A Conversation With Shree Viswanathan, founder of SVN Capital
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Hi there,
Last week I had the opportunity to talk with Shree Viswanathan, founder and portfolio manager of SVN Capital.
Shree was incredibly kind to give me 1h30m of his time to discuss several investment related topics. We also talked about two great companies in detail, Copart (CPRT) and HEICO (HEI), focusing on the main risks for each.
You can watch the conversation in the video below:
Or you can listen to it on Spotify:
If you prefer reading you can read the transcript below.
I hope you enjoy my conversation with Shree!
Leandro
Leandro: Welcome once again to the Best Anchor Stocks podcast! Actually my voice is a little bit strange because I have a cold, so it's not a different host, it's just that I have a cold this week, like 80% of the people in Spain.
So today I have the pleasure of talking with Shree Viswanathan. I hope I pronounce that correctly, Shree.
Shree: Perfect.
Leandro: Shree is the founder, president and portfolio manager of SVN Capital, a long-term-oriented fund. So, welcome Shree and excited to have you here!
Shree: It's a pleasure to be on. Thanks a lot for reaching out and, you know, look forward to our conversation.
Leandro: So, before we start, I wanted to remind listeners, or viewers if you're on YouTube, that Shree will be participating in an investor discussion hosted by Willow Oak Asset Management in Omaha. I think that it will take place just after the Berkshire Hathaway AGM. Is that right Shree?
Shree: That's correct. The evening of that Saturday.
Leandro: Okay, perfect. So if you are there by any reason, then you can go and you can watch the investor discussion.
Okay Shree, so I think I will start where I typically start every podcast. What did you do before funding SVN? And honestly, I think the question here is how tough was it to build SVN? Because I think many people know that starting a long-term-oriented fund is really difficult in the beginning because you have to wait a lot of years until you actually see the performance come through.
Shree: Yeah. First of all, Leandro, thanks again for having me on this wonderful podcast. You were gracious enough to send me some of the previous podcasts that you've run. That's quite a lineup. Both Chris Mayer and Christian Billinger are good friends, and who was the last one that you...
Leandro: François Rochon.
Shree: François Rochon, I mean, he's a Demigod. I'm looking forward to meeting him one of these days. It's quite a lineup and so it's a lot of pressure for me today. But anyway, thanks a lot for having me. Great to be here.
Yeah, I came here as a student pursuing a master's degree in accounting, I'm originally from South India. When I came here, I had plans to pursue a Ph.D. in accounting as well. I didn't see light at the end of the tunnel, and so I stopped with my Masters. Instead, I just became an accountant in a real estate firm, and then later on in an insurance company. Then decided to go to the University of Chicago for my MBA, was an investment banker for a few years, and then did corporate development at a bank.
But, over the last almost 20-plus years now, I've been on the buy side, managing money on a few different platforms. And a few years ago, three-plus years ago, I decided to launch SVN Capital. And as you correctly mentioned, it's a long-term oriented global long-only portfolio.
It's still a struggle, you know, growing an investment firm from scratch. It's a lot of work, but it's a lot of fun, like any entrepreneurial pursuit. You know, I remember Marc Andreessen, venture capital firm out of San Francisco Andreessen Horowitz. You know, he has said, any entrepreneurial pursuit will put you on an emotional rollercoaster, and you essentially have only two experiences, two emotional experiences, euphoria and terror.
I go through that pretty much regularly, even today.
Leandro: Yeah, I imagine. I actually go through the same, because I left my job one year ago to start Best Anchor Stocks. So actually, now I'm going through the same, but it's much easier if you're doing something that you like, obviously.
Shree: Yes, absolutely. That's the key.
Leandro: Yep. So how would you define yourself as an investor? So I think this question, maybe we can rephrase it as what's the ideal investment for you?
Shree: Yeah. In simple terms, I would say that I'm a value investor with a quality overlay. An ideal investment would be a business that I can understand, a high-quality business, I'm sure we'll dig into that as we go along today.
A business that's run by honest, competent management team with skin in the game, you know, meaningful ownership interest, typically they are owner-operated businesses. Then a business that's available at a reasonable valuation, that's an ideal investment for me.
Leandro: You described there several investment criteria. I think you have four criteria at SVN. Could you briefly explain what these pillars are and why you chose them?
Shree: Yeah, essentially it's those four questions. Those four items that I listed are essentially my investment criteria and what I'm trying to get to is an affirmative answer, you know, a "yes" answer to those four questions.
Is it a business that I can understand? You know, I see both individual and institutional investors make decisions based on hearsay or some peripheral work. This is one of the important reasons for deep volatility in the equity market. For me, borrowed conviction is worse than borrowed money.
I try to remain within my circle of competence. There are a few areas that I'm not comfortable with, for example, oil and gas companies, or Bitcoin or biotech. And increasingly certain areas within financial services, even though I've spent enough time in financials, having worked as an accountant and then as a banker and investor, fortunately, there are a few industries that I'm comfortable with and I try to stay within that. So that's my first question.
And then the second question...is it a high-quality business? Quality defined both qualitatively and quantitatively. Again, I'm sure, we'll get into the details of that particular question. In fact, that, and the third question, which is ownership, interest, and management, and all that.
Those are the two questions where I tend to spend most of my time when I am looking at a new business. And then the final question is, is it available at a reasonable valuation? You know, I'm not looking for really cheap multiples or really cheap valuation if it comes along. For example, during covid impacted 2020, or even last year, there were many businesses that were pretty attractively priced. If it happens, great, if it doesn't, I'm willing to pay a reasonable price.
Leandro: And double-clicking in some of those criteria. I think you mentioned a quality company and you obviously talked about quality measured in quantitative and qualitative metrics. So what would be the most important metrics for you when assessing the quality of a company?
Shree: That's a great question. Let me actually...allow me to digress a little bit and I'll bring it back to the specific answer you're looking for. So in 2017, yeah, it was 2017. And now a gentleman, a professor by the name of Hendrik Bessembinder, he's a professor at Arizona State University here in the US, he released a paper with a very provocative title, called "Do Stocks Outperform Treasuries?".
I mean, on the face of it, he would say, yeah, obviously stocks would outperform treasuries, right? But, he did some intense analysis going back all the way to 1926, and his conclusion was only 4% of stocks accounted for all the gains in the US stock market. That was you know, a revelation for many.
