(Ep.89) The Acquirers Podcast: Joe Frankenfield – Value Saga: Concentrated High-Growth Value Investing

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In this episode of The Acquirers Podcast Tobias chats with Joe Frankenfield, Portfolio Manager at Saga Partners. During the interview Joe provided some great insights into:

  • Catching Compounders On Their Inflection Point Post IPO
  • $TTD Focusing Only On The “Buy Side” Of Online Advertising Demand
  • $CVNA Disrupting The Used Car Industry
  • Using The Power Of The 80-20 Rule For Larger Returns
  • Best Holdings Should Be Your Largest Positions
  • Mauboussin’s Expectations And The Role Of Intangible Investments
  • Selecting Stocks Like A Drunk Stumbling Around In A Bar – Guy Spier
  • 7 Powers: The Foundations of Business Strategy – Hamilton Helmer
  • The Market’s Right Unless You Have A Better Argument
  • $CVNA vs $KMX
  • Clayton Christensen’s Innovator’s Dilemma

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Full Transcript

Tobias: Hi, I’m Tobias Carlisle. This is The Acquirer’s Podcast. My special guest today is Joe Frankenfield from Saga Partners. He’s at the growth year-end of the spectrum. We’re going to talk about his spectacular performance and how he does it right after this.

Tobias: How are you, Joe?

Joe: I’m great. How are you?

Tobias: Well, thanks. Tell me a little bit about Saga Partners. What’s the strategy?

Joe: Sure. First, thanks for having me on. I’m a big fan. You’re in my top 10 podcasts I listen to as I’m driving. So, I’m very excited to be on and hopefully I’ll give you some good content. Saga Partners, I guess, when you talk up to any investment manager, you ask about what first motivated them or when they caught their investing, it’s when you became obsessed with investing, and the earlier they do that, usually the better so that way you can learn and modify your craft. I really didn’t get that until right after college, when I first had money to invest. I studied finance and business in school, but nothing really inspired me to really love investing because back in school, you take classes on portfolio management using CAPM and WACC and portfolio diversification and stuff like that, and that never really interested me as much.

What does interest me is figuring out how the world works. And so I’ve always been a big reader in history and figuring out what motivates people. I didn’t know how to really apply that until I really started investing my own money and trying to figure out how basically the economy evolves and works and trying to find patterns and puzzles that I’m trying to take advantage of different anomalies. After school, I got a job in banking, which I thought was very interesting, because I wanted to learn how business works, and try to understand basically how businesses win and fail. And so that was a great experience.

Tobias: What sort of banking were you doing?

Joe: I was in corporate banking, so basically underwriting, senior lending. And so I would work with middle market companies and analyze their risks and analyze whether they wanted funding for any thing that they may need capital wise, whether it was a dividend, whether it was CapEx, whether it was making acquisition, so really the full spectrum. And it was a great because we worked with, or I worked with a lot of different types of companies, manufacturing companies, service oriented businesses, marketing company, so it was great experience to see the full spectrum of businesses. And I was in Cincinnati at the time, and it was a good space to see a diverse set of businesses. But once I actually started investing my own personal money, I really caught the investing bug, like I became obsessed, like many of this business do. I think that anyone that will succeed in this business, you have to be obsessed with this because it’s a competitive industry.

I was finding myself spending my nights and weekends analyzing industries and companies and trying to figure out the best value investments. And like many that probably share the similar philosophy at Saga Partners, so I was really inspired by Warren Buffett, Phil Fisher, Peter Lynch, and trying to– I mean, I guess the first book I read right after school was, The Warren Buffett Way. And that led me into reading all the Berkshire Hathaway annual letters multiple times, then leading you down the road of value investing. I read your book several years ago, when did you publish your book?

Tobias: Quantitative Value came in 2012. Deep Value in 2014.

Joe: Yeah, I remember reading that too. I mean, like, you just go through every single possible book, you just trying to consume information. Yeah, so that’s where I started my journey. I knew pretty early on that this is why I wanted to do full time one day, launch a portfolio one day. So my goal was to kind of work towards that. I went to the CFA program. And then after a couple years, when I was doing corporate lending, I moved into equity research and spent time on the sell side. And at that time, I was already formed my philosophy, which is long-term fundamental value investing. I’m trying to really buy companies below their intrinsic value. If you know anything about the majority of sell side equity research options, it’s more short term oriented and you’re basically helping your clients which are hedge funds and mutual funds invest based on whether a company beats or misses quarterly earnings. You’re trying to motivate them to trade with you. That’s how basically our shop made money.

