Reading Roundup: September 2022

Soul In The Game, Private Equity's Public Distress, The Wealth Of Nations, My Father's Business

This month we read:

• Soul in the Game: The Art of a Meaningful Life by Vitaliy Katsenelson

• Private Equity’s Public Distress: The Rise and Fall of Candover and the Buyout Industry Crash by Sebastien Canderle

• The Wealth of Nations (Books I, II & III) by Adam Smith

• My Father’s Business: The Small-Town Values That Built Dollar General into a Billion-Dollar Company by Cal Turner Jr.

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Soul in the Game: The Art of a Meaningful Life by Vitaliy Katsenelson

Dan and I often joke that value investing is a lifestyle. It’s more than a job description, it’s a mindset. Vitaliy explains what I mean by that in this book.

Soul In The Game is a collection of short essays on everything imaginable. There is no single unifying theme, thread, or narrative. The book covers Vitaliy’s background as an immigrant from the Soviet Union, Stoicism, dieting, exercise, mediation, sleep, addiction, parenting, and classical music. Vitaly isn’t prescriptive and he isn’t trying to suggest how you should live. He simply explains his operating system — what works for him and how he got there.

The book’s title is an allusion to Nassim Taleb’s book Skin In The Game. Skin in the game is about aligning incentives. You want to associate with people who share equally in your ups as well as your downs. If a chef refuses to eat his own cooking, you should refuse too.

Dan and I are fanatical about having skin in the game. Our entire life savings, and all of our family’s, are invested alongside EPC’s clients in the same stocks and same allocations. We and the people dearest to us share in the upside, and more importantly, in the downside from our investment decisions.

Soul in the game goes beyond skin in the game. Soul in the game means having more than money at stake. It means putting your entire being and identity on the line. It means pursuing mastery of your craft with everything you have. It means financial success achieved without honor or integrity is no success at all.

When someone has soul in the game their motivation comes from passion for their craft, not financial rewards. While this might conjure an image of starving artist, it applies more broadly. Buffett has referred to Berkshire as his Sistine Chapel, a masterpiece that is the culmination of his life’s work. He doesn’t “tap dace to work” because he wants to make another billion — he’s going to donate it anyway — he simply loves investing.

Soul In The Game is wide ranging and impossible to summarize, but I think most readers will find something they enjoy in it. At worst, it will provide food for thought, and at best may help you refine your own operating system.

Matt

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Private Equity’s Public Distress: The Rise and Fall of Candover and the Buyout Industry Crash by Sebastien Canderle

I am mildly obsessed with reading about financial implosions - hedge funds, stock markets, individual companies, governments, etc. - and Canderle’s account is the inside story of the largest ever failure of a private equity fund (as of 2011). My fascination on meltdowns stems from much preferring to learn what not to do vicariously rather than first hand whenever possible. As Munger says, “All I want to know is where I’m going to die, so I’ll never go there.”.

Private Equity’s Public Distress is an interesting account of the rise of the private equity industry in the UK in the 1980s amidst Margaret Thatcher’s reshaping of the British economy. Candover Investments was an early entrant in private equity and quickly became a leader in the space by the late 1980’s. The firm espoused all of the positive aspects of buyout leaders in its early days; an emphasis on driving operational improvements, reasonable leverage levels, and a strict adherence to its middle-market and UK-based circle of competence.

Founded by Roger Brooke, Candover grew to become a respected buyout firm that delivered solid returns for LPs through multiple cycles including the early ‘90s recession and the dot-com crash. Brooke’s prudent management of the firm and portfolio continued under his successor for a few years but when the next CEO took over the firm succumbed to the buyout orgy of the mid-2000s which ultimately took down the firm.

No longer content with managing a handful of a few hundred million dollar funds and focusing on what it knew - mid-size buyouts in the UK - the new management team pushed for aggressive expansion. Candover rapidly opened offices all over Europe and raised several multi-billion dollar funds. In a rush to deploy capital the firm bid more aggressively (paid higher multiples) for competitive and large acquisitions, participated in many secondary buyouts (which are usually less lucrative), took on much higher leverage at portfolio companies, and strayed from the markets it new best.

Thanks to poor performance of its over-leveraged portfolio that resulted in few exits and major write-downs, when the credit window slammed shut in 2008 Candover’s parent company was unable to meet is $1B commitment to it’s new $3B fund which allowed LPs to pull their money out. The firm was forced to abandon new fundraising and wind down and was just one more of the high profile victims of the financial crisis.

The lessons from investors are clear and consistent with other stories of financial ruin:

• Stick to your circle of competence. The company left the familiar deals where it knew how to add value such as proprietary sourced management buyouts and entered into a world it was not set up to effectively compete.

• Avoid “empire building”. Candover emphasized size of AUM over investment results and chased bigger deals for the sake of size.