And, there is an outfit in Scotland by the name of Baillie Gifford, they invest globally. They came across this paper and they reached out to the professor and said: "This is great. You know, would you mind running the same analysis on a global scale?" And he went back and did the same thing. He came back and said: "On a global scale, only 3% of the stocks really account for all the gains." So the reason why more than 96% or 97% of the stocks underperform, is because of that one constant in the business environment. And that is reversion to the mean.
Any business that generates a high return on capital will start attracting competition which will arbitrage away the returns. And that competition, you know, leads me to another book and a speech. This is by Peter Thiel. He wrote a book called "Zero to One", and he actually gave a speech at Stanford in again, 2017.
I think the conclusion was, you know, competition. The title was "Competition Is for Losers." And essentially what he said there was: "competition is good for capitalism, but not good for capitalists." So what does that all tell me? You know, even though reversion to the mean is the constant in the business environment, there are a few businesses that are able to defer such reversion, defer them into the future.
And the one factor that allows them to differ such reversion is the competitive moat. You know, typically monopolies or duopolies are able to enjoy that moat and that's what allows them to generate high returns on capital.
While generating that high return is an important factor, that by itself is not enough. The other equally important piece is the ability to reinvest those returns to generate similar or better returns, right? And that combination is what, you know, results in my definition. That's what leads to my definition of high quality. So I define a high-quality business as one that generates a high return on capital and has the ability to reinvest such high returns back into the business.
So that's where I would lead you to sort of answer that question about my definition of high quality.
Leandro: No, that's a great explanation. I actually was familiar with the study of the 4% of companies accounting for most of the gains, but I didn't know that Baillie Gifford actually contacted the author to do it on a global scale.
Shree: Yes. So he published this in 2017 and updated it in 2018.
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Leandro: Very, very interesting. I think another one of the criteria, which you talked about is quality management. So how would you define that? What are you looking for when you're looking for quality management?
Shree: Yeah. You know, from a quantitative analysis, I think it's a little bit easier to tell poor management teams, right?
It's an interesting question. Evaluating management teams, I think it's a very subjective exercise. It's both qualitative and quantitative, I would say.
You know, as an aside, one interesting viewpoint is if you take the income statement of any business, when you go from top of the income statement to the bottom, you'll come across gross margin, which is your sales minus the cost of goods. So high gross margin will tell you about the quality of the business itself most of the time. Always take all these things with some kind of a caveat at the end. But a high gross margin will tell you about the quality of the business.
When you take the same income statement, but go from the bottom to top...high net margin or high operating margin will tell you about the quality of the management team. Again, most of the time take it with some kind of caveat.
So quantitatively, you know, you can tell how much a business is generating in free cash flow and what the return on capital is, but then how much is the management team retaining versus returning back to the investors? You know, a few businesses have the opportunity to take in all the capital and still generate those healthy returns.
For example, I own this food retailer in Poland called Dino Polska. They continue to grow at their store base at, you know, a high 20-some percent rate. Management has decided to reinvest every penny, every zloty back into opening up new stores, 100% of the cash goes back into reinvesting. And each mature store generates in the high 20-plus percent return on capital. So this is a unique business with a very unique capital allocation strategy, particularly for a European company.
And those are the types of quality management teams that become evident when you start spending time going through the financials. Of course analyzing the quality of these decisions is, you know, it's way more difficult, right?
But we can learn more about the management team, how they treat their employees or, you know, see how the management team sets up their bonus and incentive structure. And this decision to retain versus return capital. All these things, when you read that over a stretch of time, kind of give you the qualitative color about the decision-making capability.
Leandro: Yeah, I think you touched there on are great point and it's something I typically do. I don't know if a lot of people do it, maybe everyone does it, but if you have a management team that has been a lot of years in the company, then you can actually go back, to 2008, read the transcripts and actually see what they were saying, and then what turned out to be, and I find that not only demonstrates the quality of management but actually should help you sleep better if you see that management is telling you the truth every time.
Shree: Yes, absolutely. Yeah. I know going back and reading about what the management's comments were during those, you know, volatile periods will give you a lot more information, generally speaking.
You know, in this case, in the case of Dino Polska, it's slightly different, because it's the founder who is still the chairman of the board making all the decisions. But generally speaking, you know, most CEOs get to the position because of how they have excelled in some functional area. Many of them come ill-equipped to make one of the most important decisions in the business, and that's capital allocation.
You know, Warren Buffett...he's written about this in the past. For example, a CEO who decides to retain just 10% of the net worth of the business, he would be responsible for 60% of all capital at work in the business after him being in that position for 10 years. That's an enormous amount of capital allocation decision by the CEO.
Leandro: It's funny because yesterday I actually uploaded a thread to Twitter on capital allocation and I used that quote by Warren Buffett and the thread only had one quote, so it was exactly that one.
And one question I want to ask you, because I think this is what I find the most challenging is when a manager is new to the role and he has not been in any...say he was not the CEO of any well-known company where you can go and look at his performance. How do you judge his skill?
Maybe you don't even consider investing because he's new and there's no track record. But if you had to judge the quality of that manager, how would you do it?
Shree: Yeah, that's a tough one. You know, generally speaking, I'm looking for...if I've got to that point, hopefully, he or she has you know, still good skin in the game, good ownership interest, some of the communication after taking over as the CEO is available for us to reflect upon. And many times I would want to go meet the management team in person. I've done that with almost all my companies, not all of 'em yet, with almost all, and some of them I may never get the opportunity. That's fine.
But, to answer your specific question, it'll take a lot of effort. I mean, it's not just, one document or one meeting or one event that will help me make that decision. It builds up over a period of time and I may not necessarily pull the trigger immediately, but perhaps it sort of, you know, percolates up to the top of the list for me to pull the trigger on after I've met them or heard him or her speak, or see some events that he or she's been involved in. And gaining confidence happens over a period of time. That's the takeaway.
Leandro: Now I want to shift gears a little bit. I think 95% or maybe more of investment discussions when people are not agreeing happen because they tend to have different investment horizons.
So if you are long-term oriented and you are discussing something with someone that has an investment horizon of say, one year, then it's difficult actually to be talking the same language, so to say. And I know you have a great definition for long term, so what do you define as long term?
Shree: Yeah. You know, that's again a very subjective time period. There are traders who may say, you know, being invested for a few days would be long term, but for me, I'm thinking several years.
But, you know, let me actually run a quick math exercise. You know, if we actually take a penny, you probably already know this since you read and interact with so many people, you may already know the answer to this question.
But if we take a penny, say last night, last evening, we had a penny and we sort of doubled it every day. So this evening it'll be two. Tomorrow it'll be four, eight...And now what do you think it becomes by day number 30?
Leandro: I actually don't know the exact number, but I know it's exponential.
Shree: That's absolutely correct.
So day 30 becomes $10.7 million. So one penny doubling over a stretch of 30 days becomes $10.7 million, but even better is, what is it on the 29th day?
Leandro: It's half of that.
Shree: Yeah, it's right, it's $5.4 million. That sort of tells you a few things, right? The power of compounding...it kind of builds up over a stretch of time.
And it also tells you that it's back-ended. So if you were to draw this thing on a chart, it will be, you know what's called an asymptotic curve. It'll be flat for a long time, and then it just takes off. And, it tells you all...you know, a few things. The power of compounding over a long stretch of time. And what that means is one needs to be patient and take that long-term approach.
Back in the 1960s, for example, the average holding period of stocks in the S&P 500 was almost four years. Today, it's, you know, less than eight months thanks to all the social media apps, all the interconnectedness that we have, you know, high-frequency trading and all that. It's now down to less than eight months.
You know, there is enough empirical evidence to show that patient long-term approach works and yet average holding period keeps going down. Most of us are wired not to be patient, and so that's where the temperament comes in.
When I deploy capital into a stock, I'm considering being invested for at least seven to 10 years. I'm not necessarily saying that I'll exit after seven or 10 years. No, that's not the point. I'm just saying it's a long stretch of time. But, since the fund is, you know, just about a little more than three years old, I think only time will tell whether I've stuck to the timeline or not? So far, I have not made too many changes.
Last year, the entire year, 2022, I made only one change to the portfolio. And, this year I've made two changes so far in a 10-stock portfolio.
Leandro: Yeah. That's not high turnover. It's interesting because I think people believe that because there's more information available to everyone, markets are more efficient, but actually think it's the opposite.
Shree: Exactly.
Leandro: Just because we are humans and if we are confronted with more information, then we're going to be like pushed to make a decision. And if we don't have that information, then maybe we're going to leave the portfolio alone.
Shree: Right, right. A gentleman by the name of James Surowiecki...he wrote a phenomenal book. The name of the book, kind of slips my mind. I'll bring it up.
But, in there, he ran an exercise where he had a jar full of jelly beans and had students in a classroom kind of guess how many jelly beans there were. And, and all the, the actual number, the average of that prediction of that guess, was actually not too far from the real numbers.
He then took the same jar and then went to a different classroom. And then gave them, asked them to think about the last four digits of their social security number. You know, we have social security numbers here in the US, I'm not sure about Spain. So he had them think about a social security number, the last four digits, and then showed them this jelly bean and said, now take a guess.
They were way off, way off, essentially pointing out that new information doesn't necessarily help in many of these exercises.
Leandro: It's quite funny because before it was the quote about Warren Buffett...and actually that experiment...I'm currently reading "Billion Dollar Lessons" and in the last chapter I read, actually, they quote that experiment,
Shree: Oh really?
Leandro: I'm starting to think that you have a camera here or something Shree.
That's, that's actually interesting, but I think people think otherwise because they think: "oh, I have more information, so then I must be able to make a better decision." But actually, we don't need as much information to make a decision. Like people go to the last detail, which maybe shows that they know a lot, but it's not really relevant to make the decision.
Shree: Yeah, I just found the name of the book. It's actually the "Wisdom of Crowds." It's a fantastic book.
Leandro: Okay, perfect. So everyone who's listening, you know, if you have not read it...
Okay. Now I want to talk about your investment process and I want to...I think this is a difficult question for any investor, because when you have your portfolio, well it's easy...Like, you know that you already have to research the companies that are in your portfolio. But how do you source new ideas? Because I know that there are many strategies here. Many people will use checklists, some will use screeners, and maybe some will look at portfolios of excellent fund managers and then work from there.
So how do you source ideas?
Shree: Yeah. You know, years ago I used to....I was trained in a few different value-oriented shops here in Chicago that I used to work for. And, you know, we were all required to run screens and go off of what the output from the screens were. But, you know, over a period of time my approach to investing has transitioned including, you know, the way I sort of source ideas.
I still run screens, but you know, the approach to running screens was based on the fact that we generally want to have a repeatable process that we can rely on. So I still run screens, I run them on Saturdays, I use Capital IQ. You know, look at them...look at the list for new ideas and all that.
But, you know, back in 2001...yeah, it was 2001 Berkshire Hathaway shareholders meeting. Warren Buffet was talking about how big ideas...how you should rely on just big ideas. And Charlie Munger jumped in and said, you know, big ideas come to the prepared mind. My question is, how do you get to a prepared mind?
For me, it's a combination of spirituality, a process of self-inquiry, and a lot of reading, you know, readings, both investment-related and non-investment-related. And, the combination of these is what allows me to get to this serendipity. Serendipity is you know, how things happen accidentally.
So I get to a point where serendipity can hit me with great opportunities, you know, while keeping an open mind. So I know I'm not giving a very specific answer, but that's how I approach it these days. I run my screens, but I also do a few other things on top of it.
Leandro: And you run, a fairly concentrated portfolio. I think you have, 10 positions. So how do you prioritize between the new ideas and what you already own? Because I feel that even if you have something in your portfolio, you never know it 100%.
Like, I have, in the Best Anchor Stock portfolio, 11 positions, and I have read a lot about them, but there's always something that you're going to learn if you keep reading that you didn't know before.
Shree: Right, right. So...you know, generally, given that I run a fairly concentrated portfolio with very low turnover, as I said, I'm not looking for a whole lot of ideas. I in fact spend a lot more time, on existing ideas, I'd say 80 to 85% of my time is on existing ideas.
There's still a lot to learn. I mean, they're all outsiders. The management team and the board is going to know a lot more than we do. And so...and there is a lot of information available these days. You know, not just their company's filings, annual reports and Qs and proxies, of course, transcripts.