I knew early on that’s not necessarily aligned with how I thought investing should work. And so it was only a matter of time where I felt comfortable breaking out on my own. I knew that when I started Saga Partners or the portfolio, that was my goal to start, I wanted to be self supportive. I wanted to not be motivated to raise assets to compromise our investing strategy. So, I got to that point, maybe five years ago, just under five years ago. And I also, the other motivation is I wanted to feel confident that I’m not going to invest other people’s money, as well as my own. So I had to feel confident I could beat the market.

It was in early 2016, I got to that point. Fortuitously, I met my current business partner, Michael Nowacki. And he already had an investment advisory where he was managing multiple different strategies based on suitability by for the client, and he became overwhelming. He was a one man shop, and he started his advisor, I think, in 2011. He was interested in having a core strategy, which is what my goal was, was having one portfolio. The whole idea behind Saga portfolios, I wanted to manage other people’s money the way I manage my own, which is something you don’t really find in normal money management shops, like large investment management companies, because there’s a lot of agency costs where they over diversify, they basically are just trying to beat their benchmark or track the benchmark. And so that was the idea behind the Saga portfolio.

It was in 2016, we put our portfolio together, and we launched Saga portfolio beginning of 2017. And it’s been a good run so far, and it’s been a dream come true so far.

Catching Compounders On Their Inflection Point Post IPO

Tobias: Well, let’s talk a little bit about the strategy. So, I read through your papers, would it be fair to say you’re looking for high-quality compounders and then you’re trying to find them– you’re looking for companies that are potential wide moat businesses, but you’re trying to catch them on that inflection point post IPO on that very steep ascent to the wide mud. And you’ve got this great quote from Munger where he likens it to surfing. Is that a fair characterization of what you’re trying to do?

Joe: That’s spot on where our portfolio sits today. I do say, I guess to start with the Saga philosophy, I mean, the core idea is that, fundamentally, every asset is worth the cash that is distributed to the owners over the life of that asset. Whether it’s a bond, the commodity, or an equity of a company. And so with that said, your duration or your outlook has to align with the life of that asset. And we’re looking for the best opportunities available out there. Right now, we find on equities, which is usually a case throughout history. And so if you’re going to own a company, you fundamentally have to be– people leave valuable asset as a cash that is distributed over the life, that means you have to be long term oriented, because those cash flows longer 5, 10, 15 years out are worth a lot more than the one, two, three years out. So, we are fundamentally long term investors and trying to figure out where a company will position long term.

Alternatively, if you invest in a three-year bond, your horizon is three years because that’s if you’re going to hold the asset during its life. So, all we are trying to do is buy assets for less than we think they’re actually worth. And it’s worth different to different investors, but we’re trying to find the most attractive returns available in the market today based on today’s prices. And so, where we have found the opportunities are the ones where the market is underestimating their potential long term. And if you’re looking long term, it’s like companies that have a moat that have that competitive advantage, typical Warren Buffett competitive advantage, which I think is not explained often enough or use too often by law investors, but they have to have excess earning power. They have to be earning more than their competitors to make it valuable down the road. They’re just earning subsistence earnings, just to get by, that’s not going to give you a good return.

I think from what you see, I hate the being categorized as a growth investor versus a value investor. I say, I’m a value investor, because I’m trying to earn an attractive return in any asset. You may look at our portfolio and, yes, the companies we own are high compounders today, but that’s because that’s where we find the opportunities today. I tell investors our portfolio, I mean, I would be happy to own a no-growth company if I found it an attractive rate of return. So, an example is a Coca-Cola, one of the best businesses in the world, the best brands, has economies of scale. I think in 10 years, I have an idea that what Coca-Cola will be doing in 15, 20 years. And the thing is, it’s just not attractive based on today’s price. I mean, I think it’s selling for 30 times earnings or maybe even more on a free cash flow basis. And the thing is, they just don’t have reinvestment opportunities.

What they do is they essentially distribute all that cash flow either through dividends and stock buybacks, which is what they have done. And now, if you’re going to buy a company that’s going to grow their top and bottom line, low single digits, maybe mid single digits, if they do really, really good job, and you’re buying it 30 times, you’re not going to get a market return. It’s probably fairly priced. If Coca-Cola was selling for five times their free cash flow or earnings, and they distribute, and I had confidence that they were going to distribute all those earnings to investors, that would be attractive, that’s a 20% plus yield to be held for 10 years. We’re just trying to figure out what’s the best return opportunity.

