January 2016

The market is not always efficient.  A study by Randy Cohen [1] shows that even average active managers’ “best ideas” outperform passive strategies.  Cohen shows that stocks which managers significantly overweight relative to a benchmark outperform by 5% per annum.  Everything else dilutes this result.  

Why do managers add mediocre ideas?  One reason may be that they are incentivized to gather assets beyond their true capacity to invest.  Other reasons may be fear of short-term benchmark underperformance or a manager’s desire to reduce volatility, which shouldn’t have much relevance to long-term investors or investors diversified across many managers.  These are each rooted in the link between management fees and assets under management.  

There is no single answer for how many investments a fund should hold.  But generally speaking, active managers hold too many.  After mixing in the results of mediocre ideas and subtracting fees, many funds fail to create value for clients.  John Bogle, a critic of active management, has said, “The grim irony of investing is that we investors as a group not only don't get what we pay for, we get precisely what we don't pay for.”  

The Partnership has three operating principles.  The first, which generates investment ideas, is necessary, but not sufficient, to reach the Partnership’s goals.  The other principles relate to how the Partnership is organized and the order of preference in the limited partner - general partner relationship.  They are:

• an equitable fee model

• transparency, governance, and alignment of incentives

These help prevent principal-agent problems from diluting the performance of the investment approach.  They also direct value created to the limited partners, as opposed to being retained solely by the general partner and service providers.  Sol Price, a pioneer in the US wholesale warehouse industry, used to say, “If you recognize you are really a fiduciary for the customer, you shouldn’t make too much money.”   Sol’s pricing strategy was not based on a percentage of the manufacturer’s suggested retail price, but rather a fair markup to the product’s cost.

The Partnership’s management fee is tied to cost as opposed to assets and capped at 1.0%.  As assets increase, this fee will be reduced on a percentage basis.  Our goal over time is for the fee to drop below 0.5%.  

The markup is captured through Scott’s six percent hurdle-linked performance fee.  This ensures the portfolio will be significantly invested, regardless of market volatility, when opportunities are fair to abundant.  At the same time, it keeps limited partners in line ahead of the general partner.  In order to improve the likelihood of surpassing the six percent hurdle, Scott’s portfolio is concentrated in eight to twelve holdings - just best ideas.

Any performance allocated to the general partner will likely be a fraction of the general partner’s invested capital, as opposed to a multiple thereof.  Moreover, with my total net savings invested in the partnership, I suffer losses in lockstep with investors.  Together, these ensure a capital preservation incentive.  In the absence of opportunity, the Partnership will hold large cash balances.


What maximizes the potential for outperformance?

Cohen’s work is encouraging for investors who invest with active managers.  But a wide brush approach is clearly wrong.  According to Cohen, which fund attributes maximize the potential for outperformance?  They are:

• focus (country, sector, or investment type)

• illiquid, overlooked, and inefficient markets

• concentration

• better fee structures

• staying within capacity

Scott’s operating principles are no guarantee of success, but they significantly increase the chances of the partnership reaching its goals.

[1] Cohen, Randolph B. and Polk, Christopher and Silli, Bernhard, Best Ideas (March 15, 2010)


July 2017

To generate industry-beating returns, it’s important to continuously sharpen an edge, or competitive advantage, over peers.  In the people-centric industry of investment management, the attributes that make a difference are often less tangible than, say, Booker’s scale economies or Swedish Match’s customer captivity.  While the advantages associated with investing in public equities are mostly of a type that needs to be cultivated rather than structural, they nonetheless exist.

I attribute our edge to three factors, all of which have been in place since the partnership began.  They are:

Differences in applying a value approach.  This can be subdivided into our focus and our entrepreneurial culture:

·        By focusing on a limited set of frameworks and companies over a long period of time, our analysis and judgment may be better than other market participants in those areas where we have expertise.  We sometimes pick up on subtle yet critical investment return drivers such as pricing model transitions, demand inflection points, or cultural uniqueness which are hard to otherwise notice.

·        Our unconventional setup may help us avoid calamities and size excellent investment opportunities appropriately large, without being compromised by bureaucracy and rigid structure.

A network of outstanding, engaged collaborators.  This comes from our limited partners and independent peers, who understand our ethos and interact in ways that help to reinforce it.  For limited partners who share our investment philosophy, time horizon, and tolerance for market swings, the potential upside is outperformance.  For peers and supporters who share insights, experiences, and counter arguments, the benefit is, hopefully, fresh perspectives and mutual learning.

Size.  This allows us to invest in small (as well as large) companies. Though not a rule, small companies tend to be less efficiently priced and offer greater opportunities to add value through active management.

By actively cultivating these factors they can be sustained and enhanced.  That means taking time away from routine activities to devote energy toward more lateral thinking and deepening personal relationships.  By doing so, I hope that the presence of an edge will eventually become evident in the results we produce over a market cycle.

Don’t take my argument as a sign of built up overconfidence. Instead, take it as an answer to an important question that I would want to have explained if I were in your shoes.