But, you know, there are other sources like expert network transcripts and things like that that we can rely on. And then these types of conversations, you know, you are right there in Europe, you are in Spain. I don't have a position in Spain, but there is a lot of shared knowledge that we can all benefit from.
So, you know, I spent a lot more time on existing names trying to refine my thought....trying to get that slight edge in terms of how much I know. And the priority is, yeah, don't necessarily give up, you know, looking for new ideas. That's also happening, but, you know, my day is spent on the existing portfolio. Most of it is spent on the existing portfolio.
Leandro: And I know you're an advocate of remaining always fully invested. So, if imagine you find a new idea and you are fully invested in your ten positions, you would only consider adding that idea if it's higher quality or you would maybe trim something and expand the portfolio.
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Shree: Yeah, absolutely, that's one way. You know, for me that's one way of improving the overall quality of the portfolio. So, the existing 10 names, there is a specific reason why they are in the portfolio. You know, they meet the investment criteria, they continue to meet the investment criteria. Valuations may move around, but unless it gets completely crazy, I generally don't make, you know, trims or ads, or even sell decisions based on pure valuation.
But I'm constantly looking for these types of ideas and if there is a better alternative, that's when I end up replacing one or two. And then, as I said, you know, that's the best way to sort of continue to improve the overall quality of the portfolio.
Leandro: And another relevant topic is maybe that of risk management, that many people do by weighing the portfolio one way or another.
Do you have any hard limits as to how much opposition can weigh to the upside and maybe to the downside? Because I think Giverny Capital has...if a position is less than 1%, then they'll eventually sell it because they don't think the resources that they are putting into it are not worth it.
So do you have an up and lower limit?
Shree: Yeah. Generally speaking, I let my core holdings get to 10% of the portfolio at cost and then I stay put. I haven't had this problem, but generally I don't want to end up in a position where one name accounts for 40% of the portfolio. And so, my internal, you know, unwritten limit is if a name gets to say 25% of the portfolio, I'll then consider trimming it down.
But I haven't had that problem yet.
Leandro: Yeah, I'm sure you'll have it in the future.
Shree: Thank you.
Leandro: Okay, so I think we talked about that you remain fully invested and you invest for the long term. And I think a very important topic when you have that strategy is to find companies with strong competitive advantages.
So what are your favorite sources of competitive advantage, if any? Maybe you don't have a preference. And there are some sources that it's consensus that they are a competitive advantage, but you don't think so? Here I'm thinking a bit like technology moats, for example, that we have seen that kind of erode fast?
Shree: Yeah, I think that's an excellent question. Based on what I've read and based on my experience, there are at least three types of competitive advantages. There may be more, but many of, you know, I think it falls into one of these three categories.
The first one would be the supply-based advantage where, you know, its cost advantages allow a company to produce or deliver its products more cheaply than its competitors. I'm not sure if you're familiar with Costco here in the US.
Leandro: There's actually a Costco in Madrid.
Shree: There is a Costco in Madrid. Okay. Yeah, there you go, so you know, that's sort of that's the advantage there. I mean, you know, cheap relative to its competitors. The second one would be demand based, where, you know, access to market demand that its competitors cannot match. This comes from, you know, customer captivity that's based on habit or cost of switching, or difficulty of finding a substitute provider. I'd highlight a few of my portfolio companies in this category...Evolution, which is a Swedish company that provides life casino, market leader, that comes to mind.
Dino Polska, the Polish grocery chain. They operate in...even though it's a competitive market, but they operate in rural markets of Poland. So that's an advantage.
And then Copart, you know, for example, Copart is the largest market shareholder in the salvage industry in the US. I believe this type of demand-based competitive advantage is more enduring, and that's what I prefer.
Not all my portfolio companies have that, but that's what I prefer. And the third category is, you know, sort of economy of scale. The cost per unit declines, as the volume increases, essentially you're talking about higher operating leverage. And, that again, it may not be as enduring as, you know, the demand-based category.
So, yeah, I think it's an excellent question, but that's how I've always thought about this competitive edge.
Leandro: Interesting. And I have been giving lately some thought to the concept of the Lindy effect. I'm sure you know what it is, but if listeners don't know, it basically is a theory that states that companies are not finite-life objects.
So if a company has survived for 40 years, people will rationally think that surviving another 40 is tough. But the Lindy Effect says that just because they have survived for 40 years it's probable they'll survive for another 40 because they have gone through 40 years of black swans events that no one could foresee and they survived.
So what are your thoughts around the Lindy effect, and do you take it into account in your investment decisions? I think maybe we could rephrase this as: do you look at the past when assessing a company?
Shree: Yeah. I remember, you know, Nassim Taleb referencing the Lindy effect in his books. And in fact, the first time I think I came across this phrase was in the book, the Predator's Ball, which talks about Michael Milken.
But anyway, yeah, I'm aware of it. I think it's a very important feature. You know, Winston Churchill said this beautifully: "the farther back you can look, the farther forward you'll be able to see." You know, it's true that you can't drive a vehicle by just looking into the rearview mirror, but the past should tell us an enormous amount about a particular business. So for me, in evaluating opportunities, I go back at least 10 years and in many instances, if it's available 20 years, you know, to get a sense for how the operations have moved around over time. The consistency of past performance is what gives me some confidence about how to think about the future.
And I tried to quantify this consistency through a statistical measure called coefficient of variation. It's essentially the standard deviation of that metric that you're trying to quantify, it's the standard deviation over the mean. And, I typically look at this metric for Free cash flow and you can use this for any metric, but I tend to use this for free cash flow.
And, for a consistent performer, this measure should be, for me, this measure should be at least 30 or below. And that's just a guidepost. And so yeah, past is an important predictor of what the future can be. Doesn't necessarily mean that you make all your decisions based on that, but it's an important factor for me.
Leandro: Yeah. Okay. I completely agree. I think especially if a company is old enough that you can see how it weathered old, like past recessions and you can see actually how resilient it is. Because I think that's the problem we have with a lot of new companies, like maybe Facebook or Alphabet, that no one actually knows how they're going to weather a recession because there has not been one in, like in their story as a public company.
Shree: Yeah, I agree.
Leandro: Okay. So now, I'm going to go to the difficult questions. Now we're going to talk about some of your holdings. And, well, you know that I told you that I was not going to ask you about the bull case or what's great about these companies, because I think that's more consensus. And I was going to go directly into the bear case or the risks of the company, because I think that adds more value.
So one of the holdings, which I think is the only one we have in common..like there's more overlap because I'm studying several positions that you own. But the holding that we have in common is Copart. So I think you made a brief introduction, it's the market leader in the salvage industry.
So for people who don't know how it works, basically if your car is in an accident, then the insurer must decide if they're going to repair the car or they're going to scrap the car or send it to salvage or total the car and pay you the pre-accident value that is what your car was worth before the accident.
And if the insurer chooses to total the car, then that goes to Copart. Copart puts it in an online platform, and it's an auction platform, and they sell it to thousands of buyers who bid for the cars. And then Copart just takes a several fees, and they give the rest to the insurer.
So that's, that's basically how the business model is mostly... There's more things, obviously, but that's where they derive the majority of the revenue.
Shree: It's essentially a...I'd say it's essentially an eBay of dinged and damaged vehicles. Yeah. They get paid from both sides.
Leandro: Yeah. It's not a very pretty industry, but that's actually good, it's overlooked.
So the main competitor is IAA, that is Insurance Auto Actions. And I don't know, it was two or three months ago, Richie Bros, which is a company, a Canadian company that has a similar model to Copart and IAA, but it's not... they resell used machinery, so it's not exactly totaled cars.
For example, they don't have insurers as an important customer. And in Copart and IAA's cases, most of the volume comes from insurers. So Richie Bros, this company, has proposed to acquire IAA. I mean at some point it seemed that the acquisition was not going to pass, but now it seems that it does because Richie Bros said that they have a pre-approval by shareholders.
I wrote an article for subscribers where I said that I think Copart is going to come out better off if it happens or if it doesn't, because if it doesn't, well, right, IAA has said like, okay, we can't compete here. So what are your thoughts on this deal and what it means for Copart?
Shree: Yeah. I think, you know, you described the company fairly well. It's a business where there are only two major players, and Copart is the larger of the two. And, IAA, which has been public only since 2019, is the smaller between the two of 'em, I think they have 80 some percent of the market share between both. The balance is held by mom and pop, you know, salvage yard owners.
You know, as far as this transaction, it was proposed late last year, Richie Brothers to acquire IAA. You know, while some of the large investors of Richie brothers agitated against the deal... a couple of 'em actually put out, you know, a public letter and a good slide deck describing as to why this doesn't make sense. It looks like, at least the proxy advisory firm has approved it, and now the majority of the shareholders as a result, they're voting in favor of this deal as well. So, we should anticipate the deal to go through.
Completion of this deal would essentially mean that this business, this industry of salvage business goes back to how it was back in, you know, pre 2019. At that time, IAA was under this other company called KAR. It's another auto-related business. They have a few other areas. And so IAA was actually spun out of KAR and now IAA will be going into, you know, Richie Brothers, essentially private again. So from a structural standpoint, it'll go back to a place where Copart is the only publicly traded salvage company.
I agree with you that in the near term, this merger integration and the chaos surrounding the Richie Brothers investors will be a positive for Copart. I would think that such an advantage would extend into the long term as well. You know, Copart is such a different business relative to how IAA has been run.
You know, since 1993, they've made the decision to own the land on which these salvage yards sit. As a result, they have more than 8,000 acres of land. IAA mostly has been leasing. Number two, back in 2003, they made the decision to move the entire auctioning into online as opposed to going from salvage yards. IAA was forced to switch to online during covid impacted 2020. You know, and then, the extension into international markets, you know, in Germany, in UK, Middle East, all that is just now beginning to start contributing to the bottom line of Copart. So all that has been a phenomenal strength, and I would think this would continue on.
Well, what sort of jumped out was, in the most recent call, Copart's earnings call, one of the analysts asked Jeff Liaw, the president, the co-CEO, this question about this transaction. And, he said Copart itself has considered expanding into markets like what Ritchie Brothers is doing, just to be able to increase its TAM, and that's an interesting comment which I noted immediately. In spite of that, you know, if that is the case, then Richie actually has some sort of leg up an advantage in that market. Right. But, overall I would think Copart would continue to be the leader and winner over time.
Leandro: Yeah. I think also Copart has experience dealing with non-insurance customers. Like they, they buy cars and well, they have other sources also, like charities or banks or whatever. So I think if they were to move, it would be more natural because it would be extending some part of the business.
But what I found a bit "funny", is that during the call, the Richie brothers call on the acquisition, the CEO said that they were going to be great with insurance customers because she used to work with insurers. And I'm like, well, I don't think that's a tremendous advantage.
Everything is ruled by service, the service you can give to the insurers. And obviously, Copart was much better than IAA in that regard.
Shree: Absolutely. In fact, if you looked at the most recent two quarters of IAA's releases...You know, IAA stopped conducting regular earnings calls after this deal was announced late last year. And so the last two calls have been more between the CEO, the CFO, and they just released the transcript. But if you look at the financials, the actual numbers they release and the way they talk, they always exclude that one big insurer and discuss the results, which I think is pretty funny.
I mean, that one big insurer is Geico. Which over time moved away from IAA to Copart. But, you know, to exclude one piece of the business and say, okay, look at the rest of the business. We have grown, but if you include this, we haven't. I mean, that's just, not a very...that's not just, you know, in my mind, it's not an acceptable way of communicating to the investor.
Leandro: Yeah, that was a massive red flag, I know what you mean. That they said like volumes were down 3% if we exclude the loss of a big customer. And it's like, yeah, well, but your volume depends on that customer, so...
Shree: Exactly. So yeah, over time, I think any which way you look at this, you know, this would be a long-term winner, but, it was an interesting comment to read in that transcript that Jeff made about their own thoughts into expanding into, you know, Richie's markets.
Leandro: And I think another relevant topic, probably the most relevant topic for Copart is that of terminal risk because Copart needs, obviously...lives off accidents.
They don't need to be...there's a strange dynamic because cars are getting safer, but to get safer...they're still suffering accidents but they have so many sensors and cameras and so much technology that even with a less severe accident, the cars are getting totaled at a faster rate.
So then Copart....that's a tailwind for Copart...the technology in cars. But there's a turning point that would be if autonomous driving becomes a reality, because obviously if you have a full fleet of autonomous cars, then accidents will technically be so reduced that the volume would dry up for Copart.
And I actually think this is what differentiates a bull and a bear on Copart. I think everyone agrees that it's a very high-quality company, but many people are unsure about the terminal risk that autonomous driving might bring. I obviously, as a Copart investor have a very strong opinion on this, but I wanted to know what's your opinion, because I know that you're also a shareholder and you're most likely have gone through this risk assessment.
Shree: Yeah. I actually find this not to be a near-term threat. Let me actually try and frame my argument using some numbers.
You know, there are currently about 300 million vehicles in operation in North America. 19 million new vehicles come into the system every year and approximately 13 million leave for...you know, as a result of their wear or accidents or whatever that may be. So even if all the 19 million new vehicles that enter the system are all autonomous from tomorrow on replacing that 300 million in circulation, that by itself will take 15 years.
And as we speak, there are...as you correctly mentioned, you know, there are a lot of new technologies that are accident prevention mode. So for example, when you are driving on a newer vehicle, if the vehicle sensors that you are sort of swerving, the steering wheel will start vibrating or there is usually, you know, two or three car distance that you can put between you and the car ahead of you.
But, many of them find this to be irritating and they switched off. But, even when vehicles use these extensively, continuously, you know, you can prevent the accidents only if other vehicles on the road also have that. Not all vehicles on the road have that kind of technology.
And as a result, you do continue to see accidents. And then when these vehicles get into accidents, because of all the complexity, the electronics, the computers that go into these vehicles, it becomes a lot more expensive to replace the parts. And on top of it, labor has become even more expensive. And so, as a result, you see companies like Copart benefiting from, you know, the total loss ratio continuing to move up.
Uh, even though the last couple of quarters in 2022, there was a little bit of a dip, and generally the total loss ratio is expected to continue to move up as a result. And I can tell this from my own experience. My son, he met with an accident, I had an Audi Q5 and he met with an accident because he was just distracted looking at an ambulance going in the opposite direction.
The guy ahead of him had applied his brakes and he was late. Fortunately, he's safe. He just had a bruise on his knee and he was able to get out, but he banged into the vehicle in front, not at a good pace. It was slow, only because I can tell that it was at a slow pace because the damage was not that severe.
The front portion of the vehicle kind of, you know, crushed and immediately the adjuster came and said: "this car has to be totaled." And that's because all the electronic components were all in the front and replacing those became very expensive and, you know, it was totaled. I got to see firsthand how this process of an accident, you know, this is what Peter Lynch has already said, right?
When you want to buy a company, experience the product, this is not how I wanted to experience the product, the service, but I got to see that. I don't know which yard it ended up at, but it did go through that process of being totaled by an insurance company, taking care of me. And we went through a long, drawn process of settling some of the claims.
But, it's a phenomenal business that Copart has complete control over. And even though my car had certain features in it, he still couldn't prevent the actual accident. So, my point is, you know, it'll be a long time before we get to a point where autonomous becomes a true threat.
Leandro: And I think also the international expansion also reduces the risk because if Copart starts sourcing vehicles from the Middle East or Africa or Asia, obviously autonomous driving can take longer to get to those countries than in the US.
Shree: Yeah.
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Leandro: Okay. Now I want to talk about another company. This, I think, it's a company you hold. It's not a company I hold, but it's a company that I've been studying, which is HEICO, in the aerospace industry.
So a brief introduction, HEICO is PMA, which is Parts Manufacturer Approval. So the company basically gets the parts that the OEMs put in the aircraft and they reverse engineer them and create a part that is cheaper, maybe sometimes even more functional. They receive the approval by the FAA and then they sell it to the airlines for a 30 to 40% discount.
So obviously the airlines have very tight margins, so they're looking for places to save costs all the time. And, HEICO is a great value pro proposition and obviously has a very strong competitive advantage because they have, I think it's 12,000 PMA parts, and it's actually a very fragmented industry. So they do both organic and inorganic growth.
So what I've learned researching HEICO is that the engine OEMs, they actually retaliated against HEICO and they introduced by-our agreements where when they sell the engine, they basically lock the airline into their maintenance and their parts.
When I see this, okay, it's...I think it's 15% of high-cost revenue is engines. So there's, it's not a terminal risk, but do you think this retaliation could spread to other OEMs in the aircraft?
Shree: You know, before answering that question, one additional comment I would make to that description that you gave about HEICO is, you know, any part within the aircraft, even if it is just a food tray in an aircraft that needs to be replaced, it has to be approved by the FAA in the United States. That's what makes this whole process of PMA so very attractive. Every, you know, even if it's a small screw that has to go into an aircraft, it has to be approved by FAA.
So, there is a built-in, you know, protection for PMA providers. There are many PMA providers. HEICO is one of the largest in terms of PMA. But, otherwise I think, you know, what you described is perfectly correct.
They don't have too much in terms of, you know, engine or critical parts associated with an aircraft. They do all these, you know, inside the cabin, they do many other parts within the aircraft, but not necessarily the critical components, and for a reason, you know, till date, HEICO, touch wood, touch wood, you know, HEICO parts have not been cited as the reason for any type of an aircraft crash so far around the world. So they focus on certain, non-critical components within the aircraft.
And, generally speaking, these PMA parts are approximately 40%, at least 40% lower than what you can get from OEMs. There's been a constant back and forth in terms of accepting these PMA parts, as you would expect, right? These OEMs, they don't want to give up this good revenue stream. And, the operators on the other hand, they want to keep the costs down so that they can manage their margins. So there's a constant struggle back and forth.
Interestingly enough, over the last few years now, more and more the aircraft is being owned by aircraft leasing companies, the Air Lease, and, you know, Air Lease is a big US based leasing company. AerCap is another European based, you know, leasing company. These guys control more than 51% of approximately 30,000 commercial planes flying around. And so they have a say in what goes in and what goes out. And it eventually comes down to the service, the cost, and the service being provided by HEICO. In fact, you know, a few years ago, EU actually asked Safran, the French engine manufacturer and CFM, which is actually a, you know, a joint venture between GE and Safran, you know, they asked them to use PMA parts. EU, you know, came out with a specific request to have these companies use PMA parts. But in spite of all that, the acceptance rate has not been as high as you would expect. So your question is valid, but it's only a matter of time before this becomes even more widely accepted.
So as we sit, the commercial air traffic is now just slightly better than where it was pre Covid, you know, in 2019, and it's improving, but, it's only slightly better than where it was in 2019, almost, you know, three and a half, four years ago. So, while that is happening, more and more operators are looking to keep their costs down. So I'm confident that over a period of time, you know, more PMA parts will be accepted, be it in the engine or outside.
Leandro: And I think people that are listening to this and have not studied HEICO, there must be saying, but "how can they copy a part?" Isn't there like IP or something in the parts of the OEMs? I think it's a fair doubt. When I started researching HEICO, it's something that at the start always comes up. Like: "why are they no IP infringements?" And basically if you have a part and it's safe to go on the airplane, then the IP just doesn't matter. That part can fly in the airplane and the airlines can buy it.
Do you see this changing in the future, or do you think it will remain always like that?
Shree: Actually the other way, I mean, more and more PMA parts. That's why, you know, as you correctly mentioned, more than 12,000 parts have been, approved for HEICO itself. The most recent, for example, the most recent Boeing Triple 77 has, you know, a little north of one and a half million parts in an aircraft. So there's a long way to go in terms of, say, capturing more PMA parts.
I'm not saying the entire aircraft is gonna be done via PMA, but there are more, there is a lot more room for companies like HEICO to capture their, you know, capture their products within PMA.
Leandro: Yeah. I agree. I think it's actually...the aerospace industry, I think it's interesting because the consumer facing part is probably the worst, which are the airlines. Because you are like...you see the small margins that they have. It's so competitive, but then you start digging back and in the supply chain and there are lots of interesting things. Yeah.
Shree: Yeah, and HEICO is more than just PMA. You know, they've got two segments. The commercial is one segment, and the other just as equally big is the non-commercial, you know, they cater to defense space medical and a few other areas like that. So, that's growing as well.
And we are gonna have, you know, as we are seeing this war in Ukraine play out for more than a year, we are gonna have skirmishes around the world all the time, unfortunately. And, even if there are no skirmishes, countries would want to equip themselves, would want to be current with defense. And so, HEICO's defense arm would continue to benefit irrespective of what's happening on the commercial side, so it's an interesting diversification mechanism from the company.
Leandro: Yeah. And I think that's interesting because there are a lot of synergies between both. So there are a lot of companies...I also researched one that is MTU Aero Engines. That is a German company. They get what they are doing for the defense customers and they obviously get that the same technology and re-apply it to commercial, so they are always ahead.
And also defense is much more resilient obviously than commercial. Like during Covid, they still got their contracts, so that's a plus obviously.
Okay, so now I'm going to talk about something that not many investors talk about, which is mistakes. I think a lot of people tend to ignore the mistakes and I always say that you can make a mistake even if you make money, because many people think that if they're making money, then they made their the right decision. But maybe if you look back at what your thesis was and why the stock went up, it's completely different.
So there's obviously some mistake in the process. So what was your biggest mistake and what did you learn from it?
Shree: I think it's just another brilliant question. I think all of us need to kind of reflect upon where we have come from. We don't wanna be frozen because of the mistakes in the past. We wanna be able to learn from those and not make the same...go ahead and do other mistakes.
For me, you know, I personally have a list of stocks that I used to own. And, you know, recently in a conversation with another gentleman, this question came up and so I looked at the list to be able to answer this question.
What I found out was the biggest mistake was an error of omission. Meaning, for a variety of reasons, I decided to pass on a particular stock even after doing all the work. Yes, generally speaking, when we try to answer this question, the mistake of commission, meaning, you actually invested in the stock and it was a disaster. You know, that's the first thing that would pop up and that did pop up. But when I sat down to actually compute the impact, the mistake of omission was much, much bigger.
So, you know, back in 2009, as the US economy was struggling to come out of this great financial crisis, many stocks were cheap, particularly those related to real estate, somehow peripherally related to real estate. Maybe they were, you know, definitely cheap. So I actually tried to evaluate Copart at that time in 2009 to see if at that price, you know, market cap was about $350 million, to see if I can actually get just the real estate piece for that price and get the entire operations for free. I couldn't, and so I actually moved on, I was working for advisory research here in Chicago that time, but I moved on and I stood on the sideline, watched the stock go up 10 times until 2020.
In 2020 when, you know, the market got impacted by covid related stuff it got pounded hard. It was down by as much as 45 or so percent. That's when I added it to the portfolio. Generally speaking, the gestation period for me to pull the trigger doesn't run into 10 plus years, I do monitor them over a stretch of time, but not this long.
This is by far the longest I've had and I'm sure...I don't know if you've inquired other other guests on your podcasts or other friends, but if you really sit down and think about the quantitative impact, I think error of omission would be much, much bigger. That's the case in my case.
Leandro: Yeah. It's funny because when I asked François Rochon the same question, Copart came up too, because it's a company that he said that it's a company that he knew and he liked it. And then when he got interesting, he didn't pull the trigger. And then obviously it's an error of omission.
Shree: Does he own it or no?
Leandro: Not yet. No. I don't think so.
Okay, so now I want to jump to the last topic of the conversation, which is valuation, which I think should always come last in any investment process, despite people many times putting it the first thing just by looking at the multiple.
So how do you go about valuation? Because, for example, I do an inverse discounted cash flow model to just understand what's priced into the company and then I judge if that is reasonable or if it's not reasonable, but I know that most people do a regular DCF model and they plot out the...what the company will earn in five years.
So what do you do?
Shree: Yeah. I look at a number of metrics in evaluating a company, you know, both before buying it and even after buying it. So, you know, a number of years ago, the CEO of a company that I used to be invested in, you know, he wrote in his letter, respect to using, you know, certain metrics in terms of evaluating investments.
Now he said, because metrics or proxies for performance managing by a single metric causes the tail to wag the dog, using just one metric is akin to taking a picture of a two turn elephant. No single angle can capture the big. I thought that was brilliantly said. And so, you know, I sort of look at a number of different things.
