How We Prepare for Anything, but Nothing in Particular
The benefits of investing in businesses who control their inputs and outputs
Matt and I will be in Omaha for the Berkshire Hathaway meeting and would love to meet up with our readers. We’ll be available May 1-2. If you’d like to meet up, get in touch with us by emailing info@eaglepointcap.com.
Mark Twain was credited with saying “It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.” Whether he said it or not is beside the point because it’s one of the most important idioms to keep in mind with investing.
Until recently, over the last several decades many economic and political realities had become nearly universally accepted. Things like low interest rates, low inflation, benign commodity prices, expanding global free trade, and a lack of large-scale global conflict have driven economies, political systems, and investment strategies. Many investments became a one-way bet on these conditions persisting into perpetuity. For instance, many private equity funds appeared to generate exceptional risk-adjusted returns when it reality they were just short interest rates (there are, of course, a small subset of truly skilled investors in the PE world).
In other words, investors knew for sure that these factors would continue to drive the investment landscape, particularly in the U.S. The problem is, it appears some of these things “just ain’t so” anymore.
The future of macroeconomic and geopolitical factors are completely beyond our, or anyone’s, ability to predict. A natural tension arises for investors whose aim is to deal with the future. Preparing for and guarding against unknown unknowns is one of our primary jobs. We contend with this dilemma by building a portfolio that is “prepared for anything yet prepared for nothing in particular”. What does this mean exactly?
We like owning a collection of stocks whose businesses can withstand just about anything but are not a directional bet on any single outcome. We don’t want to have to “root” for factors beyond our control to turn out in a certain way for our investments to succeed.
For example, we didn’t have the faintest idea when we woke up on April 2nd that the U.S. would enact the largest tariffs in 100 years which would wipe out 6 trillion dollars from the American stock market in the ensuing week. Still, we didn’t lose a wink of sleep during that period because of the nature of the businesses in which we’re invested.
Our businesses should march ahead during the good times and, in aggregate, continue marching ahead (some even at an accelerated pace) when things like tariffs, inflation, recessions, and global conflict arise. How do we find businesses that should prove to be “all terrain” (as Vitaliy Katsenelson puts it) investments? We look for companies that control their inputs and outputs.
Freedom from Extrinsic Factors
No business is completely free from outside factors – this would be akin to a machine that just prints money. However, there is a spectrum of how impacted businesses are by factors beyond their control, and we spend a lot of time thinking through these before making an investment.
Things we look for include:
A fragmented supplier and customer base so the business isn’t subject to cost-downs or lack of control of input prices;
No over-reliance on commodity prices;
No dependence on interest rates being high or low;
No hyper-sensitivity to unemployment or broad economic factors;
Relative scale vs. competitors and customers;
Pricing power to pass along inflationary costs;
Predictable recurring revenue streams such as subscriptions, royalties, contractual revenue, and non-discretionary consumables or services;
High returns on tangible capital which enable the company to grow will still returning substantial cash to shareholders;
Significant free cash flow generation and manageable-to-low debt loads.
Each of our businesses check multiple of these boxes, some check all of them, and collectively they make up a portfolio resilient against things we cannot foretell. As Howard Marks has put it much more succinctly, “you can’t predict, you can prepare.”
For example, we are shareholders in British American Tobacco and Philip Morris. They sell non-discretionary consumables (i.e. nicotine products), have tremendous pricing power, earn exceptional returns on capital, generate substantial free cash flow, and are relatively unscathed by interest rates, inflation, unemployment, and other macro factors. People still need their nicotine fix and BTI, PM, and others are there to supply it.
Take AutoZone as another example. AutoZone instantly passes on parts inflation to customers and actually benefits from it due to its negative working capital position. Consumers don’t really bat an eye given the non-discretionary nature of auto repairs and an average basket of $30. 10% inflation? Are you really going to not pay $33 instead of $30 to get your car fixed? Doubtful. The economy turns down? More people decide to DIY auto repairs, lifting AutoZone’s business. They also tend to stick around even when the economy recovers. The economy is booming? People spend more on non-discretionary car projects they’ve been holding out for. You get the idea.
We own a number of other subscription, annuity, or royalty-like businesses with similar characteristics. We recently distributed our spring portfolio update to our investors that outlines each business we own. As a reminder, premium subscribers will receive a full copy of our letter on May 15th.
Now consider an automotive supplier on the other hand, which is the antithesis of the type of business model we like. They are usually jammed between huge raw material suppliers who can raise prices when their costs go up and a concentrated customer base on the other side. Despite rising input prices the OEM supplier cannot raise their prices because they’re locked in to multi-year price-down contracts with large OEMs customers. Their businesses require significant capex just to maintain the status quo, are subject to fierce competition which usually limits pricing power, and have virtually no revenue visibility. They’re also often saddled with debt. Some people can make money investing in these types of business models, but we prefer to steer clear.
Many business models fall somewhere in between these extremes.
The fun part about studying these businesses is that just because a business possesses many of these qualities doesn’t mean the stock will always reflect that fact in the short run.
For instance, we recently purchased shares of Wendy’s; a resilient, growing royalty business with significant scale advantages and substantial free cash flow generation. We struggle to identify why or how Wendy’s business will be meaningfully impacted by tariffs on China, an economic downturn, rising or falling interest rates, or anything else going on in the news today. Yet the stock has sold off in sympathy with…NVDIA? Tesla? Apple?...and created what we view as a substantial margin of safety for a high-quality business returning gobs of capital to shareholders each year.
Our job is to look for mispricings when a business’s underlying fundamentals do not jive with the stock’s narrative and valuation. It’s a fun endeavor and one where there will always be opportunities.
Looking for stocks whose businesses have little reliance on extrinsic factors is but half of the equation to building a portfolio ready to withstand external shocks. The other half, and just as important, is remembering that the price you pay matters.
If you invest with a margin of safety and buy stocks that are already cheap (and ideally returning a meaningful portion of the market cap to investors) it naturally provides downside protection against external shocks. This is only true insofar as the business doesn’t fall apart from the external shock, which brings us back to why the list above is so important.
You can’t separate valuation and business quality, and we need both to own a stock. This is why we only own around ten stocks at a time; it’s hard to find opportunities that check both the valuation and business quality boxes. It makes sense that it’s hard to find these opportunities; as Charlie Munger reminded us, “it’s not supposed to be easy, anyone who finds it easy is stupid.”
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