounding these cases might obscure many more who have never risen to prominence because they were considered untrustworthy at an early stage.

On Fame and Recognition

Gaining recognition and fame is a major motivator for many people.  This is probably more common among investors than in the general population.  Human beings seem to have an intrinsic desire to be well regarded by others today and remembered once we are gone.  However, sometimes the pursuit of fame leads us to take actions that may not be rational or ethical.  In doing so, we are losing sight of the fleeting nature of fame itself:

“People who are excited by posthumous fame forget that the people who will remember them will soon die too.  And those after them in turn.  Until their memory, passed from one to another like a candle flame, gutters and goes out.  

But suppose that those who remembered you were immortal and your memory undying.  What good would it do you?  And I don’t just mean when you’re dead, but in your own lifetime.  What use is praise, except to make your lifestyle a little more comfortable?”  — Book 4, Section 19.

Again, we can look to a modern example and consider Warren Buffett’s notion of an “inner scorecard” and an “outer scorecard”.  People who live their lives based on an inner scorecard have a set of standards by which they judge themselves.  How well they do in life depends on their own judgment, not that of others.  Those who live their lives based on an outer scorecard allow their self-worth to be based on the judgment of others.  As Marcus reminds us, those who are judging us during our lifetimes will also soon die.  The judgment of others is, in reality, of limited utility to us personally during our own lifetimes.

One ironic aspect of this quote is that Marcus is himself remembered long after his lifetime through a book that he never intended to publish.  As he wrote these words, it is unlikely that Marcus cared at all whether any of us are reading his words today.  His philosophy of life was entirely based on an inner scorecard despite the immense power he held as Emperor and the obvious knowledge that his actions would be recorded for posterity.

There is nothing wrong with wanting to leave a legacy so long as we remember the limitations of legacies in general, the fleeting nature of fame, and the need to avoid taking shortcuts in order to attain something that might not really matter in the long run.  Later in the book, Marcus makes the following observation:  “It’s quite possible to be a good man without anyone realizing it.  Remember that.” — Book 7, Section 67.

On Dealing with Difficult People

It seems obvious that the world has always been full of difficult and unpleasant people.  Those of us with the misfortune of having to tolerate office politics know all about this, and of course the same can be true in one’s personal life.  Marcus has several interesting observations on dealing with difficult people and limiting the harm that they can do to us:

“When you wake up in the morning, tell yourself:  The people I deal with today will be meddling, ungrateful, arrogant, dishonest, jealous, and surly.  They are like this because they can’t tell good from evil.  But I have seen the beauty of good, and the ugliness of evil, and have recognized that the wrongdoer has a nature related to my own — not of the same blood or birth, but the same mind, and possessing a share of the divine.  And so none of them can hurt me.  No one can implicate me in ugliness.  Nor can I feel angry at my relative, or hate him.  We were born to work together like feet, hands, and eyes, like the two rows of teeth, upper and lower.  To obstruct each other is unnatural.  To feel anger at someone, to turn your back on him:  these are obstructions.” — Book 2, Section 1.

With a healthy degree of skepticism regarding the number of such people a Roman Emperor actually would have to tolerate, we can still see the wisdom in the sentiment Marcus expresses here.  There’s an element of giving difficult people the benefit of the doubt, and adopting a stoic philosophy in which one cannot be harmed by the meddling or dishonest misdeeds of others.  In a practical sense, one can obviously be harmed in the short run and it does not appear that Marcus is advocating total passivity, only acceptance and recognition of the way the world is and that we can only control how we react to others, not how they choose to behave.

The following quote might resonate with anyone who has been in a meeting with certain types of people harboring a guilty conscience:

“The despicable phoniness of people who say, “Listen, I’m going to level with you here.”  What does that mean?  It shouldn’t even need to be said.  It should be obvious — written in block letters on your forehead.  It should be audible in your voice, visible in your eyes, like a lover who looks into your face and takes in the whole story at a glance.  A straightforward, honest person should be like someone who stinks:  when you’re in the same room with him, you should know it.  But false straightforwardness is like a knife in the back. — Book 11, Section 15.

The next time you’re tempted to say “Honestly, my opinion is … ” or “I’m going to level with you … ” or  “To tell you the truth … “, consider the message this might be sending regarding your normal level of trustworthiness.

On Reading

Perhaps it is fitting to conclude with some thoughts on reading:

“Stop drifting.  You’re not going to re-read your Brief Comments, your Deeds of the Ancient Greeks and Romans, the commonplace books you saved for your old age.  Sprint for the finish.  Write off your hopes, and if your well-being matters to you, be your own savior while you can.” — Book 3, Section 14.

There’s not much to add here.  Time is limited and we must make the most of what we have while we can.  Those who are unfamiliar with Meditations will almost certainly gain a great deal by taking a few hours in the near future to absorb its important lessons.

How to Read a 10-K Annual Report Efficiently

“We read a lot.  I don’t know anyone who’s wise who doesn’t read a lot.  But that’s not enough: You have to have a temperament to grab ideas and do sensible things.  Most people don’t grab the right ideas or don’t know what to do with them.”  — Charlie Munger

Successful investors often have very different approaches when it comes to the research process but one common thread that seems to come up again and again is that the best investors are voracious readers.  Warren Buffett spends nearly every day sitting in his office and reading rather than tolerating a calendar packed with meetings and conference calls.  Charlie Munger read so much when his children were growing up that they thought he was “a book with a couple of legs sticking out”.

Comments on the importance of reading have come up time and again during Berkshire Hathaway annual meetings.  People in the audience invariably nod and agree with the sentiment but most people do not follow through on the advice.  Modern society provides an enormous number of distractions that seem to leave little time for focused reading.  This provides a huge advantage to those who can tune out the distractions and devote the time toward reading.  However, this is only a first step.  Dedicating the time toward reading is necessary but, by itself, insufficient when it comes to improving results.  Our time must be wisely spent and our attention must be focused.

500 Pages Per Week

Depending on the source of the quote, Warren Buffett either reads 500 pages per week or 500 pages per day.  Based on a statement made by Todd Combs, it seems like 500 pages per week is more likely to be the actual figure (and it certainly seems more attainable for the rest of us).  The reading material was described by Mr. Combs as “a complete hodgepodge” rather than a pile of books.  There isn’t any doubt that numerous S.E.C. filings would be found within that pile of reading material.