I also run a back of the envelope DCF in the end. But before getting there, you know, I look at the gross margin. Gross margin by the way, is one metric that consistently remains within a very small band for most businesses. Gross margin, operating margin, operating leverage, revenue growth, free cash flow growth, cash return on invested capital, reinvestment rate, dividend, and share repurchase as a percentage of free cash.
And so, you know, I look at all these things, and the actual decision would come down to a combination of these things and then, you know, how does it trade relative to free cash flow. And then do the, you know, I don't do a reverse DCF, but I do have a back of the envelope DCF run as well.
So, there is no, you know, I'm not trying to have just one metric for all companies. As we know, Copart is an outstanding opportunity and some of the other companies in the portfolio may not be as just as good. I hope they are. So it has to be on a case by case basis and there is no one metric but a combination of.
Leandro: So now the, the last two questions. First of all, I know you are a long-term investor that cares more about company fundamentals than macro, but I know also that you know a bit about banking. So I wanted to ask you how you view the current environment with SVB and Credit Suisse and now maybe Deutsche Bank.
Shree: Yeah. You know, there's been a lot written about the SVB, Signature, First Republic, Credit Suisse, and now Deutsche. You know, particularly if we focus on SVB, that was a weird balance sheet to look at, you know, much of the focus was on the asset side. Much of what I read, people had written was on the asset side of the balance sheet, and rightfully so. You know, assets, some of the loans had sort of stumbled and the investment portfolio being bigger than the loan book was somewhat interesting, unique.
But, you know, just as important as the right side of the battle sheet, which is the deposits, more than $150 billion of the $172 billion or so of deposits were uninsured....was in a sort of a clubby group, that was just as responsible for the disaster that ensued. For me, this sort of highlights a very important factor and many bank investors, many SVB and other investors I believe now realize the value of this, which is the franchise value of a bank, lies in its deposits.
It pains me to say this as a former financials focused analyst, but for me, this space has become uninvestable. You know, combination of factors. It's a levered balance sheet to begin with. You know, a typical bank is at least eight to 10 times levered. And a small dip in the asset side of the balance sheet will cause enormous pain as we just saw.
And then mismanagement of the deposit side, as we just saw, can actually end up in a run. So, you know, it's become quite...it's another transformation that I've had to go through in my lifetime.
Leandro: It's definitely for me...it's out of my, not only circle of competent of competence, but also comfort zone because I find it very difficult.
How I see it is that the banker is so important in how they are constructing the loan book, and you're not going to have full visibility of that.
Shree: Yeah, I mean, there are so many factors that we can end up with a separate podcast just on this bank balance sheet, or a bank operations itself.
But, yeah, there are so many nuances to it. It's become quite complex. And at the end of the day, it's a levered balance sheet. And what I focus on is businesses that are self-funding that do not have...that have very little to no debt on the balance sheet. So, that sort of leads me to say that, you may not be investing in a bank in the future.
Leandro: And, and when we were talking, I think a couple of weeks ago I liked very much the distinction you made between insurance and banking where you said that you cannot do a bank run on an insurance company, but you could do a bank run on a bank.
Shree: Yeah. I mean, the fact that we saw this SVB collapse that actually started with the deposits leaving Right.
Just on one day, $72 billion in deposits were drawn out. So yeah, you have a deposit base, you have a structure, you have a balance sheet where you are lending long meaning loans and investment books will be over a longer stretch of time and you are borrowing short.
I mean, these deposits can walk out at any point, and so that by itself makes a mismatch. It can be it has been managed exceptionally well in other banks, there are some high quality banks even today as we speak. But this was a unique setup for a large bank, 16th largest bank at that time in the country to be set up this way.
And the reason why we had a bank run is because the deposits ran away. If you sort of move your focus over to an insurance company, it's not quite as levered as you would expect in a bank to begin with. And secondly, the insurance reserves, you know, insurance policy as we were talking about in a Copart scenario, you know, an insurance policy, kind of ends up resulting in the company actually maintaining a certain level of reserves that's the equivalent of a deposit in a bank. But then those reserves don't necessarily leave as quickly or do not have the capacity to leave as quickly as the deposits in a bank and you generally don't see.
It can also be mismanaged. It has been mismanaged. Insurance companies have been mismanaged in the past. Poor underwriting, poor pricing, less investment income and all that. But, you know, you don't see an insurance run. You see a bank run. That's the reason.
Leandro: Yeah. It seems like the insurers rely on statistics and banks rely on human psychology.
And I don't know if that's the best thing, because the bank run, it's a black swan actually, so you cannot estimate it. You also can have a black swan in insurance, I guess, but you have maybe more you can forecast it maybe with some kind of data.
Shree: Yeah, the mistakes can be in a different piece of the balance sheet in an insurance company. But yeah, I've worked for a bank, I've worked for an insurance company as an investor. I've invested in those categories in the past. I still prefer insurance company over a bank.
Leandro: Okay. Perfect. And now the last question is one I make to every guest which is what's your favorite book?
It can be investing on non-investment related. Well, you named a few books during the conversation, but I don't know if one of those is your preferred book
Shree: Actually. One of the best investment books that doesn't get enough, uh, recognition is called "Of Long-Term Value and Wealth Creation from Equity Investing."
This is written by a gentleman in India. His name is Bharat Shah. He's alive. He's in his mid seventies maybe, I don't know the exact age, but he wrote this book sometime back. It's a fantastic book about investing in quality businesses.
He is a portfolio manager himself. He works for a company called SKN India. It's a book in two parts. The first part is the text. The second part is a whole bunch of tables and stuff. He invests exclusively in India and those tables relate to, you know, Indian companies in Indian statistics. You can ignore that, but the first part is where the text is and it's a phenomenal book.
I have a copy of it. It is not readily available. He hasn't updated the book in a long time. It's not readily available in Amazon or other places. Perhaps you can search it through other used book sections. But alternatively you can search on Google and find a PDF version that's floating around.
Leandro: Okay. I'll definitely look at it because I have not heard about the book. I think this is the first time that happens that someone recommends a book that I have not heard about.
Shree: There you go.
Leandro: Okay. So, thank you very much, Shree for being here. I think it was a great conversation and we touched a lot of topics.
Shree: Absolutely. Thank you for having me. It's a pleasure.
Leandro: Thank you Shree. Bye.