Analysis

Over the last few years there’s been a lot of talk about whether value investing still works. Without rehashing what the two sides are, I would argue that it’s not dead, but rather simply misunderstood, and it’s important to assess what value investing is on a first principle basis.

Say you have two businesses, company X which is highly valued at some X multiple of revenue, and a company V which is valued very cheaply at some small multiple of FCF or earnings. Over the last several years, investors may have observed that company X have enjoyed more share price growth than company V even though it looks like company X is more expensive. Some may go as far as to say value investing in companies like V simply doesn’t work anymore. I would argue this is an incorrect assumption based on faulty interpretations of recent market trends.

To assess if value investing is still alive and well, it’s important to first recognize why value investing works in the first place. The basic element of value investing is you’re buying some business that’s valued at a low Price/FCF basis which results in a good yield on your invested cash annually. This is an attractive way of investing because it offers investors a sense of confidence, in that their valuation of a business is grounded on something, and that something is real returns. The keyword here is real returns.

The problem I see with many of these ‘value’ picks today, is that while the business is generating cash, it isn’t returning it. This causes people to question if value investing works when they should really be reassessing whether the business they’ve invested in is truly returning the FCF they generate.

While many investors may have a slightly different flavor of value investing, mine is that it offers an acceptable return on my investments.

However that return of value generated by the business must be real. I would generally accept the following 3 ways of being paid back for my investments:

1. The business is reinvesting earnings into more (real) growth
2. The business is buying back stock
3. The business is paying a dividend

#2 and #3 are traditionally how you would be paid back, but I would argue #1 is a more attractive way of being ‘paid’ back, and also my preferred method.

The problem with many of the value stocks I see out there today is that they do not grow, they do not buy back stock, and they do not pay a dividend. At which point, I would ask the question; when am I going to be paid for my investments? The companies that do not take action to repay investors the FCF they generate are NOT value investments, they are simply retirement homes for management and board members to reap all the rewards while investors question if value investing works.

Value investing works, some investors are simply not invested in a company that is returning value to investors. Instead of questioning if value investing works, it’s important investors reassess if these ‘value’ businesses are really of high value from a first principle basis as opposed to simply looking at their multiples (are they returning their cash to you?).

I was introduced to AUTO late last year and recently got around to taking a look at this business. I was attracted to it primarily because this is a lead gen business which has many of the same qualities as SaaS businesses on their rev gen side (marketing metrics/conversion rates). AUTO acquire website traffic via their portfolio of sites, convert this traffic into leads, and sells it to local dealerships. A capital light business that have some similarities to SaaS and tech businesses we’re normally invested in. Ultimately I decided against taking any positions, but I thought I’d share my quick analysis of AUTO with those who are interested. Feedback is welcome if I missed anything as I may take another look at it in the future.

AUTO is a lead gen business that owns a portfolio of automobile related websites, namely: autobytel.com, car.com, usedcars.com, and usedtrucks.com.

This is a an asset and capex light business in that they generate traffic from different sources (which I’ll cover briefly below), convert these traffic into leads of customers who are interested in used cars, and then sell these leads to local dealerships who has the inventory of the cars customers want. In a general sense, AUTO’s business makes sense and provides value for both their partners (car buyers and car sellers).

I’ll spare everyone the history of the business, but the short version is the old management team was shown the door due to poor management and declining revenues. New CEO was brought in and brought in his own executive team in 2019.

When the old guards leave and new ones come into a declining business, investors want to see the following:

1. Transparency, and honesty on how the business is actually performing (PAR’s new CEO is a great example of how a new CEO should act)
2. A plan to get the business back on track
3. Signs that the business is stabilizing

Unfortunately I would rate management’s #1 & #2 as a 5/10 at best, and as for #3, there’s been no signs the business decline is stabilizing.

#1 & #2: After joining, the new management’s plan is essentially optimizing on revenue per lead as opposed to driving new leads. This is very disappointing as it shows management has no plan to solve the root cause of their problem to begin with, which was the decline in traffic (i.e., revenue).

I’m equally disappointed in the constant frugality talk instead of solving their root problem. “What you’ll find is that we are doing more with what we have” (19Q3 CC)

Most of the company’s trouble have to do with a decline in traffic and unfortunate timing in the slowdown of the US auto market. AUTO lost many of their paying car dealerships in the last 2 years in the market wide slowdown. However this is conflicting, as when car sales drop, you would think car dealerships would be more inclined to buy qualifying leads.

This leads me to believe car dealerships do not find AUTO’s leads meaningful in providing a ROI, and dealerships are cutting cost around ineffective marketing (AUTO’s leads) and increasing spend elsewhere (Google Ads). Indeed, management have also signaled in conference calls that they have been revamping their internal tracking systems to better show ROI for dealerships. I believe until this problem is solved and dealerships are persuaded that they should be spending their marketing dollars with AUTO, AUTO will continue to experience difficulties keeping old clients and signing new ones.

#2 and #3: As mentioned earlier, I was initially attracted to AUTO’s business model frankly because the same rev gen models that are used to calculate conversion rates from SaaS or growth tech companies can also be used with AUTO. At it’s root, AUTO can sell more leads if it can generate more leads, and if it can generate more leads if it gets more traffic. However the decline of their traffic have resulted in a decline in revenue, and new management is currently optimizing this remaining traffic instead of growing their traffic base.

While optimizing their conversion rates is a understandable thing to do, you’ll never grow if you’re forced to make more with the same amount. You don’t get rich by trying to make the most of a minimum wage job, you get rich by making more money (while also optimizing your monthly spend).

It’s admirable that the new management is looking to stabilize the business by increasing conversion rates and optimizing lead revenue, but this doesn’t fundamentally change their situation until they can find a way to renew their lost traffic. The current optimization plans will at best get them to a rough breakeven point. Their current market cap is 30M, with a 1.1M balance sheet while losing 2M per quarter. While they can likely bring in some AR, this will likely only buy them a longer runway until they can solve the real problem.

Importantly, we noticed AUTO’s primary website Autobytel.com’s traffic halved in late August 2019, dropping from an average of 1.2M visitors per month, to 600k per month:

With Q4 2019 earnings coming up, AUTO will likely be reporting more bad news before any good ones come in.

For now, I’ll be waiting on the sidelines until they can prove they have a plan to increase traffic and revenue, show stabilization in quarterly losses, and importantly show some honesty in their performance metrics.

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It’s finally 2020. Over the holidays I recalled a conversion I had with a colleague where in early 2019 we spoke about the results of the Q1 2019 CFO Survey, which had the headline “Recession Expected by Late 2020” and stated that “Sixty-seven percent of U.S. CFOs believe that the U.S. will be in recession by the third quarter of 2020, and 84 percent believe that a recession will have begun by the first quarter of 2021.” I felt this was meaningful as the CFO Survey results are aggregate of around 500 CFOs based in North America, so it had some representation of what CFOs think.

As it’s now Q1 2020, I felt it’s only fitting to go back to check up on the results of the survey over the course of the year and see how their predictions changed over time, here they are:

Q1 2019 results: 67% predict recession by Q3 2020, 84% predict Q1 2021

Q2 2019 results : 49% predict recession by Q2 2020, 69% predict Q4 2020

Q3 2019 results : 53% predict recession by Q3 2020, 67% predict Q4 2020

Q4 2019 results : 52% predict recession by Q4 2020, 76% predict Q2 2021

There’s a few interesting observations. First, at least half of CFOs believe a recession is just around the corner (6-9 months out), while the significant majority (70-80%) believe a recession will happen within 12 – 24 months. Second, it seems these timelines gets postponed a little quarter. Most like the dangling a carrot in front of the horse.

One thing to note however, and this seems evident in the fund manager circle as well, is that a good number of people seem to think there’s some market risks around the mid-2020 election time frame, and to an extent, increased market volatility. The CFO survey results is also consistent in this regard, having a recession expectation around this time frame in each of their last 4 survey results.

The other thing that’s been going around is that it seems most firms predicts 2020 to enjoy some modest stock growth based on what ever reason they choose to use this time. So to summarize, it seems census believes:

1. Market risk around US elections
2. Increased market volatility
3. Modest market growth

For the most part I think these predictions are pretty reasonable. I think the folks who are buying utilities to be more defensive are taking it a tad too extreme (I also believe utilities are over priced at the moment, but that’s a separate post). I don’t think 2020 will be too bad, but it may be painful for some. I don’t think 2020 will be too great, but we’ll likely see modest gains across the market.

In terms of portfolio strategy for 2020, we are likely to raise cash while reduce holdings in stocks with the lowest expected returns (the least favourite of our favourites), as well as stocks that require the longest timelines to play out. We are also likely to sell into highs and buy lows, consistent with our belief that we’ll see some volatility (opportunity) and overall market gain for 2020.

Also, if volatility increases meaningfully, we’re likely to write options around our favourite names.