• Beware of high levels of leverage. Candover became path dependent because of high leverage. Even if its investments were to be successful, it couldn’t survive the credit crunch to make it through to the other side.

• Price matters. Easy credit and competitive secondary auctions led to much too high of valuation multiples that left little room for error and low prospective returns.

Candover was in private equity, but all the same lessons apply to public equities, real estate, or any other asset class. Candover was a casualty of the same lessons so many investors seem unable or unwilling to take to heart during every cycle.

Dan

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The Wealth of Nations (Books I, II & III) by Adam Smith

Written in 1776 by the “father of economics”, The Wealth of Nations is one of the founding books of capitalism. While most of us have been taught the ideas and premises that Smith taught, I’ve always felt it a moral duty to give The Wealth of Nations a firsthand read. It is not an easy read given it’s written in 1776 style prose, but after awhile your brain adjusts to the language of the time.

Smith lays out many important concepts about economics and free markets that are still true today, and will be true 300 years from now. Some of the key ideas are:

1. The division of labor and individual specialization result in massive societal benefits. These ideas, which we take for granted today, were novel a few hundred years ago. Smith’s famous example was that of a pin maker. Making a pin could be separated into 18 different steps, and if 10 workers were each given just one or two specialized tasks to complete they could collectively churn out 48,000 pins per day or 4,800 pins per worker per day. Absent the division of labor the average person would be lucky to make just one single pin in a day.

   1. This idea is what resulted in societies going from no-growth and subsistence-based (everyone produces what they need, and if you need a pin for something you make it yourself at painstakingly poor levels of productivity) to ever increasing standards of living and wealth. When workers and companies specialize they produce far greater quantities at far lower costs, resulting in surpluses that can be traded and exchanged, greasing the wheels of capitalism.

2. The basic laws of supply, demand, and price. While he doesn’t draw out the supply/demand curve anyone who has taken economics is familiar with, he does lay out the concept that still holds true today. Smith provides countless examples showing whenever there is too much supply of a good (gold, silver, cattle, coats, etc.) the price has to fall until capacity is removed from the marketplace, at which point prices rise to their natural level again. This is a lesson that has to be true in free markets, and we’re seeing it over and over again over the past few years coming out of the pandemic.

3. The invisible hand, which is probably what Smith is most famous for. His invisible hand theory is that, in a free market economy, individuals who are acting in self interest (motivated by profit) act in a way that actually leaves society better off. Governmental mandates and broad policy’s that are meant to benefit society usually fail. All a country needs to advance is the right system. When individuals are allowed the freedom to pursue their own self interests it results in specialization, efficiencies, innovation and an interdependence on one another that leaves the country richer and better off as a whole. America has been benefiting more than any other country from this system since Smith coined the invisible hand metaphor hundreds of years ago.

The most interesting thing to me about reading books from 50, 100, or 300 years ago is how applicable the core ideas still are. The economy looks nothing like it did in 1776, yet the laws of supply and demand and the invisible hand still hold. Just ask Target, who spent the summer liquidating an excess of inventory at fire-sale prices, or all E&P energy businesses during 2015 after the last energy bust.

I’d wager 300 years from now these immutable laws will still be true and will still be creating opportunities for investors (or perhaps we’ll be robots by then) who take the time to learn from Smith.

Dan

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My Father’s Business: The Small-Town Values That Built Dollar General into a Billion-Dollar Company by Cal Turner Jr.

My Father’s Business is about the history of Dollar General. It explains how the company started, found its niche, and scaled.

In 1929 the author’s grandpa, Luther Turner, opened Turner’s Bargain Store in Scottsville, Kentucky. Turner’s Bargain Store focused on closeouts, much like Ross Stores and TJ Maxx do today. 

Luther got the idea to start the store when he saw an opportunity to buy a failed store’s inventory at a bargain price. During the Great Depression, he repeated this several times. He’d buy the inventory at auction, hold a “going out of business sale” to liquidate most of the inventory immediately and get his money back, and then take the remainder back to his store in Scottsville. Luther always took his son, Cal Sr., to auctions which developed his eye for bargains from a young age.

Luther also did some creative marketing.

The importance of tobacco as a local crop gave my grandfather one of his best early promotional opportunities. Farmers sold their tobacco late in the fall, receiving checks they turned into the only cash many of them saw all year. Luther knew those sale barns were cold and he came up with the idea of giving each farmer at those sales a good right-hand work glove with a note attached. It said, “Get the mate to me free at Turner’s Bargain Store. We will gladly cash your check.” The farmers would go to the store and get the mate to a good pair of gloves, then cash their checks. There they’d be, inside a store loaded with useful merchandise, with a year’s worth of crop money in their hands.