So, what we have found is, and the market has not fully appreciated, and it’s appreciating more today as valuations continue to go up, is that if you find a company earlier in their lifecycle that established themselves as the leader in an industry, and it’s a big TAM, that word is also used a lot by– but it’s a big end market, oftentimes, they’re under estimating their potential. But that’s not always the case. It’s always like trying to weigh the cost benefit of every single situation, but you might look at like, a Shopify, or Zoom and like, yeah, those companies are amazing, fundamentally. Look at the financials, and they generate a lot free cash. And they’re growing at such high rates, they do have an advantage relative to competitors. But like, if you actually are looking for that 15%, 20% return, like Shopify is, I think selling for– might be $120 or $30 billion at this point. And they’re not distributing cash to shareholders, and probably won’t for the next 10 years because the reinvesting in the business, especially in the distribution and network.

They’re going to be $830 billion company one day, if you wanted like a 50% return. What would you need to fundamentally to justify a $800 plus billion market cap? You probably would need at least 80 billion in sales, 30 billion in operating income, and you’re thinking about like, the thing that makes me say, we’re not in a bubble or anything like that is like, it’s possible. I mean, at Shopify, if I were to guess on a company, Shopify would be a company that would do that. I mean, they have a counter Amazon position. But I mean, it’s not one where I think like, there’s that margin of safety, but it’s one that– that company I followed for the last four years pretty closely and just haven’t watched it gone up, up and up. But all we’re looking for is the best return based on today’s prices. And that has led us to companies that have these high growth rates that we think the market still under appreciates, based on where they’re going to be positioned in 10 years from now.

$TTD Focusing Only On The “Buy Side” Of Online Advertising Demand

Tobias: Do you want to talk about a few names that you have in the portfolio?

Joe: Sure.

Tobias: Well, let’s talk about Trade Desk. What is Trade Desk? Can you walk us through the opportunity there?

Joe: Sure. Trade Desk is a platform for ad agencies to purchase ad inventory. Customers, our advertisers, like Nike, Procter & Gamble, any company that’s trying to advertise, and then basically suppliers is anything connected to the internet. It could be a website, it could be audio, visual, connected TV. And we came across the Trade Desk in mid to late 2017, and very fortuitously, like, I think was my partner, Michael Nowacki, he went to some networking event or some marketing event where someone at his table said their son worked there, and was raving about the company and saying how great the company was. And that’s enough to be like, “Oh, it’s publicly traded. We’ll look it up.”

We’re always just awkward opportunistically looking for ideas. It’s one of those few moments where like, you open up the investor presentation and you listen to the Investor Day CEO speaking, like the stars align, you’re like, “Wow, this company has something very special.”

We didn’t know a lot about the ad tech space at the time. We started digging and learning about the different value chains within the ad tech network. We even contacted one of the guys we know in Silicon Valley that works with a lot of tech companies and asked him about demand-side platforms, which is what Trade Desk is. He said, “I won’t touch that with a 10-foot-pole, it’s a commodity.” There’s a history of although they’re publicly traded companies in this kind of screwing over shareholders, not being shareholder-friendly. But when you look at the numbers, you look at the story, it was very appealing. And the reason why is because basically, they are trying to give ad agents that use the highest ROI on their ad dollar. And the way that they do that is by analyzing the world of inventory that’s available. espn.com, google.com, Facebook, all the content where you might want to advertise. And there’s inherent economies of scale in that where it costs money to look at the whole world of inventory, and then you only get paid when the agency actually purchases one of the inventory. So, you have to have this high fixed cost, and then the largest company in the space is going to do really well or have an advantage.

At that time, there are other DSPs or demand-side platforms that look weaker. And so the thesis was that the Trade Desk did establish themselves as the dominant independent demand-side platform and hence at that point, I mean, multiples are very low and potentially for what they could be doing in 5, 10 15 years. Since then, the thesis has evolved to the point where all those other independent demand-side platforms have either been acquired or gone out of business. There’s like one or two left, like MediaMath is still out there. But there have been reports where MediaMath is trying to sell itself as well. And the reason why they want is because, basically, they had a better way, algorithmically, a cheaper way to figure out which ads to place accurately for ad agencies. Also, they only serve the demand side, while allow these ad tech firms also serve the supply side of inventory. So, there is an inherent conflict of interest, where they were taking a big take rate, which was uneconomical for anyone that’s trying to advertise.