There are many worthwhile reasons to read that have nothing to do with investing but presumably Mr. Buffett’s advice is related to the typical question he gets all the time:  “How do you go about finding great investments?”  The answer to this question invariably comes back to reading, but not just any kind of reading.  In order to learn about companies in a manner that does not introduce too many preconceived notions or biases, one needs to go to primary sources.  However, primary sources can be defined broadly or narrowly.  A broad definition would include all of the information a company publishes about itself on its website, glossy annual reports, C.E.O. letters, company presentations, and quarterly conference calls.  A narrow definition would be restricted to S.E.C. filings that are more driven by the concerns of a company’s general council than the head of marketing or investor relations.

Effective techniques for reading books have been well documented for years but the same isn’t really true for S.E.C. filings.  S.E.C. filings are legal documents that a company is required to file on a periodic basis and the consequences for making mistakes can be significant.  Depending on the nature of the company, risks and disclaimers of a legal nature can vary in length.  Nearly all companies include information that is, in some regards, repetitive or unenlightening due to the need for legal cover.  While all information in a filing should be read prior to making an actual investment decision, trying to read filings sequentially on a page-by-page basis when just getting to know a company is not the best approach.

It is risky to make assumptions not derived from direct quotes, but it seems more likely that Mr. Buffett has some method of rapidly reviewing S.E.C. filings:

What are some of the possible techniques for approaching a filing and obtaining enough information to determine whether further study is warranted?  In this article, we will take a look at some possible ways of approaching a 10-K report for a company that one is not familiar with for the purpose of determining whether further study is required.  Readers who have been reviewing S.E.C. filings for many years and have their own method are probably not going to find the rest of this article very interesting but, based on questions received on Twitter and email over the years, many readers might benefit.

Reading a 10-K Report

The best way to get an understanding of a business at a more than superficial level is to read the company’s latest 10-K filing.  There are important differences between a company’s 10-K filing and an annual report, especially for larger companies.  Annual reports are typically glossy marketing materials that start off with a one or two page C.E.O. letter and are followed with magazine style pages showcasing the company’s products or services.  They are designed to make shareholders and the general public “feel good” about the company and its management.  Useful information could very well exist in this material but this information will be contained within a specific agenda.  This agenda is not necessarily nefarious but it will always seek to influence our opinion.  It is best left until after one has read the 10-K.

Stated simply, a 10-K report is an annual report required for all public companies that must be filed with the S.E.C. within a short period of time following the end of a fiscal year.  It is critical to read the 10-K filing and many other filings, in their entirety, before one actually makes an investment decision.  But if our goal is simply to “get to know” the business in order to decide if we want to allocate further time, there are better ways to go about the task.  The more efficient we are at looking at a 10-K and quickly deciding whether more study is warranted, the more time we can allocate to looking at additional 10-Ks.

Finding 10-K Filings

Prior to the mid-1990s, an investor would have to send a request to a company or to the S.E.C. in order to receive paper company filings but we do not have to wait today thanks to the EDGAR system.  EDGAR makes it possible to retrieve information regarding a company in near-real time using the company search tool:

In the screenshot above, we are going to run a search for Sensata Technologies by using the ticker symbol “ST”.  Using a ticker symbol will take you directly to the company’s filings.  Querying by company name will usually result in an additional step listing a number of companies so using the ticker is more efficient.  When this query is submitted, the following results will come up:

We can see all of the company’s recent filings in the results screen.  This includes a number of 10-Q reports, which cover quarterly periods, as well as other types of reports.  We do not see the 10-K in recent results, but filtering on the filing type bring up all of the 10-K reports in the system:

We can see all of the 10-K reports since Sensata went public in 2010.  For purposes of our initial review, we will want the latest 10-K report filed on February 2, 2016 (2016-02-02).  Clicking on the Documents option for the latest 10-K and then on the “Form 10-K” link will bring up the actual report.

We can see that this report is about 147 pages long which obviously would take a great deal of time to read from cover to cover, and indeed a cover to cover reading is needed before investing but not in order to gain a basic understanding of the business.  In order to obtain a basic understanding, we will focus on a few specific areas.

Business Summary

The business summary is only nine pages long, running from pages four to twelve.  The purpose of this section is self-evident.  Management is supposed to provide a clear overview of the economic purpose of the business, the products or services that it sells, the key economic conditions under which it operates, some sense of its history, and a view of the competitive conditions within the industry.  This entire section should be read carefully in its entirety.

From reading the overview, we quickly comprehend that Sensata is in the business of developing, manufacturing, and selling sensors and controls that are used in a variety of applications.  These sensors are customized for specific uses and, at a simplified level, translate a physical phenomenon such as pressure into electronic signals that trigger a microprocessor to take some kind of action.  The company’s principal end-markets include automotive, heavy vehicles, HVAC, industrial, aerospace, and semiconductor markets, among others.  The company is research driven and works closely with customers.  Operations are diversified with meaningful fixed assets and revenues throughout the world.  The automotive market is the most critical with over two-thirds of revenue attributable to that end market.

Management provides a brief history of Sensata which has roots going back to businesses that were founded in 1916 and, more recently, was part of Texas Instruments until 2006 when Sensata became an independent company.  It is also apparent that the company has grown through numerous acquisitions since 2006.

Typically, management will provide an overview of the business as a whole and the segments that it uses for management and reporting purposes.  We learn that management has divided the company into two segments: Performance Sensing and Sensing Solutions.  Usually, facts and figures are presented in tabular form on a per-segment basis, as we can see with the presentation for the Performance Sensing segment:

This presentation quickly allows us to understand a little bit more about the business by translating a vague term like “performance sensing equipment” into applications that we can all understand more easily.  In general, we want to see an attempt by management to make the business understandable to investors.  In this case, the business sells highly technical components but we can generally understand what these components are used for without being technical experts.  Management also breaks down revenues by category for the past three years giving us a clear sense that pressure sensors are the most important aspect of the segment’s operations.

A similar presentation exists for the Sensing Solutions segment which we will not show here since we aren’t attempting to analyze Sensata, but rather to provide an overview of what is contained within its 10-K.

The business overview proceeds to cover intellectual property, customers, competition, seasonality and other factors, all of which adds to the overall picture and should be reviewed carefully.  The business overview section is only nine pages long and takes perhaps 15 to 30 minutes to review.  However, it provides enough information for most people to determine whether to short-circuit the process and move on to something else or to continue the process.  If one reaches the end of the business summary and is left with a great deal of confusion regarding how the company operates, it can either mean that management has done a poor job explaining the business or that the industry is outside an investor’s circle of competence.  In either case, it is probably best to move on to another company.

Risk Factors

The next major section of a 10-K involves a discussion of risks facing the business and the industry in which it operates.  Risk is a critical component of evaluating a business but it must be noted that this is also where the lawyers get heavily involved.  S.E.C. filings are legal documents and a failure to make required disclosures can invite shareholder lawsuits.  The lawyers who write these sections are usually more concerned with guarding against lawsuits than providing much enlightenment.  This is not to suggest that these risks shouldn’t be reviewed, but rather to put the section into context.

Usually, each risk is presented as a title in bold type followed by a more lengthy description, such as the following:

This section isn’t terribly enlightening. Nearly all businesses operate in industries that are highly competitive.  In nearly all industries, heightened competition results in companies feeling pricing pressure.  The description does provide a little more context, but really just states the obvious.

Our recommendation for the risk section, when it comes to an initial reading of a 10-K, is to quickly review the title of each risk but to not review the entire description of each of the risks.  Areas of particular concern that would determine whether an investor is going to proceed with research on the company should be reviewed in full but areas that appear to be boilerplate should be left for a more thorough reading at a later time. The same is true for the legal proceedings section of the document.

Selected Financial Data

One of the best ways to get a very quick overview of a company’s economics is to look at the selected financial data section which, in most cases, presents selected data for the past five years.  The selected financial data for Sensata appears below:

Although the data presented in this section cannot be sufficient to form any conclusions, we can begin to get a sense of factors such as revenue and earnings growth, figures such as gross and operating margin, the overall level of capital intensity, and the degree to which net income converts to free cash flow.  We can also spot unusual items such as the fact that Sensata benefited from large tax benefits over the past two fiscal years.  Also, we note that there is a category called “Other, net” that seems significant (we take a note to look for more information about that later in the report.)

Digging a bit further into the details, we can see that amortization of intangibles is a very significant line item and that management has a history of classifying costs under “restructuring and special charges”.  We can also see that the company is highly leveraged with $3.6 billion of debt and $1.7 billion of shareholders equity.

The best way to review this table is to take notes on factors that seem unusual or worthy of further study and to come back to it after a more complete review of results.  A review of this section could also short-circuit the process if an investor notes that certain attributes fall outside his or her parameters for investment.  For example, leverage ratios above a certain level may leave an investor uncomfortable regardless of other aspects of the business.  If that is the case, the investor can put this 10-K in the “too hard” pile and just move on.  Arguably, the selected financial data section should be read even before the business summary to efficiently short-circuit the process by filtering for unacceptable attributes.

Management’s Discussion and Analysis (MD&A)

This is the section of the 10-K where management has the opportunity to put the company’s recent results into the proper context.  However, this section also includes much information that is redundant with the business summary section and should be skipped during a first reading of the 10-K.  In the case of Sensata, the MD&A begins with overview information that, in some cases, appears to be taken verbatim from the business summary.  There is also information on the history of the company that is basically an exact repeat of the information provided previously in the report.  It is unclear exactly why redundancy exists here, and the amount of it varies from company to company, but it is a fair assumption that we can blame the lawyers and their attempt to limit legal liability.

The core of the MD&A that readers should focus on is the section where management explains the underlying economics of the business and the results of operations over the past three years.  In Sensata’s case, management provides much useful information regarding the underlying economics of the business.  For example, the following section explains how production material cost varies based on commodity prices:

It is useful to know that the company is relatively sensitive to commodity prices, especially related to Chinese production of rare-earth elements.  Also, we note that the company has a hedging program in place and that derivatives gains and losses are recorded in the “Other, net” category, which provides some detail on an area we noted when looking at the five year summary of selected data.

The MD&A goes on to describe a number of other factors impacting operating results before moving on to a summary of the results over the past three years – the results of operation. The following table is presented at the start of the discussion:

A great deal of information is presented here and discussed in much detail in the paragraphs that follow.  Different companies will present the data differently here but the table shown above is fairly typical.  We can see revenue by segment and operating costs expressed in dollar terms and as a percentage of revenue.  Trends in both the movement of revenue and costs over time and relative figures such as operating margin give the reader a quick view of recent trends.

Here it is interesting to take one note that would escape someone who looks only at a simplistic figure such as net income margin.  We see that the net margin is basically unchanged between 2014 and 2015.  However, the lack of movement in that measure is due to the fact that the company realized a materially higher tax benefit in 2015 than in 2014.  In reality, gross margin was significantly lower in 2015 and operating costs were also elevated.  A transitory factor such as a higher tax benefit holds less weight than factors such as gross and operating margin trends when looking at a company’s results of operation.

Generally, management goes through each of the important figures and explains reasons behind changes in revenues, trends in cost of goods sold, operating costs, etc.  In some cases, management will then present “adjusted” figures on a non-GAAP basis that they believe better reflect the underlying trends of the business.  Sensata provides such a reconciliation:

Do we take non-GAAP adjustments at face value?  No good analyst should do that but it does not follow that all adjustments are illegitimate.  At this stage, it is unlikely that the reader understands the company well enough to decide whether the adjustments are warranted or not.  However, we would make one skeptical note right off the bat:  management has a history of restructuring charges every year yet wants investors to ignore those charges in adjusted net income.  A company that has restructuring charges on a yearly basis cannot really claim that such charges are “unusual”.

The MD&A proceeds to discuss cash flow, debt, liquidity, and capital resources.  All of these areas are important but we would recommend reviewing these areas quickly, to be revisited if the company is more seriously considered after reading the financial statements.

Financial Statements

The next major section presents the company’s audited financial statements and detailed notes to the financial statements:

For purposes of this article, we will assume that the reader knows what to expect in this section and will not go into much detail other than to suggest a selective reading of the notes for this initial review of the 10-K, with a complete review to follow once the company is under more serious consideration.  One exception might be to review the notes on business segments more carefully at this stage if there are questions regarding the nature of the segment economics as they relate to the consolidated financial statements.

In terms of sequencing, some readers may want to slightly reverse the recommended order in this article by reviewing the five year summary first, followed by a quick look at the financial statements prior to reading the business summary.  Investors who are more quantitatively oriented and have checklists of factors that would disqualify an investment might do this as a process of elimination.  The risk is that without understanding at least the basic attributes of the business, certain figures in the financial statements may be misconstrued in some way that obscures the real economics.  Ultimately, the sequence of review is up to the investor and has to match his or her preferred process based on experience.


It is somewhat dangerous to suggest that an investor should not review a 10-K report word-for-word, but that is not really the intent of the recommendations in this article.  Instead, we are suggesting a way in which an investor can more quickly assess whether a company warrants further study.  In a perfect world with unlimited time, it might be fine for an investor to go through a 10-K line-by-line and word-for-word during the first reading.  In the real world, this will require an investor to be exposed to far fewer companies than would otherwise be possible.

In a competitive investment landscape, it makes sense to be exposed to as many companies as possible and to do so as efficiently as possible.  The ideas expressed here could be one way to do that.  A sub-set of the companies that are initially reviewed would receive more thorough attention at a later time and, always, before any investment decision is made.

Disclosures:  No position in Sensata.  Sensata is only an example based on a recently reviewed 10-K and this article doesn’t provide any analysis of Sensata. 

America’s Car-Mart: Navigating the Subprime Market

America’s Car-Mart is one of the largest retailers in the United States operating in the “buy here, pay here” segment of the used car market.  Companies operating in this segment, also known as “integrated auto sales and finance”, sell older model used vehicles and provide financing to virtually all customers.  The typical customer either has no credit or very poor credit and would find it very difficult to qualify for conventional automobile financing.  Many customers do not have checking accounts and live paycheck-to-paycheck without recourse to emergency savings.

The fact that half of Americans lack emergency savings, or a “rainy day” fund, can be hard to believe for those of us who have no direct experience with poverty.  Most people without savings have jobs that either pay so little that they cannot save or they have poor financial management habits that prevent savings.  Regardless of the cause, however, many of these people would not be able to hold down a job at all without reliable transportation.  Big cities have many transportation options for people with limited financial resources but small cities, towns, and rural areas are car-centric cultures.  Services like Uber either do not exist or are spotty, and traditional taxi services are not long-term solutions for commuting.  Owning a car is simply a necessity in many parts of the United States.

In this article, we take a closer look at Car-Mart by providing a brief overview, discussing the unique attributes of the business model, delving into the details of the financing operation, and considering the company’s prospects for continued growth.


We recently discussed CarMax which is the largest used car retailer in the United States but tends to sell cars at price points that would not be affordable for poorer customers even if they could obtain financing.  Car-Mart, in contrast, operates at a much smaller scale and sells older vehicles at lower prices.

In fiscal 2016 (which ended on April 30, 2016), Car-Mart sold 46,483 vehicles at an average sales price of $10,361 through a network of 143 dealerships operating in eleven states.  The majority of dealerships are located in smaller communities with populations of less than 50,000 people.  Vehicles are typically between six to twelve years old and have 90,000 to 140,000 miles.  The company acquires vehicle inventory through a variety of channels and generally pays between $3,000 to $7,000 per vehicle.  The exhibit below, adapted from the company’s recent investor presentation, shows the geographic distribution of existing and planned dealerships:

Unlike a CarMax dealership, which typically has extensive inventory, showrooms, and service departments, a Car-Mart is usually a small lot offering inventory of between 25 and 75 vehicles.  When a new dealership is opened, a modular structure is often placed on the lot while the business gains traction and is potentially replaced with a building at a later point.  This allows the typical $1.5 to $2.5 million initial investment in a dealership to be directed mostly toward inventory.  The exhibit below shows the total number of dealerships in operation over the past eleven years:

Car-Mart prefers to promote managers from within the company, although recent growth has also involved some outside hires.  New managers handle a variety of tasks as a new dealership grows.  A typical new dealership reaches profitability after the first year of operations.  Established dealerships generate free cash flow that is returned to headquarters and reallocated either toward expansion or returning capital to shareholders. The growth of dealerships was quite rapid in the years immediately following the financial crisis, but has slowed recently.

Dealerships are operated on a decentralized basis with each manager responsible for all aspects of his or her operation including buying and selling vehicles, making credit decision, and servicing and collecting installment contracts.  In fiscal 2016, 321 vehicles were sold per dealership, on average, and same store revenue growth was 2.7 percent.  The exhibit below shows that the company had strong same store revenue growth for several years after the last recession, although growth turned negative in 2014 before recovering more recently:

The combination of strong same store revenue growth and the addition of new dealerships has driven overall revenue growth over time, as we can see from the company’s recent investor presentation (figures in millions):

The vast majority of revenue is attributable to retail sales of used vehicles.  The company also sells a small number of vehicles through wholesalers which is immaterial to the overall business.  All vehicles are sold on an “as-is” basis.  However, customers are offered a service contract which covers certain components.  This is essentially a warranty purchased by the customer in exchange for service provided by third party service centers that Car-Mart has contracted with.  The company also offers payment protection plans to customers who have used financing (which is nearly all customers).  A payment protection plan obligates the company to cancel the remaining amount financed on a vehicle when it has been totaled or stolen.

Gross margin has typically been in the low 40-percent range but has been pressured in recent years because of a general inflation in the value of used vehicles.  Because Car-Mart’s typical used vehicle is between six and twelve years old, the effects of the collapse in automobile production during the recession is now being felt in a shortage of older used cars on the market.  This has driven up the cost of acquiring vehicles and has pressured margins because Car-Mart’s customers cannot necessarily afford to pay more.  The average retail sales price of a vehicle has increased from just under $7,500 in 2006 to nearly $10,500 in the first half of fiscal 2017.

Readers who are interested in more details can refer to the income statement data shown below (click on the image for a larger view):

Unique Aspects of Business Model

There are many elements of the “buy here, pay here” industry in general, and Car-Mart in particular, that are initially somewhat less than intuitive for those who do not have direct experience with poverty.  Perhaps the most salient point is that the typical customer has very little disposable income and almost no savings.  However, Car-Mart views all of these individuals as potential customers as long as they can provide proof of employment, a proposed budget, and personal referrals.  Traditional credit scores are not relevant in this business because the customer will either have no credit or extremely poor credit.

When one views the industry in this light, Car-Mart’s focus on small communities makes much more sense.  Other than the lack of public transportation in such communities which makes automobiles non-discretionary, Car-Mart also gains numerous other benefits by close association with a community.  If credit scores cannot be used to gauge credit worthiness, it helps to know people in the local community who can vouch for a potential borrower.  If someone has held a job for a reasonable period of time, is active in the community, and has demonstrated good character, a dealer operating in a small town is likely to have the confidence to extend credit.  On the other hand, word travels quickly in small towns and the grapevine can often reveal individuals who should not be trusted.

The dealer will also develop a reputation fairly quickly in small communities and has an incentive to treat customers as fairly as possible.  This can create a virtuous cycle where referrals make up a growing part of a dealership’s business.  Car-Mart reports that a “large percentage” of business is from repeat customers and an additional ten to fifteen percent of sales results from referrals.

One might wonder why repeat business would be high given that automobiles are lasting longer than in the past.  The answer is that Car-Mart’s vehicles are much older than average with significant mileage already on the odometer.  As we will see shortly, this requires shorter financing terms to ensure that a vehicle does not break down before the note is fully paid since most customers will simply stop paying their note if the vehicle is no longer running.  At the same time, it is probably unrealistic to expect that a car purchased from Car-Mart will run reliably for many years after the customer pays off a loan.  This creates a cycle of repeat business as vehicles need to be replaced fairly quickly.  Customers are basically taking the last few “puffs” from a vehicle before it is no longer economical to maintain it.

Many Car-Mart customers do not even have bank accounts and pay for all purchases with cash.  Payments are usually made in person and in cash at Car-Mart dealerships on a weekly or bi-weekly basis.  In an age of electronic payments, this might seem hard to believe for many readers but it is apparently not uncommon at all.  Car-Mart schedules payments to coincide with a customer’s pay day and offers free check cashing service in dealerships to encourage customers to make payments on their note as a first priority after receiving their pay.

Most investors will not be able to personally relate to the economic issues facing the typical Car-Mart customer but it is important to gain an understanding of some of the unique aspects of serving low-income customers, especially as we delve into the financing business in more detail.


When one looks at core competencies for a retailer, it is normal to focus on attributes such as sourcing inventory, advertising and attracting customers, providing a compelling product, and having the skills needed to close a deal.

While these are all important skills for a Car-Mart dealer, by far the most important aspect of the business involves servicing and collecting loans.  

Why?  Readers who reviewed the income statement shown above probably already know the answer:  defaults are extremely high in this business.  Car-Mart knows that a very significant percentage of customers will default on their loans.  The provision for credit losses as a percentage of sales has historically been in the low to mid 20 percent range but has increased in recent years as we can see in the exhibit below:

When you are in a business where you know, in advance, that your customer base is very likely to default, this expectation must be built into your overall business model in terms of pricing and strategy.  As of October 31, 2016, the allowance for credit losses of $111.3 million was approximately 23.5 percent of the principal balance of $474.3 million.

How does Car-Mart mitigate the fact that many of the loans it originates will fail to perform?  First, the company targets gross margins on vehicles that are substantially higher than auto dealers selling to a more creditworthy market.  Perhaps counter intuitively, the higher sticker price on the vehicle may not, by itself, dissuade customers because what they care most about is the affordability of the weekly or bi-weekly payment, not the sticker price on the vehicle.  Second, the fixed interest rate charged on all loans is relatively high at 16.5 percent. This is obviously far higher than the interest rates available to credit-worthy customers and mitigates some of the risk of default.  Third, loan terms are far shorter than one might expect.  The average originating contract term during the first half of fiscal 2017 was 29.2 months while the weighted average contract term of all receivables was 31.7 months.  Finally, the company specializes in efficient collection by encouraging customers to pay in person on their payday.  By getting “first crack” at the customer’s paycheck, the risk of loss is lower than if other obligations are paid first.

The average down payment is relatively modest.  After holding in the 7 percent range for several years, the average down payment was only 5.8 percent during the first half of fiscal 2017.  The company is known for taking nearly “anything” in on trade, even accepting horses, mules, and even a “four legged chicken”, according to a video posted on the company’s website.  (Obviously those are amusing exceptions; presumably most trade-ins are motor vehicles!)

The following exhibit adapted from the company’s recent presentation shows the economics of the company on a per-vehicle basis and makes it a little easier to understand how all the moving parts fit together:

Obviously, these figures are averages and accounts for typical credit losses across the entire loan portfolio.  We can see that a good repeat customer who pays on time is highly profitable for Car-Mart which is why repeat and referral business is so valuable.  Obviously, defaults are going to occur but the combination of the gross margin and high interest rates make the overall portfolio yield acceptable results.

Collection efforts are very important both from the perspective of keeping credit losses down and ensuring ongoing customer satisfaction and a good reputation in the community.  Within a couple days of a missed payment, Car-Mart’s local staff will contact the customer by phone and mail to determine why the payment was missed and how the account can be made current.  The company does not generally make loan modifications except to extend the time of a loan when management believes that doing so will increase the total amount collected from the customer.  Repossession of vehicles is either handled by management or contracted out to a repossession specialist.  GPS units have been placed in vehicles to make repossession more likely.  However, repossession is a last resort because the recovery on a repossessed vehicle is typically not sufficient to cover the outstanding loan amount and obviously taking away a customer’s car can involve reputational harm for the dealership.

Even with diligent collection efforts, a high level of net charge-offs as a percentage of finance receivables is the norm, as we can see in the exhibit below:

To provide further context, the exhibit below shows changes in finance receivables over the past eleven years (click on the image for a larger view):

It should be apparent by now that the company does not securitize its receivables.  Loans are retained on the company’s balance sheet and funded with a combination of shareholders’ equity and a revolving credit facility.  As of October 31, 2016, the company’s debt-to-equity ratio was 53.1 percent with total debt of $124.7 million against net finance receivables of $363 million.  Shareholders’ equity was $234.9 million.

The data shown above demonstrate that the company weathered the recession quite well.  Although one might think that charge-offs would skyrocket in difficult economic times, it appears that the Car-Mart business model is resilient during tough economic times.  This is probably due to the fact that customers are perpetually strapped economically and their disposable income does not really vary with economic cycles (assuming, of course, that they retain their jobs).  Furthermore, for those who do have jobs, keeping their car is even more critical during difficult economic times because it is necessary to get to work.  A large pool of unemployed people ready and willing to take any job during a recession likely makes people who do have jobs feel less secure and even more averse than usual to missing work due to unreliable transportation.

Growth Prospects

As we could see from the first exhibit in this article, management believes that there are ample locations available for future growth.  There are many small towns within the company’s historical regional base of operations that could support a new dealership.  With a start-up dealership requiring only $1.5 to 2.5 million in initial capital, the company could afford to expand much more rapidly based on internally generated cash flow.  If unit economics of each incremental dealership could be brought up to the company’s average in short order, this would appear to be a good use of capital.

Some degree of caution regarding growth prospects is warranted, however, based on management’s decision to repurchase a significant number of shares in recent years.  Over the past decade, the share count has declined by 35 percent principally due to deployment of $143 million toward repurchases since February 2010, as shown in the following exhibit taken from management’s recent presentation:

From management’s conference calls and actions, it seems like there is a great deal of conservatism when it comes to the rate of expansion as well as the decision to restrain growth to within the company’s historical region of the central southern states.  How scalable is the company’s business model and what are the constraints that would prevent a nationwide rollout of the Car-Mart concept?  The United States is obviously full of small cities and the underlying economics are likely to be quite similar.  Management may not feel that they have enough local knowledge to operate effectively except in their existing region and is moving beyond it carefully.


Car-Mart operates in a very difficult market.  The company’s customers are people who have very little disposable income and are perpetually strapped for cash.  Such customers inevitably will default on their obligations at a rate far higher than more credit-worthy customers.  In order to successfully operate in such an industry, management must strike the right balance between pricing of vehicles, financing options, and collections of delinquent accounts.  A merciless approach will earn the company poor reviews while a softer than justified approach ruin the economics of the business.

Despite initial qualms regarding the business model, it does not appear to be “predatory” in the sense that it operates in a free market system in which customers do have alternate choices.  One may obviously purchase a used vehicle from a private party or a huge number of “mom and pop” dealerships.  Car-Mart offers customers convenience that is obviously appealing and the growth it has experienced validates the overall model.

Recent results have been pressured by a combination of higher prices for used vehicles which has pressured gross margin, more aggressive financing options provided by other players in the sub-prime auto market, and elevated credit losses compared to typical experience earlier in the decade.  As the inventory of used vehicles in the six to twelve year old range increases over the next several years (due to recovering new car production after the recession), the price of used vehicles is likely to decline which should lead to a recovery in gross margins.  Aggressive financing options by competitors could abate due to higher short term interest rates.  Recent installation of GPS units in vehicles could improve customer payment compliance and aid in repossession of vehicles, thereby trimming credit losses.

At a recent market capitalization of approximately $340 million, Car-Mart trades at approximately 145 percent of book value and about 14 times earnings.  Share price weakness in late 2015 and early 2016 was clearly due to the headwinds described above and the stock has recovered significantly since then.  However, the current quotation could still be an attractive entry point for long term investors who believe that the potential headwinds are transitory in nature and likely to abate in the coming years.  If management figures out a way to accelerate growth and take the concept nationwide, returns to shareholders are likely to be very attractive.

Update on February 2, 2016:  The Rational Walk published an article on analyzing proxy statements using Car-Mart as an example.  Readers interested in the company might want to review this post for more insight into the company’s corporate governance.

Disclosure:  No position in America’s Car-Mart.


CarMax: A Better Way to Buy and Sell Used Cars?

CarMax was founded in 1993 in Richmond, Virginia under the ownership of Circuit City Stores.  In the early 1990s, Circuit City was looking for growth opportunities in different markets outside consumer electronics.  The automotive sector was identified due to its large size, fragmented nature, and a reputation for less than stellar consumer satisfaction.  CarMax was separated from Circuit City and became a publicly traded company in 2002.  The business model turned out to be very successful and the company is now the largest retailer of used cars in the United States, selling 619,936 vehicles at retail in fiscal 2016 along with an additional 394,437 vehicles through wholesale auctions.  Although CarMax is the largest used car retailer, it does not have a dominant share of the market.  In 2015, Over 17 million new cars and 40 million used cars were sold at retail, with an additional 10 million vehicles sold at auction.  The total fleet of light vehicles in the United States was approximately 260 million at the end of 2015.

Purchasing a car has traditionally been a frustrating process for most people.  Unless you are someone who particularly enjoys the negotiating process or derives energy from confrontation, buying a vehicle, especially a used one, is about as pleasant as getting a root canal.  One can choose between going to a dealership or transacting with a private party, but informational asymmetry, the complexity of the product, and financing issues make the transaction inherently difficult.  No one wants to overpay for a lemon or be pressured into making a complex decision in a less than hospitable environment.

The CarMax approach is fundamentally different from the typical auto dealership experience primarily because the “no-haggle pricing” policy removes the most contentious part of the process.  The goal is to provide the customer with the same experience they get at a typical “big box” retailer.  Sales consultants are paid commissions on a fixed dollars-per-unit basis and have no incentives to sell inappropriate financing or extras.  The company also provides a five day money back guarantee which reduces risk to the consumer.

There are other benefits for the customer as well including the ability to sell a trade-in vehicle to CarMax regardless of whether one purchases a vehicle.  Effectively, the trade-in of a customer’s vehicle and the purchase of a CarMax vehicle are completely separate and handled transparently.  CarMax benefits from a stream of inventory coming in from trade-ins that can be obtained for better prices than through other channels.  Vehicles obtained via trade-in are either reconditioned in CarMax production facilities or sold at auction.  CarMax tends to focus on selling newer vehicles through its retail channel, as evidenced by the average selling price of $19,640 over the first nine months of fiscal 2017.  The typical sales price of a vehicle sold at auction was $5,165.

CarMax offers financing to customers either through its CarMax Auto Finance subsidiary or through “Tier 2” and “Tier 3” providers who cater to customers with lower credit scores.  All financing offers include the right to pay off the loan within three days, which allows the customer to refinance through another lender within three days at no charge.  The combination of the three day payoff option and the five day money back guarantee obviously removes quite a bit of anxiety from the process.

Although CarMax is the largest used car retailer in the United States, it has yet to saturate the country geographically.  As of September 28, 2016, the company had 165 locations (increased to 169 locations at the end of Q3 of fiscal 2017 on November 30).  The store count was only 67 units at the end of fiscal 2006 and has increased during every fiscal year except for 2010. The exhibit below shows the location of CarMax stores in the United States along with planned locations through August 2017.

In this article, we will take a look at CarMax in more detail focusing first on the history of its retail and wholesale operations which forms the core of the business.  We then examine the company’s financing unit which is an integral part of the success of its retail operations.

Retail and Wholesale Operations

CarMax offers a broad selection of used vehicles at retail that generally range in price from $12,000 to $35,000.  Although there are some older vehicles listed on the CarMax website, the majority are relatively new and have less than 100,000 miles.  Vehicles are reconditioned to ensure that all vehicles sold at retail qualify as “CarMax Quality Certified” vehicles.  Most routine mechanical maintenance and minor body repairs are handled in-house.  Vehicles that do not qualify for sale at retail are sold at auction.  The typical vehicle sold at a CarMax wholesale auction is 10 years old and has more than 100,000 miles.

The exhibit below shows the CarMax income statement over the past eleven fiscal years as well as for the first three quarters of fiscal 2017 (click on the exhibit for a larger view):

It is important to examine more than the past few years for a company like CarMax given the fact that automobile sales were quite depressed during the financial crisis as well as the early part of the current decade.  Predictably, results were pressured during fiscal year ending on February 28, 2009 which represents the worst of the crisis.  However, the company was still profitable, albeit at a depressed level as reduced revenue was not matched by a reduction in SG&A.  However, the recovery in the years that followed is quite impressive.  Looking at some more granular data helps to illustrate CarMax’s recovery after the financial crisis (click on the exhibit for a larger view):

In terms of used cars sold at retail, the decline from fiscal 2008 to fiscal 2009 was fairly modest at 8.4 percent.  Unit sales recovered slightly in fiscal 2010 before exceeding pre-recession levels in 2011 as store expansion resumed.  Used vehicle gross profit held steady during the worst of the crisis and then exceeded pre-recession levels in 2010.  Average selling price of used vehicles sold at retail increased substantially from fiscal 2009 to fiscal 2013 and has held steady since that time. Store expansion accelerated over the past few years and has driven unit sales higher. As per-unit economics have been maintained, overall profitability has increased with diluted EPS rising from $1.24 in fiscal 2010 to $3.03 in fiscal 2016, a compound rate of 16 percent. EPS growth has also been aided by a repurchase program initiated in fiscal 2013.

What seems impressive about CarMax is the relative stability of gross margin per unit over time coupled with the company’s expansion potential.  Management expects to open 15 stores in fiscal 2017 (ending on February 28, 2017) and an additional 13 to 16 stores in fiscal 2018.  Some of these stores will serve smaller metropolitan areas using a smaller store format and some stores will serve additional large metropolitan areas.  Looking back at the map of store locations, it is clear that there are major parts of the United States that are yet to be served.  CarMax has a strong brand and is not anywhere near the saturation point.

CarMax Auto Finance

Since the majority of customers shopping for a vehicle cannot pay cash for the purchase, providing easy and competitive financing options is an integral part of operating in the retail channel.  The auto financing industry is comprised of banks, captive finance divisions of new car manufacturers, credit unions, and independent finance companies.  CarMax Auto Finance (CAF) primarily competes with banks and credit unions that offer direct financing to customers who are purchasing used vehicles.  CAF is ranked 8th in market share for used vehicle loans and 14th in market share for all vehicle loans in the United States (as of the 4th quarter of 2015).

All customer application for credit are initially reviewed by CAF.  Applications that are declined or conditionally approved by CAF are then evaluated by third-party finance providers (which includes Santander USA, Wells Fargo Dealer Services, Ally Financial, Exeter Finance Corp, American Credit Acceptance, Capital One Auto Finance, and Westlake Financial Services).  When an application is referred to a third party provider, CAF is either paid or pays a fixed fee per contract.  “Tier 2” providers typically pay a fee to CAF while “Tier 3” providers receive a fee from CAF.  Tier 3 providers serve customers with low credit scores and CAF is willing to pay a fee to facilitate their financing because it provides incremental retail sales that would otherwise not occur.  Regardless of whether a loan is retained or referred to a Tier 2 or Tier 3 provider, CAF services all auto loans it originates.  This includes maintaining contact with delinquent customers and, if necessary, repossessing vehicles securing defaulted loans.  At the end of fiscal 2016, CAF serviced approximately 709,000 customers and the managed receivable portfolio was $9.59 billion.

The exhibit below shows the results of CAF from fiscal 2006 through the first nine months of fiscal 2017.  There was an accounting change that required CarMax to consolidate CAF on the balance sheet starting in fiscal 2011 and this also changed the presentation showing the components of CAF income.  However, for purposes of this article, we will focus mainly on overall CAF income as well as key metrics associated with the loan portfolio.  Click on the exhibit for a larger view.

There are a number of moving parts in the exhibit, but we will focus on the following:

  • Total managed receivables is the size of the overall loan portfolio, whether retained by CAF or referred to third-party provider.  We can see that this portfolio of receivables has increased rather dramatically over time and now exceeds $10 billion.
  • Net loans originated and vehicle units financed gives us a picture of the percentage of vehicle sales that CarMax is financing through CAF each year and the approximate amount of financing per vehicle.  The Net CAF penetration rate represents the percentage of unit sales that are financed through CAF.  This figure has been trending upward for some time, rising from 30 percent in fiscal 2008 to 44.7 percent for the first three quarters of fiscal 2017.
  • The weighted average contract rate line indicates that the interest rate charged on the overall portfolio has held above 7 percent in recent years.  The margin between the weighted average contract rate and CAF’s funding costs for securitizations (discussed below) influences CAF income as a percentage of average managed receivables which was 4.3 percent in fiscal 2016 and 3.8 percent on an annualized basis for the first three quarters of fiscal 2017.
  • Credit scores, loan-to-value, and term.  FICO score information is not available for all periods, but we can see that the weighted average credit score is around 700 which is generally considered to represent fair to good credit.  The loan to value ratio is the amount of the loan relative to the value of the vehicle (presumably as represented by the selling price).  The fact that the loan-to-value ratio has been in the mid 90% range for the past few years indicates that CarMax customers typically pay very small down payments.  The typical loan term appears to be slightly more than five years.

Perhaps the most important question regarding CAF is the quality of the loan portfolio and how big of an issue credit losses have been historically.  We can see that the allowance for loan losses has typically been slightly below 1 percent in recent years which has roughly matched net credit losses.  If we look back to the financial crisis and recession, credit losses were predictably much higher, as were past due accounts.  However, CAF was still profitable even in 2009, albeit at much reduced levels.

CAF auto loan receivables are primarily funded through securitization transactions that are structured to legally isolate the auto loan receivables.  Investors in the non-recourse notes have no recourse to CarMax assets beyond the securitized receivables plus the amounts on deposits in reserve accounts and restricted cash held by CAF.  In addition to securitization, CAF has access to warehouse facilities to fund non-recourse notes.  At the end of fiscal 2016, there were $8.13 billion of non-recourse notes payable related to securitizations and $1.4 billion related to warehouse facilities.  The warehouse facility limit was $2.5 billion at the end of the fiscal year.

While the mechanics of CAF are relatively complex, we can draw some conclusions based on the data and CarMax’s history over the past several years.  First, it is apparent that CAF is integral to CarMax’s ability to successfully sell cars through the retail channel.  Given the fact that most customers require financing, it is critical to have a financing unit capable of either funding loans directly or referring customers to a third party.  Second, securitized funding is very important to CAF’s operations.  Auto loan receivables have grown significantly in support of the company’s overall expansion and growth plans and funding for these receivables must continue to be available to facilitate future growth.  Third, although CAF weathered the financial crisis and recession relatively well, it is much larger today than it was previously and should be monitored carefully when we enter the next recession.

Cash Flow and Repurchases

CarMax management uses an adjusted figure for operating cash flow to eliminate distortions caused by the activities of CAF.  Cash flow from operating activities reflects changes in auto loan receivables, which have been increasing in recent years, and this results in negative reported operating cash flow.  The offsetting impact of changes in non-recourse notes payable is reflected in cash flows from financing activities.  However, these are really operating cash flows given CAF’s business model.  The exhibit below reconciles reported operating cash flow to adjusted operating cash flow and also shows free cash flow:

We should note that our calculation of free cash flow simply deducts all capital expenditures.  In reality, the majority of capex is attributable to the company’s rapid store expansion program.  However, there is no breakdown of maintenance and expansion capex in the company’s filings.  It is likely that free cash flow at least approximates net income if we were to back out the expansionary capex.

CarMax does not pay a dividend but management initiated a stock repurchase program in fiscal 2013.  From fiscal 2013 through the third quarter of fiscal 2017, the company repurchased $2.9 billion of stock.  This was funded by a combination of free cash flow and additional long-term debt.

Risks to the Business Model

As we have noted, CarMax operates in a highly fragmented industry and has relatively low market share.  The company has room to expand geographically and appears to have a brand that permits it to generate attractive gross margins per unit sold even in difficult economic environments.  Obviously, one potential risk involves the emergence of “copycats” who could seek to replicate parts of the CarMax model such as “no haggle” pricing.  However, it would be difficult to replicate CarMax’s ability to offer quotes for any trade-in regardless of whether a customer actually purchases a vehicle and it would not be easy for a new entrant to match CarMax’s financing operation or its overall scale.

We would regard major disruption in the automobile industry to be a more significant long term risk relative to new entrants.  Currently, the automobile market is undergoing two major shifts.  First, electric vehicles with relatively long ranges have been introduced by Tesla Motors as well as General Motors and many more models will soon enter the market.  Electric vehicles are fundamentally different than vehicles powered by internal combustion engines, especially when it comes to long-term maintenance.  Although there will clearly be a resale market for electric vehicles, the distribution channel could change.  For example, with fewer moving parts, it could be easier to determine the relative “health” of an electric vehicle relative to a gasoline powered vehicle making the process more transparent to buyers and sellers.  This would reduce the value of services such as reconditioning and certifying used vehicles.  However, the competitive advantages of a company operating at large scale will continue in terms of offering wide inventory and attractive financing.

The second major shift involves advances in automated vehicles.  Greater automation, including the ability of a car to drive itself most of time, will dramatically change the way in which individuals interact with vehicles.  It is plausible to believe that private vehicle ownership will decline especially in urban and suburban locations.  Large fleets of automated vehicles could transport people to their destination efficiently.  It would no longer be necessary for individuals to incur the significant cost of vehicle ownership and having an expensive asset sit idle 95 percent of the time.

From the perspective of early 2017, the idea that people will forego personal vehicles may seem to be farfetched.  Even if automated technology advances rapidly, many people will resist change and the overall vehicle fleet will not be automated for an extended period of time.  No one knows when or if automation will change the nature of transportation but this seems like a risk that cannot be ignored when evaluating companies in the automobile industry.


Many readers will be aware that CarMax is the second largest holding in Markel Corporation’s equity portfolio.  We have discussed Markel several times over the past few years and admire Tom Gayner’s stock picking abilities.  At nearly 7 percent of Markel’s portfolio, CarMax is obviously a high conviction investment.  After looking at the company in some detail, it is clear why Mr. Gayner was attracted to the business.  CarMax has demonstrated attractive economics over the past decade and managed through the financial crisis and recession reasonably well.  The unit economics of new stores appears to be very attractive and CarMax is nowhere near saturating the United States.

At a recent price of close to $65, CarMax has a market capitalization of slightly over $12 billion relative to book value of $3 billion as of November 30, 2016.  The stock is trading at close to 20 times likely net income for fiscal 2017 (ending on February 28, 2017).  While it is hard to get too excited about the shares at the current valuation, we would note that CarMax shares were punished quite severely during the 2008-09 recession.  As long as the long run secular risks to the business model described above do not materialize in the near future, CarMax seems likely to weather the next recession relatively well.  Given the attractive economics of the business and Mr. Gayner’s involvement, we would be inclined to put CarMax on a watch list and to take advantage of a stock price decline when a new recession (or fears of a recession) emerges.

Disclosure:  No position in CarMax.  


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