By 1939 the Great Depression wasn’t over, but the economy had stabilized. The retailers that remained were the survivors, and they needed inventory. At age 24 Cal Sr. saw an opportunity to go into the wholesale business. He started L. J. Turner and Son as a joint venture with his Dad.

When WW2 ended, manufacturers freed from wartime production began flooding the market with cheap goods. Prices plummeted and Cal Sr. was swimming in bargain inventory. He realized that he needed more stores to sell all of this inventory. He began to develop  joint ventures with local businessmen in small towns near Scottsville.

J. L. Turner and Sons always needed more capital to fund growth. Luther would say, “In retailing, you lose money for eleven months, just hoping to make it all back in December. Then in January, you begin the struggle all over again.” Eventually Cal Sr. bought Farmers National Bank to ensure a steady supply of cheap capital.

In 1966 Cal Sr. became intrigued by the Dollar Day sales the big department stores in Nashville and Louisville ran. Once a month, they’d take out full-page color ads in the newspaper and sell a variety of merchandise for exactly one dollar.

My dad knew what those ads cost, and he understood that if they were spending that kind of money, they were selling a lot of goods. Customers obviously loved that $1 price point. Somehow, it made real value seem even more obvious. Why couldn’t we simplify all of our operations, he thought, by opening a store with only one price—a dollar? Every day would be Dollar Day. 

Cal Sr.’s team thought it’d never work. But Cal Sr. trusted his gut and remodeled a failed store into a prototype. He gave the concept a new name.

The word Dollar was a must—that was the whole point. With a nod to the term general store, he added the word General. He was an opportunity buyer. He looked for bargains, and the word General would let customers know they might find just about anything inside. He often said, “Back in the country, the general store is where everything and anything was sold.” The Dollar General sign, he decided, would be black and yellow, a combination he knew really stood out. “I wanted the colors to leap right off the store signs,” he said.

Dollar General was an instant hit. The second store sold $1.1 million of merchandise in its first ten months. Sales like that would be good even in today’s dollars, but that was in 1956.

Initially Cal Sr. would sell single shoes (not a pair) for $1 a piece in order to conform with his slogan, “Nothing over a dollar.” However, some people bought just one shoe. He went to $2 for a pair of shoes and quickly branched into other multiples of $1. This might seem like a small decision, but Dollar Tree, under pressure from activist investors, only realized the value of doing that this year.

During this period Cal Sr. began grooming Cal Jr. to take over the business. 

My dad’s bottom line since the beginning could be summed up in one word—survival—and he reasoned that the key to survival in retailing lay in something his father had said. He’d quote him often—“If I control my expenses better than the competition, I just have to buy as well as he does—and I’ve got him!” That’s why he watched the company’s sales and expense reports so closely. That approach kept the company going during its early years, but he realized it wasn’t going to be enough in the future.

Cal Jr. found ways to reduce risk and put the odds in their favor.

We wrote three-year leases with three-year options, and that’s about all it took to see whether a store was going to make it. After three years, if a store wasn’t making money, we closed it, and while it took us four days to open a store, we could close one in a day and move on!

This ethos is still at Dollar General today. The company does thousands of real estate projects a year and can stand up a store in less time and for less money than its competitors.

During the sixties and seventies closeouts still made up the bulk of Dollar General’s merchandise. Cal Sr. was an opportunistic buyer, and his skills were one of the reasons Dollar General was so successful.

My dad’s buying habits were one of the things that set us apart. By and large, the other retailers studied and copied one another. That’s why you could probably go into any department store and find pretty much what was in every other—you still can. They advertise the heck out of being like one another, then try to put just a bit more style, a bit more froufrou, into the presentation, hoping to woo you to this one instead of that one.

That froufrou also allows them to mark things up a little higher, getting more from shoppers for the same merchandise. That is perhaps a good retailing example of what happens when you pay more attention to the competition than to the customer. We were different. We avoided froufrou. We knew it was harder to convince the customer she’s getting a bargain if she sees carpeting and a boutique setting. That’s part of why our furnishings were so sparse.

While Cal Sr. had a gut feel for pricing, Cal Jr. wanted to operate in a more professional and scalable manner. Where Cal Sr. laid down rigid rules, Cal Jr. offered more flexible principles. Cal Jr. introduced computers and optimized the company’s warehousing and logistics. He also dealt with threats of unionization.

As that election neared, we took the advice of our law firm and divided paychecks in two. The department head would hand out checks that represented each worker’s pay minus what he or she would be paying the union in dues. “That’s what you’ll take home if you vote this union in,” they said. Then they handed out the check that represented the union dues. “This will be going to the union,” they said, “but don’t forget it is really your pay and the money does come from us.” That little bit of drama was perfectly legal, and we did attempt to stay inside the lines, something we were concerned the union might not do.

Cal Jr. also dealt with shrinkage.

Playing cops and robbers is not loss prevention. It’s dealing with loss on the back end rather than the front end. So why not let the operators—the manager and assistant manager, backed up by the district manager—take charge of the total operation of that store, including loss control? You’re bringing accountability closer to the action, so you should be more effective in controlling it. In this case, we made it clear that shrinkage affected bonuses. If they could stop it at the store level, their year-end checks would be larger. We figured that would inspire sufficient self-policing

Despite several close calls, Dollar General continued to grow and prosper. Cal Jr. explained why:

“John, would you like to know the real strategic genius of Dollar General?” “Yes,” he said, looking very interested. “What is it, Cal?” “Well,” I told him, “our past has always been screwed up, and every year, we just selectively unscrew a bit.”

If there is a single key takeaway from the book, it is that retailing is hard. Cal Jr. says, “Customers grant loyalty when retailers earn it, and it has to be earned every day.” Dollar General’s commitment to low prices and narrow focus have won it loyalty and that should continue.

If you’d like to learn more about Dollar General you can read my write-up from April 2022.

Matt

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The Best Of The Rest

• Howard Marks — Illusion of Knowledge. “Where are the people who’ve gotten famous (and rich) by profiting from macro views? I certainly don’t know everyone in the investment world, but among the people I do know or am aware of, there are only a few highly successful “macro investors”. When the number of instances of something is tiny, it’s an indication, as my mother used to say, that they’re “the exceptions that prove the rule”. The rule in this case is that macro forecasts rarely lead to exceptional performance.”

• Albert Bridge Capital — Staying In The Game. “But the blow didn’t kill the dog. The driver that hit her sped off and left Chica half-dead and crying in the road. But the next car did stop. It was a young black kid. A young black kid who saw a young white kid on his knees in the middle of downtown Indianapolis. His name was Kenny.”

• Jason Zweig — Where You Can Find Stock Bargains. “If the future unfolds according to the consensus, markets won’t move much. Surprise is the source of extra returns, magnifying gains and losses alike.”

• Oaktree Capital — Three Misconceptions about Private Credit. “Surviving on average is an irrelevant concept. What’s key is to survive on the bad days”.

• Patrick McKenzie — Siting Bank Branches. “A recurring theme of this column is that banks are privately funded public infrastructure. Bank branches continue this trend.”

• Bloomberg — Restaurant Staff Shortages Are Easing in Shift for US Labor Market. Fast food service employment is finally close to its pre-pandemic level. Now that kids are back in school and child care is more consistent, more women have been freed up to join the labor force. No Covid stimulus checks and rampant inflation have also spurred people back to their jobs.

• WSJ — The Most Convenient Inflation Haven. “A candy bar at a convenience store isn’t necessarily cheaper than at Walmart, but customers typically pick up only a handful of items per visit at the former. That shields convenience stores from price sensitivity compared with bigger-ticket retail. If you pass through 4% to 5% of inflation on a small item, it doesn’t move the needle as much.”

• Scuttlebutt — Sidecar Investing (v2.0). “So, to fully achieve compounding magic, one must first arrive at the “second half of the chessboard”, a phrase by Ray Kurzweil about the point where an exponentially growing factor begins to have a significant economic impact. To arrive there, however, means minimizing interruption and not blowing up in the meantime, both at the business and investor level.”

• Acquirers.com — Serial Acquirer Primer

• Michael Mauboussin — Understanding Competitive Advantage Through Market Power

• Morgan Housel — Incentives: The Most Powerful Force In The World. ”One has to remember that in 1923 we had the inflation… nobody had anything, everybody was unhappy. Then Adolf came to power with his new idea. For most that was indeed better. People who hadn’t had a job for years had a job. And then the people were all for the system.”

• Jason Zweig — When Bad Things Happen to Good Stocks. “It’s never certain, however, that investing in any particular one of these factors will provide a durably superior return in the future—especially given the perennial tendency of investors to jump in with both feet after a period of hot performance only to bail out when returns go cold.”

• Vitaliy Katsenelson — Picking The Right Clients. “You mention that you are monitoring your brokerage account “frequently.” You’ve said it with pride, like you are doing your part of the homework as a responsible steward of your family’s capital. I can understand the intention, but I’d argue that looking at your portfolio daily will do you more harm than good. First off, what you are observing on a daily basis is complete and utter noise. But it’s not harmless noise….My advice to you and to all clients: Don’t look at your portfolio more than once a quarter. If you are a long-term investor, you have little to gain from it. We will suffer the toxicity of the stock market on your behalf; this is why you hired us.”

• A usually sleepy corner of finance almost pushed UK Pension funds over the brink in September. “The central bank stepped in Wednesday after the calls threatened to push the gilt market into a downward spiral. The BOE had been warned by investment banks and fund managers in recent days that the collateral requirements could trigger a gilt crash, according to a person familiar with the BOE’s deliberations before they stepped in.”

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Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.