Basically, they have a platform that is very scalable, that has wide, growing barriers to entry and it’s a huge market because if you think about how advertising used to be transacted, it was like the old Madman era where you go to get a martini lunch and you have your ad budget, and then try to allocate it to the three national networks and then do on a handshake lunch. Well, now it’s using data. So basically, the Trade Desk is figuring out what is the best way to advertise. Basically, what they’re disrupting is no data versus using data. A lot of these disruptors are disrupting company that has an inherent interest in not being disrupted. So, they have to battle them. Basically, it’s a Greenfield opportunity.

There was a saying, with advertising, 50% of advertising worked, you just didn’t know which 50%. Well, now the Trade Desk can determine which 50% works. Well, the ad space is supposed to be a $1 trillion business globally by 2027, I believe. And how much of that of those ad dollars will go over a platform like Trade Desk to then be allocated and what’s going to be the take rate? Well, right now, like the argument still why Trade Desk is still very attractive, even though it’s been a– I think 13 bagger for us, since we first bought it three years ago, is that a lot of people are scared of Google and Facebook. Google and Facebook are the most powerful internet companies, software companies in the world, like how are they able to compete with these very strong companies? Well, the key to the Trade Desk is they’re independent platform. They’re not biased, where you allocate ad dollars. Google and Facebook are biased. They have demand-side platforms, DSPs, but that’s not their core business. Their core business is selling content. They’re selling advertising on facebook.com, google.com and youtube.com.

One statistic I read is, for every dollar that goes over the Google’s DSP, maybe 60, or 65 cents of that dollar goes on a Google property. For every dollar that goes over the Trade Desk, it might be like 25, or 30 cents goes to Google. And so obviously, the Trade Desk doesn’t care where you spend money, we’re just trying to help you as the advertising agency trying to figure out the best ROI for the ad dollar. It’s like Amazon versus Shopify. Amazon can’t compete with Shopify. Amazon is the consumer-facing brand, where they create this really good consumer experience. Shopify is the infrastructure supporting these other e-commerce sites. For Amazon to go head to head with Shopify, they would have to change your business model. Google and Facebook are not going to change their business model, which is a very lucrative successful business model. For Trade Desk, which is just to allocate ad dollars. Inherently, this is going to be the winner. It’s a winner, virtuous cycle type business model, where eventually how much of those ad dollars are going to go over the Trade Desk platform, and they’re in the advantage relative to the suppliers of inventory.

There’s this general theme that a lot of our companies have and that we’ve come to really appreciate is how the internet has impacted a lot of the economics of businesses across the economy. If you think about the value chain of a business, there’s suppliers, there’s distribution, and there’s customers. Those are the three main things for any value chain. And historically, a lot of the companies that have had these excess economic returns, control distribution and then integrated backwards to control, supply, restrict supply, you can go to General Electric, US Steel, IBM, these companies restricted access to supply. These internet companies, they basically are opening up supply. There’s infinite supply, especially if you’re talking about like content, and so now it’s gone to become controlling the customer experience. If you control the customer experience, you are in power. It’s like the Googles, Facebooks, Amazons, Netflixs of the world.

Consumers, customers, they don’t know how to filter, an infinite supply of whatever it may be in whatever industry it may be. Well, now what the Trade Desk is doing is controlling the customer experience. They’re on the demand side for decipher the infinite supply of inventory. That similar thesis that we’ve seen play out in many other companies, but one of those businesses where– I think it takes investors a long time and to evolve where you go from, I guess, a lower multiple investor and trying to really look out 5, 10, 15 years about what will the fundamentals do to support the current valuation. And for these platforms that are highly scalable, that have established themselves as the winner, or at least looks like the winner in this space, they can grow revenues at 50%, 60%, 70% a year, depending on what type of industry or the growth of the end markets. It’s interesting.

The reason why you reached out originally to me was on Twitter, I posted something about growth expectations. I posted something that I was doing analysis about saying, like, “What’s a reasonable expectation for growth companies?” You have to be reasonable, because you have to look back last 10 or 15 years, and how many of these companies actually compounded at 30%, 25%, 20%. If you find one that does that, the multiple from current fundamentals, it’s a very high multiple that you can pay, but there’s very few companies that actually do this. And so you have to have conviction that you found one and make sure there is some type of margin of safety baked in– [crosstalk]

Mauboussin’s Expectations And The Role Of Intangible Investments

Tobias: Do you think the internet has created more of these?