The following is from the opening pages of Zen and the Art of Motorcycle Maintenance [2], written by Robert Pirsig, who died earlier this year at age 88:

“Chris and I are traveling to Montana with some friends riding up ahead, and maybe headed farther than that…Secondary roads are preferred. Paved county roads are the best, state highways are next. Freeways are the worst. We want to make good time, but for us now this is measured with emphasis on ‘good’ rather than ‘time’”

Among other themes, Pirsig’s novel deals with the nature of quality.  It was one of the first books recommended to me when I started in investment management.  I believe my boss at the time, Burkhard Wittek- who suggested it, was trying to impart that the work should be viewed, like law or management consulting years ago, as a profession rather than a business.  This was not to make the activity sound grand. It was to get me to screen out what others were doing and focus on first principles to improve our odds of exceeding a highly set bar for results.  Constant attention went towards understanding the source of outcomes, rather than the outcomes themselves.  I’m grateful to mentors, friends, and partners in Scott’s network who have tried to convey wisdom like this to me over the years.  Hopefully, some of it is soaking in.

[2] Pirsig, Robert M. Zen and the Art of Motorcycle Maintenance: An Inquiry into Values. New York: Morrow, 1974.


July 2016

In investing, the only thing it makes sense to be dogmatic about is price (in relation to value). That may not seem like a high bar, but investors are affected by all kinds of institutional and behavioral factors which cause price to be ignored when making capital allocation decisions.

Strong investing foundations are built on low price strategies (low price-to-book, low price-to-earnings, etc.).  These are easy to internalize and powerful in that it’s hard to lose money employing them, if adhered to, over time.  Walter Schloss, who beat the market applying these strategies for a half century from 1956 until 2002, compared his operation to a retailer, “we are like a kind of store that buys goods for inventory (stocks) and we’d like to sell them at a profit within four years if possible.  We receive some income while we wait which is more than a store does but, unfortunately, we have to wait for someone to come along a make our merchandise go up in price.  We can’t do this ourselves by running sales”.[1]  At a low enough price, a stable, low return on capital business is a preferable investment to a great company at a fair price.  I consider these opportunities.  Ideally, management and the industry are unable to degrade the value of the asset, and the investor can get a sense of how and when fair value can be recognized.

Over time, however, frictional costs eat away at returns generated by first-order low price strategies.  If a company’s reinvestments can be worked into a multi-period framework, holding periods lengthen, friction decreases, and gains come from earnings snowballing as well as value recognition.  But it’s easy to be too smart by half – over confidence and the pari-mutuel nature of the stock market significantly increase the risk of heavy losses when employing this, sexier, strategy.

First, investors too quickly dismiss the nature of competitive markets to mean-revert capital returns, capping the period during which value is created. For example, as the dominant consumer electronics retailer in America, Circuit City’s advice-driven model, which worked in the late ‘80s as product variety exploded, was replaced by Best Buy’s warehouse model in the late ‘90s, which has since been partially supplanted by Amazon’s internet model.

Second, investors forget that agents (the board and management) are typically responsible for allocating owners’ capital.  Take a more durable industry like telecom, and consider the Spanish incumbent, Telefonica.  In 2005, it produced € 9bn of EBIT and a pre-tax ROIC of 22%.  Over the subsequent decade, 30% of operating cash flow was dividended to shareholders.  The remaining 70% was reinvested, either in the business or repurchasing shares.  Management’s investments in numerous international markets look more like empire building than stewardship.  At the end of the period, invested capital had grown by € 30bn, but EBIT cratered to € 3bn - the buybacks were a dumpster fire.  Shareholders received a 3% annualized total shareholder return over the decade; entirely attributable to the dividends.  Using similar assets in their own local markets, Deutsche Telekom and British Telecom returned 9% and 11% per annum.  The difference in the gain was 5x, 184% at British Telecom vs. 34% at Telefonica.

Herein lies the importance of management in strategic decisions, allocating capital, and shaping culture.  To do exceptionally well on an after-tax basis (i.e. in a single company over an extended period), management increasingly becomes the driving variable in a function that is a product of price, quality, management, and time.  They forcefully skew the distribution of long-run outcomes. That’s why I try to stuff our portfolio with management teams that “get it”.  Founders run 45% of our companies; the average tenure of management is fifteen years.

Even with our conducive setup, investing is competitive and arduous.  As the number of investors who purchase stocks based on quantitative factors that focus on historical financial results and price movements grows, an approach that focuses on evaluating underlying business dynamics and management capabilities seems as sensible as ever.


At the end of the period, the Partnership invested in Wizz Air plc, an ultra-low cost air carrier (ULCC) connecting Western and Central/ Eastern Europe.  It’s been managed by József Váradi since its 2003 founding.  In an industry notorious for value destruction, the ULCC sub-segment has historically been an up-and-coming neighborhood in a dangerous city.  For every decision that involves a tradeoff between revenue maximization and cost minimization, the ULCC strategy is to always minimize cost.  The resulting cost position is not designed as an offensive against traditional carriers, but rather to expand the air travel market to previously un-reached, higher price elasticity, demand. Some ULCC decisions are big and easy to identify:

·        fly large, fuel efficient planes and pack in as many seats as possible to spread fixed costs

·        operate a uniform fleet to reduce maintenance expense

·        fly point-to-point, rather than hub and spoke, to increase utilization

·        cross-function employees to increase labor productivity

·        fully de-bundle pricing to reduce variable costs of baggage, food, etc.

·        be outrageous to stimulate media attention, while keeping marketing expenses low

·        keep a hefty liquidity position

But Wizz’s neighborhood has boarded up houses, too.  In reality, there are hundreds of smaller decisions with less obvious answers.  Which routes get prioritized?  How are planes best acquired and financed?  Success is linked to experience curves and execution.  Having a copy of the ULCC playbook is not the same as having won a few championships.  With William Franke as Chairman and controlling shareholder via Indigo Partners, Wizz is well coached.  Franke was CEO of America West Airlines, an early investor in Ryanair, and Chairman of Spirit Airlines.  He has cumulatively managed a few billion passengers flown vs. Wizz’s hundred million.

Wizz’s unit cost is below every carrier in Europe, save Ryanair, which is comparable.  They are of similar size in the geography, and together, dominate the local ULCC market with a combined share of 75%.  They have historically been tough, but rational competitors - focusing on growing the pie, rather than dividing it up.  I note that Ryanair’s Chairman, David Bonderman (of Texas Pacific Group), is a long-time business associate of Franke.

Since 2007, Wizz has grown passengers at 23% per annum.  After adjusting for operating leases, Wizz achieves an after-tax return on invested capital of 19%, despite immature routes. Going forward, earnings will be reinvested into capacity increases which could result in a mid-teens rate of earnings growth over the next decade.  

The partnership invested at a single-digit multiple of earnings.  After capitalizing leases, the multiple of enterprise value to net income was roughly eleven.  Prior to investing, the Euro converted share price declined sharply on Brexit related fears, which I feel are likely misplaced.

[1] WalterSchloss, “Seminar in Value Investing” (Columbia Business School, 1993)


January 2020

I focus on just a few business models, or frameworks, and try to understand how they work globally.  This focus sometimes helps to uncover insights that may be difficult to derive from backward-looking line items on an income statement or balance sheet, but which may be critically important down the road.


When thinking about frameworks, I study companies across the world; Australia-based REA Group, for example, as a marketplace, Canada-based Constellation Software as an adept serial acquirer, or America’s Costco as a low-end disruptor.

However, when it comes to putting money to work, I have a preference for Europe.  I focus on companies that “do it right” when allocating capital and treating shareholders as partners.  A smart capital allocation framework can attract patient, rational shareholders that become an asset to the firm.  It’s possible to create a positive feedback loop in this regard, but precious few companies even bother to try.  Equally important, but with negative consequences, the wrong management team or shareholder base can ruin an otherwise outstanding investment opportunity. Knowledge of these qualitative aspects takes time to acquire, and Europe is where I have the most value to add in this regard.


Defining and categorizing serial acquirers

Approximately one-third of the companies I follow are serial acquirers.  These firms operate businesses that have competitive advantages but lack sufficient organic reinvestment opportunities to substantially absorb the free cash flow they produce.  That said, their talented management teams are able to acquire new businesses in private markets at prices that generate higher rates of return than their firms’ cost of capital.  Consequently, instead of distributing cash directly to shareholders, they retain much of it for future acquisitions.


Companies such as Addtech, a distributor of electromechanical components, Assa Abloy, the world’s leader in locks and security solutions for the commercial market, and Vitec Software, a provider of niche industry vertical software, have, together, accounted for 30% of the Partnership’s portfolio.  Given their footprint, I want to share how I sort through these companies.


To begin with, I sub-divide the serial acquirer category into largely self-defined buckets: roll-ups, platforms, accumulators, and holding companies.  The table below briefly describes each type:

In my experience, two of these buckets have tended to offer better opportunities than others.  Specifically, I target platforms and accumulators but avoid roll-ups and holding companies. I’m looking for industries where:

·        Small companies can be good businesses on a stand-alone basis (which typically excludes consolidation-driven roll-ups).

·        There is a direct line of sight between minority shareholders, executive management, and the point of customer interaction (which generally excludes holding companies).


Both platforms and accumulators can work.  I don’t believe there is one right answer for the level of operational integration at a serial acquirer; approaches should and do vary based on industry landscapes.


For example, Assa Abloy produces many lock products with shared features, which are adapted to local market requirements.  Over five years, the company has reduced its supplier count by 28%, from roughly 9,000 to 7,000.  In contrast, much of Addtech’s business can be described as value-added distribution, with either limited production taking place internally or no real potential for common sourcing.  Thus, its subsidiaries operate in a more decentralized manner than at Assa.


The key to success at each is that the customer relationship remains anchored at a low level within the organization.  Preserving entrepreneurial independence in choosing, developing, and marketing products is a crucial differentiator in both cases. