Category: Columns

Hidden Gem at Central Securities $CET

Reading Time: 5 minutes

I typically spend my time analyzing small cap, underfollowed stocks. But I’ve been drawn to closed-end funds for a long time, so I wanted to write a quick post on Central Securities Corp, where we are getting a blue-chip stock portfolio PLUS a top notch insurance company for free.

Most investors have crossed passed with closed-end funds: They’re alluring because they can trade at discounts to NAV, meaning if they liquidated tomorrow, many would result in 10%+ returns just from the discount narrowing (i.e. I can buy a dollar for 90 cents). Unfortunately, discounts often persist without a clear catalyst.

However, there’s one closed-end fund that I’m not buying for a discount to narrow over the next year or even 10 years. I’m owning the Central Securities for (i) the manager who has a great track record, (ii) who owns great companies with low turnover (personally, I get Akre / Phil Fisher / Buffett vibes), and (iii) a hidden insurance asset on the books that makes the discount even more steep.

I think I’m literally “being paid to wait” through an outstanding manager while its largest asset compounds at what I expect will be better than market.

The really interesting thing about CET’s performance is that they own a concentrated fund and the turnover is very, very low. Check out these holdings from the report.

I have to admit – It would be extremely difficult for me to hold Motorola for this long. Or Analog Devices. But at the end of the day, these are largely blue chip stocks.  Other top holdings include Charles Schwab, Berkshire Hathaway, Intel, Capital One, Liberty Latin America, Kennedy Wilson, and so on.

Who is this manager? Central is one of those closed-end funds that started back in the 1920’s. However, the track record is owed to Wilmot H. Kidd III and he’s been at Central for almost 50 years. His son, Kidd the IV, also works at Central. Eventually the baton will be passed on (Kidd the III is 77) and that may be a catalyst for Central in one way or another.

But I want to focus on that top holding, a private company called The Plymouth Rock Company.

Plymouth Rock is a P&C insurer, providing home & auto insurance. However, the manager of the insurer makes me just as excited as Kidd the III. Despite being a private company, they have a financial information section of their website.

Here you’ll find the annual letters from Jim Stone, the chairman and founder of Plymouth. Now this is some Buffett-esque letters. Plymouth, like Geico, invests its float in equities. And their track record is also amazing.

Below are some of the comments in the 2019 letter. I personally can’t wait for the 2020 letter.

Here’s the track record of Plymouth book value over time — it’s a 13% CAGR over 23 years!

One thing you’ll notice about this table is that the value is discounted for “lack of marketability”. The value is appraised by a third party, Shields & Company, as “the price at which the relevant shares would change hands between a willing buyer and a willing seller, both in the possession of reasonable knowledge of all relevant facts, with neither party being under any compulsion to act or not act.” That is the value presented in the table above which is then discounted.

This is where it gets interesting: Central DOUBLE Discounts. 

I pulled the Plymouth Rock values from Central Securities and then compared it to the appraisals from Plymouth. Central is valuing Plymouth Rock at an extreme discount.

Central provides reasoning. They use market comps as well as a massive discount to the appraised value. I’m not sure a 30-40% discount makes sense…

It seems pretty clear to me that CET is just using 1.2-1.3x Book Value for valuing Plymouth. (Note, we don’t have the valuation yet for 2020)

Honestly, paying 1.3x book value for a company that has compounded capital so greatly seems cheap, but currently this is roughly where P&C insurers are trading (Allstate, Travelers, though Progressive is 3x for its growth).

CET trades at 18.7% discount to NAV. Given Plymouth  Rock is ~22% position (based on CET’s valuation), we are almost getting all of Plymouth Rock for free.

As of 9/30/2020, the value of Plymouth on CET’s books was $206MM. This foots to a price of ~$7,250/share for Plymouth Rock (down about 5% from 2019 value of $7,600). This also means that Plymouth is worth about $8/share to CET’s NAV, again 22%. But CET trades at a significant discount to NAV. So if we invert and say  Plymouth is worth the reported value, then at the market price Plymouth is worth 25% of NAV.

Appraised value is obviously more compelling: If we assume the discount is about what the average has been since 2015 (36%), that means Plymouth would be appraised at $11,316/share, or $322MM vs. what CET reported at $206MM. This means Plymouth actually makes up 31% of NAV or nearly 40% of market price.

So invert what I just said before: you believe in the value of Plymouth then you are getting a lot of blue chip stocks for free!

How will Plymouth Rock asset be monetized? I frankly don’t care – I’m fine owning it for 10+ more years if it can compound BV at its current rate and am currently getting it for free. (In the meantime, I also own other blue chip stocks under Will Kidd’s management.)

However, I think insurance will continue to consolidate over time, so it’s possible they do sell it eventually. A strategic would likely pay in excess of 1.5x due to synergies. I don’t think an IPO is likely given its been private for 30+ years.

CET has sold shares in Plymouth in the past. However, with hindsight, those have been mistakes in my view given Plymouth has continued to compound book value at such a high rate.

Secret SAAS Businesses

Reading Time: 4 minutes

SAAS stocks are all the rage. While the S&P500 is up ~12.5% at the time of writing, the Tech-Software ETF is up 41%. Over the past 4 years, the gap is +215% for Software and +88% for the S&P.

It makes some sense. These are companies that have long runways of growth, are FCF generative (if you count stock-based comp as an addback, but point is they tend to be people-heavy, but asset lite), and a good portion of them are really sticky businesses through the subscription model.

A sticky business is important. Imagine you’re a business owner trying to prepare shifts for your employees. You don’t know if a customer will come into your store or if you’ll be bombarded that day. If you are bombarded, you might lose sales because you don’t have enough staff. Recurring revenue companies can plan much more effectively and align costs with revenues appropriately.

I’ve outlined this before, but the subscription models also tend to spend a lot of money on just acquiring the customer. So the first year, the business isn’t that profitable, but on renewal it is highly profitable.

Also think about this dynamic in COVID-19 impacted world. Economies were literally locking down. I was running scenarios on companies that I’ve never had to do before – “how would these businesses look with ZERO revenue for the next 3 months.” If you’re in a business where you are mission critical to the customer and get paid a small monthly fee for that service, then you weren’t sweating it as much.

Therefore, I think there was a changing of the guard this year. Well, maybe it actually happened in the 2015/2016 recession scare. (The latter would make more sense because that’s when we saw the atmospheric launch of FANG and SAAS.)

Investors had long been valuing recession proof businesses at much higher multiples than more cyclical peers. Think Utilities, Consumer Staples, large Healthcare companies. I think following the great financial crisis (the GFC), it had a big psychological impact on investors – “try not to own things that can get crushed like that again.” And therefore, the discount rate on these cash flows went lower (due to perceived lower risk).

SAAS combines those attractive characteristics with ultra growth. But the subscription really made it easy to count on what was going to be in the bank account. So low discount rate + hypergrowth = highly valued.

Secret Subscription Models

Something I’ve been thinking about the past few years is “secret SAAS” or really, “secret subscription” businesses. These have very similar characteristics to SAAS, but aren’t in software.

Some of these companies have highly recurring revenue, but may not have a monthly subscription. Some of these names are also dominant and will own their category, but it might be niche and many people just don’t know about them.

The only thing missing from my list is the hypergrowth. But you also aren’t paying 10-100x sales for any of them…

Perhaps I’ll do a post on each of these, but please feel free to reach out, comment below and comment on Twitter (@DollarDiligent) names you think should be added to the list.

Secret Subscription Business Models (no particular order):

  • Flavor and Fragrance Names such as Sensient Technologies and International Flavor & Fragrances
    • I really like names that are critical to an end product’s use, but are a very low cost input. This typically translates into limited switching and little pushback from some price increases
    • Flavors & Fragrance names provide the products that impart taste, texture, or smell to consumer end products.
    • These are mission critical. They also are sold into pretty recurring end market – food and fragrance.
  • WR GraceAre you a refiner that wants to upgrade that barrel of oil into higher value products like gasoline or jet fuel? Well – you need a catalyst. The catalyst creates a chemical reaction to start the process. This is also true in creating plastics.
    • Unfortunately for you, refiner, you can only get this catalyst from 3-4 companies. But they are very high touch, high R&D businesses and the cost of the catalyst is very little compared to the cost of a refinery.
  • Beacon Roofing and Carlisle Roofing segmentThere is a large installed base of roofs. And many were put in place 15+ years ago. As they age, the roof needs to be replaced.
    • No matter what the economy looks like, if the roof is leaking, it needs to be replaced ASAP.
    • This leads to very high recurring revenue (albeit storms can make some years lumpy)
  • Moody’s / S&P Global / MSCINeed to refi your bond? S&P and Moody’s are the gatekeepers. Need to access the ratings? If you want to access detailed reports, investors need to pay a fee. In a large market, this adds up to highly recurring revenue (in addition to other platform services the companies offer, such as Platts and Cap IQ)
    • For MSCI and S&P – Having managers benchmark to your indices provides a highly recurring fee each year. Changing your benchmark tends to be a “no no” and the more recognized the benchmark company, the more circuitous it is
  • Apollo and Blackstone and other asset managers.
    • Earn management fees on a large, mostly locked up capital. Sure, there are incentive fees that may not be highly recurring, but the bulk is actually just management fees
  • Franchisors – many come to mind like Domino’s, Planet Fitness, McDonald’s etc. These names take little capital to run themselves and earn recurring royalty fees from the franchisees

Is Google Going to Encroach on Pinterest’s Turf? $GOOGL $PINS

Reading Time: 2 minutes

Google is shifting its Photos storage business to a paid model. Clearly, Google is trying to capture more of that sweet, sweet cloud storage money. And kudos to them for playing the long game. I know I have a lot of photos stored with them plus about a million unread emails…

Now that they have a bunch of users hooked on keeping photos they’ll never print out, they know they can charge a token amount and not have much churn.

But this tweet really caught my eye….

Essentially, Google Photos will scan pictures and identify objects. Apple Photos does this as well on the paid model. For example, I recently needed my license plate number on my car, but didn’t want to go outside and look at it. So I went on my phone searched “White SUV” in my Apple Photos and it popped up. Bam – I got my license plate number without leaving the house.

While that was nice, this feature is much more valuable to Google which makes most of its money from business advertisements.

Let me paint a picture: If Google’s algorithm gets really good at identifying objects in pictures, it could add new “billboards” onto our photos. Let’s say you’re walking by a piece of furniture you like, snag a picture as a reminder for later because it would look great in your living room. Now, an icon pops up of where you could buy something similar from Google Shopping.

That’s clearly Pinterest’s bread and butter and I think what Pinterest investors are banking on. My wife recently was looking for wallpaper and was frustrated that Pinterest couldn’t just link her directly to something very similar to what she was looking at for sale. So it appears to me Google is slowly but surely moving that direction. And Google is a pretty strong competitor, especially in search algorithms…

MasterCard Stock – Opportunity to Add a “CARP”: Compounder at a Reasonable Price $MA

Reading Time: 5 minutes

Mastercard reported earnings this past week and the stock got hammered as it missed expectations. Take this as an opportunity to buy Mastercard stock.

MA Chart

MA data by YCharts

A lot of people know Visa and Mastercard, but they don’t know how the business actually works. Simply put: card networks act as the toll booth connecting the “issuing bank” with the “acquiring bank” and they take a fee as the transaction goes across. The “issuing bank” is the bank that issued the credit card. The acquiring bank is the bank of the merchant. Ryan Reeves has great commentary on this network, which I found in a tweet of his. He also has a blog post on it where he explains it well:

The company where you put your money, called a bank, gives you a piece of plastic, called a credit card, that signals you will pay for something later. When you buy coffee from Starbucks using your piece of plastic, your bank sends the $4 to Starbucks, instead of you paying. But before Starbucks gets the money, two things need to happen.

Your bank has already made a promise with another company called a card network whose job it is to act like a toll booth between two banks. The most popular card networks are Visa and Mastercard.  These card networks make promises with other banks called merchant banks, who hold money for the stores where we buy stuff. So the money from your bank first goes to through the card network and then to the merchant bank and finally to Starbucks, each company taking a little bit of money along the way for their services. And then the final piece, at the end of every month, you pay back your bank for the money they sent to Starbucks. And that’s how credit works!

Here’s a diagram from Plaid as well as their explanation:

Card networks—for simplicity in this explanation, let’s say Visa—receive fees from the issuing and acquiring financial institutions. Visa makes money by collecting a small percentage (0.13 percent as of early 2015) of total transaction volume, rather than by charging a fee on each transaction. But it also sets and doles out the rest of the fee paid by the merchant to the other players. While this percentage may seem nominal, billions of transactions processed each year (with minimal overhead) add up to a very profitable industry.

What’s more, a network like Visa’s entrenched partnerships and critical technologies create high barriers to entry for new players. Established card networks also have low marginal costs to continue operating, making them attractive business models.

So Plaid touches on a few things here: High barriers to entry, toll booth business, low marginal costs. This translates to really high margins and super high FCF. And since payment transactions are growing quickly (ex-COVID), the company is able to leverage those costs and expand margins. For example, look at both revenue growth and margin expansion. Most companies I follow don’t even have 50% gross margins

People often look at the current market structure and think, “This will clearly be disrupted. It is too complicated.”  Card networks work because they have high degrees of trust and a large network, which makes their usage more attractive. Take American Express on the other hand which actually has a different model. Have you seen many merchants say they don’t accept American Express? Amex “consolidate functions of the merchant bank, card issuer, and card network by personally extending credit and cards, and minimizing parties involved.” However, their fees are too high for the merchant and AmEx gives a lot back to the consumer.

Square also differs somewhat, too. Instead, they aggregate the merchant transactions and pass of the processing to Chase.  You will always hear about one of these names (Square, Stripe, Apple Pay, etc) are “disrupting payments.” In reality, they are all still passing through the card network monopoly.

As I discussed in a post where I broke down the core driver for long-term shareholder returns, Mastercard has compounded FCF at ~20% rate for almost 14 years. And its stock has compounded at an even higher rate as people realize this.

So why is there an opportunity now? Well, COVID-19 has caused investors to reset the bar lower this year. Sales were down 14% in Q3’20, but Op Income down 20% (due to fixed costs). You can’t have a dramatic recession and expect spending to be up. That obviously will have a direct impact on Mastercard. But that makes Mastercard interesting because its a very strong business, but also a recovery play. Indeed, there may even be higher tailwinds on the way out – think of less use of physical cash.

And the long-term growth story is still intact. Look at how much in transaction volume is still down via cash and check.

Is Mastercard Cheap? I think so. But you say – Mastercard trades at 45x 2020 EPS?? And 34x ’21. That is not cheap.

First of all, is Mastercard an above-average business? Yes. Is its long-term growth rate above the market? Yes. It should trade at a premium.

Second, Mastercard trades at ~3% FCF yield, but also it can grow FCF/share at a 10%+ CAGR for the next 10 years. This would be half the rate of the past 14 years. I think growth will continue from continued market gains (remember, pre-COVID, the company was growing top-line in the high teens and bottom line even faster due to operating leverage. This will continue at a high rate in a post-COVID world). That points to at least a low double-digit IRR for the stock. I would also point you to my post on how Growth can help pay for a lot of sins

I’m not going to publish my whole model here, but I encourage you to check your models for this. This is the beginning FCF yield + what I expect FCF to compound out. It is interesting how it almost matches up perfectly with the IRR of the investment:

There are still capital structure benefits that could come. As I talked about in my MSCI post, MSCI is leveraging its cash flow and returning significant cash to shareholders. Mastercard is roughly net debt zero. If they had 2.0x of leverage, that would be an incremental $18-$20 billion available for shareholders, which would obviously boost returns. I also think they’d be comfortably investment grade at that level as well.

MSCI Reminds Me Why I am a Long-term Bull on SAAS Stocks $MSCI $IGV $DBX $NOW

Reading Time: 3 minutes

I’m taking a look at MSCI stock. It’s an interesting one and pretty easy to understand. The bulk of the business is a subscription revenue tied to the indices MSCI  creates. These indices are then used by asset managers for their benchmarks. It’s kind of funny how similar it seems to a SAAS stock.

MSCI’s business is growing well (though not gangbusters) which you can see below and ~97% of it is tied to recurring subscriptions. The thing that sticks out to me is the EBITDA margins!  In total, the company has ~55% EBITDA margins. If you were to just take the Index business they have, that segment is >70% EBITDA margins.

Given capex is so low, this results in a ton of FCF. MSCI can’t really invest it all back into the business, so they pay a reasonable dividend and do share repurchases. They also have levered the balance sheet ~3.5x to juice returns, which makes since on a highly recurring business.

The table below shows how much in share repurchases + dividends MSCI has done. I also put the market cap at the end of the year for context. Obviously, buying MSCI would’ve been a great call back in 2015. But also just look at how much capital has been returned. It’s around $4BN and if you bought at the end of 2015, that’d be nearly ~60% of your capital back. 

Why does that make me bullish on SAAS stocks?

For one, its still early days. And as these names get scale on their costs, I think they too will be generating a significant amount of FCF (some already do, but I think it will be higher).

Some names will eventually reach a “maturity” point. Take Dropbox for example, which I did a post on recently. Arguably, they are reaching maturity and their margins are exceptional, as is the FCF.

If you made it to the end of my Dropbox post, you would’ve seen some analysis I did for long-term margin potential which I’ll repost here (saved you a click). This is a template I typically use to evaluate SAAS names. In some cases, like for ServiceNow, I arrive at “mature” operating margins of near 50%. The main reason is that the typical first sign up is actually negative margin, but the following renewal is very high margin (i.e. lots of costs in to win your business, then I just need to keep you).

Fast forward ten years: Some SAAS stocks will still be plowing every dollar back into the business. Some will still be very nascent and growing quickly, but not have much earnings. Some SAAS stocks will be more mature, be willing to take on debt like MSCI, and will likely gobble up shares and pay dividends.

Remember when Apple shifted to this strategy after generating so much cash? That makes me excited.