Joe: Yes, definitely. Michael Mauboussin, he came up with a really good piece a couple of weeks ago, maybe last month about the rise of intangible assets in the economy. And this has been written about a lot. One really good book is Capitalism Without Capital, and the innate characteristics of intangibles, and how they’re different from a tangible asset. As the rise of intangible assets have become increasingly important in the economy, there are different characteristics and dynamics between these intangible assets. Eventually, you can only own so many cars, so many houses, so many whatever, or have so many buildings, but the scale and the ability to have these intangible assets of business processes of software, like they’re very scalable, and they have these very specific competitive advantages often are their economies of scale because there’s a lot of upfront costs, but once you establish them, and then you establish yourself as the winner, and there’s a lot of times network effects. So, these businesses could potentially be very large on a global basis and it will increasingly become so going forward. But then, again, you also have to be conservative and realize that there’s not going to be 50 winners. There’s only going to be a handful, especially since it’s a winner take most dynamic in many of these spaces.

Selecting Stocks Like A Drunk Stumbling Around In A Bar – Guy Spier

Tobias: You gave us a little flavor then about how you source and filter ideas. But what’s your sourcing process? How do you filter down to the ones that are the most interesting to you? And then, what do you do to prove up the idea? How do you validate it?

Joe: Yeah. I think I listened to an interview maybe this past summer with Guy Spier. He had an analogy I really liked where looking for ideas is kind of like a drunk in a bar trying to grab a beer or something. It’s very hazy and dark. If you look at a lot of them– and I like that analogy because it’s more honest, it’s really how it happens. If you look a lot investor presentations, at least the ones I’ve come across, it always has like funnel. It started as this big top of funnel and then you’re like, I have 3500 publicly traded companies, so you narrow down to a 500, then 100. And, boom, you have the Trade Desk, or boom, you have Carvana, or– all these companies. That’s not how it works.

Basically they’re trying to sell themselves, this is a process that is repeatable, like that’s what– but like the world is a messy place. And so I think if you are in this business, you have to be obsessed with it. I mean, we constantly are thinking about when you wake up and go to bed, to the point where my wife is like, “This is all I think about.” I’m like, “No, I swear. You’re my number one, this is number two.” But I’m thinking about business all the time. It’s just how you’re programmed. And so you have to be opportunistic, and always looking–

When you go to a convention or an event and somebody mentions a really great company, you look it up, that’s just what we do. Basically, we’re always looking and we find ideas all over, whether it is like screening– one of my best favorite activities, if I’m not doing anything else is like looking at the list of 3000 publicly traded companies in the US and Canada by industry. And I just like to look at their historical operating metrics and see why some companies have been successful. Usually, winner in certain industries gets most of the economic profits. And then you can see sometimes there’s a company that’s really growing fast based on the revenues or operating income. And you say, “What’s happening? Something’s interesting.” You look at Carvana, or something, it is another one of our large holdings, where you look at used car dealerships, and they’ve had stagnant operating metrics forever, decades. And then you look at this Carvana is like, ballooning. What’s happening? Why are they able to grow in this industry that has not had historical growth? And so you just see these weird anomalies and then you try to pick them apart. And really bucket, do they have an advantage?

7 Powers: The Foundations of Business Strategy – Hamilton Helmer

One of the books that I think best explains competitive advantages is 7 Powers by Hamilton Helmer. And he really breaks into seven advantages and bucketing them into one category. And companies can have multiple advantages. But for every company that we are interested in, or potentially want to invest in, they have to have something, whether it’s economies of scale, network effect of process power, some type of cornered resource, counter positioning, which is one of my favorite when business model has fundamentally changed. That happens earlier in the lifecycle of a business for a lot of companies, or a lot of investors. People will say, “Well, how are they supposed to compete with these huge, very strong companies when they’re so small?” Well, they have a different business model that’s advantaged. That’s what we’re looking for is trying to figure out what is the advantage for the success of this company? If we can’t answer that question, we don’t invest.

There’s a lot of companies that have high growth and look like they’re winning, but if I can’t picture what they will look like in the year 2030, I can’t invest in them, because I can’t get conviction because for every single one of our positions, there’s going to be times when they’re down 50%, and for every time there’s going to be all these opinions, especially when we write about them and write heavies, we write research on our large positions, and I get hate email. I wrote about Carvana, Trupanion, Facebook, all of our positions, I get emails about why I’m stupid, why I’m wrong because they’re heavily shorted. There’s a lot of people that have different positions, and they’re incentivized to make the stock go down. And that’s often a good sign that it might be a good opportunity, because if you can have a different position and have conviction in that, because oftentimes not, I always assume the market is correct. When I look at something, I’m like, there’s just not free money lying in the streets typically.

The Market’s Right Unless You Have A Better Argument

When I look at something, I’m like, unless I know alternate, a better argument for why the market would be wrong, I just assume it’s right until I can get to a position of conviction because you get so much noise and information and you have to filter it. For every buyer, there’s a seller in the market. And so for all these companies we own, there’s people that think they’re not good investments. We set that conviction and that’s usually by establishing what the competitive advantage is for a certain business.

$CVNA Disrupting The Used Car Industry

Tobias: Let’s talk about Carvana a little bit because that is one that is a little bit more controversial. I don’t follow it closely, but there is a view that they might be overpaying for some of the secondhand cars that they’re buying. There’s some suggestion, from what I understand that folks might be buying and then flipping to Carvana as a side hustle. How do you see the opportunity in Carvana? What do you say to those sort of sentiments?

Joe: Yeah, I see some of that, as in, like, I see people asking questions about, are the prices they’re paying for used cars too high? Is the price that they’re selling used cars for too low in order to spur their growth? There could definitely be cases where they– Well, they basically have a strong position because they can see a huge inventory of cars, versus a normal used car brick and dealer used car dealership. And so they’re looking at all the cars in country and they’re trying to determine what the demand and supply is. So, they have a technological data advantage and being able to see like, what is the demand for a Ford Mustang or like a SUV or whatever. And versus think about– I’ll go back. I bought a car in college was a Buick LeSabre maroon vehicle was about 10 years old and bought it for $3,000. How did we go about buying that car?

Well, my dad looked in the classifieds and said, “Here’s a car.” We needed a used car for me to get my internship junior college. And it’s $3,000, we went to the guy that was selling it was like, I don’t know what the prices I think he actually originally said it was like $3300 and we’re like, “We’ll give you $3000.” He’s like, “Okay.” I bought it for $3,000. What is the right price for that car? Well, it was enough up for me to pay for it paper like $3,000 in college.” Today, Carvana can see what the demand for that used car is. And it’s different in every city, it’s different based on what the economy is doing. So they will adjust their algorithms based on what makes sense for them to earn economic return.

The main important idea about Carvana is that they scale. There is this winner take most dynamic in this very large space, and what is the alternative to Carvana is buying a used car from a brick and mortar used car dealership, or like CarMax, which is their main competitor, or doing it private transaction. Well, really, you’re basing competition based on, if you’re trying to sell your car like convenience, getting a fair price and that’s the main thing, you want a fair price and you want them to take your car from your house and Carvana provides that.

I could see how sometimes the pricing algorithms mismatch. It’s not completely different from Amazon, where they sold things at a loss at points in order to gain volume and gain the distribution and the customer, so customers go to their site. You can argue that they’re pricing their cars cheaper than a price that they could have sold for, but they’re trying to get the volume. If you do look at the long-term trends, they’re reaching EBITA breakeven this quarter according to their early release of their financials. So, the long-term trend is tracking where their gross profit margin per unit is now going to break even. And, obviously, you hit a tipping point where it’s going to become cashflow generative. So Carvana, when we invested in it, which was about a year plus ago, I think, the story was that as long-term generally would continue. It was a little bit riskier than most of the companies that we invest in, which are cash flow neutral. I usually to make sure that if the capital markets dried up, like they would be okay. But I believe that they had this long term track record since 2013 of showing how they were scaling their fixed costs. And that there was a really large demand for this and they were growing at 100% plus for years, on this year, obviously, with COVID become lower. But this is a service that people like and appreciate. I think we’ll continue to scale on this very, very large industry.

$CNVA vs $KMX

Tobias: Why Cavana versus CarMax?

Joe: CarMax is a great company as well. Obviously one of the biggest questions that we had to answer before we get comfortable with Carvana. CarMax did disrupt the old used, brick and mortar used car model as well, but they still are using a storefront and a salesperson. And their model is much less scalable, where they build a store, they have about 200 plus stores across the country. They’re probably growing their top line, like high single digits, maybe low double digits. It’s consistently growing and doing well, but if you actually look– it’s the counter positioning of Carvana. They basically have all these large upfront fixed costs of software to develop a consumer-friendly way to purchase cars, the infrastructure for reconditioning centers, the transportation network, and also building the inventory of cars. They basically have integrated the whole value chain of the used car buying process. I think maybe even go from a higher level, one of the most underappreciated things and trying to figure out how durable competitive advantages are Clayton Christensen’s Innovator’s Dilemma.

Clayton Christensen’s Innovator’s Dilemma

What you see is the companies that earn excess profits that do really well, they basically are– they have to integrate, because that product or service is not good enough. Carvana basically is the end to end of a vertically integrated supply chain for buying used cars. Always supplying cars, reconditioning them transporting them, having the consumer interface of the website, also to financing. They integrated the whole entire supply chain, it’s because it was clunky before, it was very on consumer-friendly. CarMax is a great company has done well, they have a cash cow, they have a very successful business where they actually earn a good amount of money. However, they are now– you can go back, it’s typical counter position, you come back a year or two and people would ask or investor analysts who asked about Carvana and say, “It’s not a big deal. They’re not a big threat,” because, obviously, CarMax has historically done very well.

Well, now a year ago, you can see that they are a threat. We’re going to give an omnichannel offering where anyone can buy online or you can go into our stores. Well, that doesn’t change your cost structure. And so, yes, CarMax has the capital and the ability to potentially compete with Carvana, but they would have to disrupt their current cash cow, like, they would have to disrupt the current business model. The line item of a salesperson is expensive. And so basically Carvana is operating from a better cost structure once they scale. Obviously, there’s always upfront costs.

CarMax still has more variable cost structure. You can go to the brick and mortar dealership, which is a highly variable cost structure. And it’s not uncommon. It really is a similar type of investment thesis of Borders versus Amazon. I mean, and even going back to retail having department stores where there’s a salesperson spraying perfume on you and selling shoes versus having the discount retailers, where you have Walmart and Target and Kmart where you don’t need that. You just go in and buy the cheaper goods all the way to the Amazon. So, you can see the transition of how the cost structures have transferred.

I mean, we have conviction that Carvana is business model is going to be the future and 20– When I buy a new car, I’m very fairly frugal, I’m probably going to buy a used car whenever I need my next car, I’m going to look for the best deal I can possibly find for the car that I want. Most people know the car that they want, they have an idea, they do the research. And then they’re looking for the best, most convenient deal, best price and convenience. I’m thinking, let’s say it’s the year 2030, I have a high level of conviction that best deal, cheapest car for the car that I want is going to be in Carvana. Well, maybe I might want to test drive cars, but if I’m going to be fairly frugal, and I can save $500 to $1,000 on the car, I’m going to buy it wherever I can find. I’m not going to buy Carvana because we’re investors in Carvana, I’m going by it because I want the best deal.

That’s the most fundamental important thing is their cost structure room recently went public and I got lots of questions on Vroom because people know that we are long Carvana. Vroom still has a variable cost structure. They still outsource their reconditioning, their transportation, and of makes it more clunky process. If you want a streamlined easy process. Clayton Christensen explains this very well. Once the industry becomes more mature, and things become more plug and play, then you can see Carvana will be like where is the commodity, the modularized part of the supply chain, where is the commodity part? That’s probably inventory.

What Ccarvana is doing is they’re basically commoditizing car inventory, where like, you don’t care– If you want to blue Ford, or blue GE– whatever car, you don’t care where it comes from, you just want it. And they have all these options. Well, Carvana is going to recondition it for you, they’re going to transport it to you and you have their interface where you can find that car. And they can do it cheaper than alternative options.

And then you can go back in history, go through the 1950s and 1960s, who were the best company? It’s GM and Ford. They were the most powerful companies in the world. And they earned really high-profit margins because they still were innovating. They had sustaining innovations. But once innovations got too far, where people no longer cared how fast a car went, because we have speed limits and things that make– it doesn’t matter how if you can go 200 miles on car, because you can’t drive that faster, like how comfortable can the seat actually be?

Well, once that happens, you start competing on different matters. You start competing on convenience, price. Then GM and Ford became less powerful because they no longer could innovate because the actual product became too good. And so then you compete in other matters. Right now, Carvana has integrated the entire vertical supply chain, likely going to be the winner in this space, a very large space. And there will still be a CarMax’s of the world. And I think it’s something that we still have to watch because CarMax still does have the power to change your business model however you look at history throughout business, it’s unlikely that they will do that. Something similar to the Trade Desk.

The thesis was, they would be the established winner of independent DSPs. And we just have to track that. But if one thing to verify our thesis is over quarter, quarter year over year, they need to be gaining market share and programmatic advertising space, or else our thesis is wrong. So, that’s something to watch and then verify.

Using The Power Of The 80-20 Rule For Larger Returns

Tobias: How do you think about concentration, diversification, trimming positions? So, you’ve got something like your Trade Desk, which has gone up 13 fold. Do you just hold that initial position and let it run? Or are you trimming that back? How does that process work in the portfolio?

Joe: Yeah. I think of concentration and diversification, it’s an art and partly science. It’s a matter of how competent you are that a company will do what you think it will do and then more, you’re also alternative options. If I could choose 50 companies that I had high level of conviction would earn a 20% CAGR over the next 10 years, I’d diversify on 150 opportunities. But that’s not the world we live in.

What we do is we rank our ideas based on conviction and the expected return that we would range of expected returns that we would think might happen over the next 10 or so years. The thing about investing or just investment management is that there aren’t a lot of opportunities that you can get with conviction before they actually happen. It’s always easy to look back in hindsight. It’s like Apple’s a no-brainer or Facebook is a no-brainer. But sometimes you can see that there’s a company that’s established themselves as the winner, they have a competitive durable advantage and they’re valued attractive price. If you look at where the returns of stock market have come, historically, it’s that Pareto’s 80/20 principle. I mean, 20% of the opportunities provide 80% of the return, and then you can reapply the 80/20 within the 20%.

There are a few companies that have extremely high excess returns. And so if you get a conviction, like a Trade Desk, like we did have, you concentrate. I mean, I wrote in our investor letters, it basically is a once in a 10 year– since I’ve been investing probably for the last 12 years, it’s the best opportunity that I came across. And when you find that, like you better concentrate because they don’t come around often. You have to also understand, what you’re trying to avoid are that the unknown unknowns, like the Black Swan events, the things that you aren’t thinking about. So, you never want anything to destroy your portfolio.

So, that’s why we never use leverage, we don’t even store because the risk-return doesn’t make sense to us. So, anyways, when you find that we concentrate, but it’s also like, what’s our number two idea? Is it just as good? Or is it far worse than Trade Desk. But as the Trade Desk has grown and become a 10 plus bagger for us, the future returns have gone down. What is the potential market value of Trade Desk in the year 2030? Is 100 billion, 200 billion, 300 billion? What would justify those returns? How much advertising would have to go over the platform to justify it?

Well, based on our analysis, like it’d be $50, or $60 billion of this $1 trillion industry would probably have to go over their platform to justify today’s price. Right now, there’s 3 or 4 billion that goes on with a platform. What’s the likelihood of that actually happening? I mean, if they’re the winner, it’s probably in our opinion, pretty high. But, yes, at one point, the Trade Desk was over 30%-35% of our portfolio and we have trimmed it and return it. Actually, during March crashed, the stock fell from, I think it was $300 to $150, and just under maybe 140. The expected return went up a lot more because nothing else changed. Except for that we potentially are going to go through a recession, so ad dollars will go down.

Then, we actually increased our allocation materially in March, same thing with Carvana, and a few other holdings. We’re always trying to be like, what’s expected rate of return? And that gets into another part of our philosophy, which is that we’re not trying to time the market. If you look back, and that’s one thing that no one has the ability to do. And what we’re always trying to do is think of what is the best opportunity today with our capital. And if it’s long term money, which I think all money into the stock market is long term money, or it should be, you’re not going to put in cash like, which is going to depreciate in value over time. Or if the best opportunity we can find is 50%, we will invest in the 50% opportunity relative to what we think the S&P will return.

Best Holdings Should Be Your Largest Positions

But to get back to your question about diversification in concentration, yes, we have trimmed Trade Desk because the expected return has gone down. We have found other ideas that we think are very attractive as well. So, we would increase those allocations. We generally say that we hold about 10 holdings and we’re not stuck to that number, because if we’re not going to invest in the 10th holding just to have 10 holdings, it has to be an attractive opportunity.

A good analogy of like, how much makes sense for portfolio, like whether it should be a 10% holding or 15%, or a 20%. It’s similar to like, if you’re trying to shoot a basketball hoop, generally know where you’re going to be aiming and you know how hard you have to push the basketball, but you don’t know needs to be 35% angle and 10 feet this way and the actual. You just generally know, that’s a good amount for the risk, reward, payoff. And that’s how I think about it, where we have a general idea that this is a very attractive opportunity. It should be a large percent of the portfolio, but we don’t know if it should be 18% or 19%. Stocks fluctuate all the time. And if there’s one thing in owning common equities, is that people trade too often, not too little. We generally like to leave stocks and as prices really fluctuate which– and this year has been the case because we’ve had higher turnover because stocks have moved all over the place.

Tobias: That’s absolutely fascinating. Joe, I really appreciate the time that you’ve spent with me today. If folks want to get in contact with you, how do they go about doing that, or follow along with what you’re doing?

Joe: I recently got involved in Twitter in the last year. So, you can reach me at @SagaPartners or you can go to our website, www.sagapartners.com and you can reach out that way through our communication site.

Tobias: Thanks very much, Joe Frankenfield, Saga Partners. Thank you.

Joe: Thanks, Tobias.

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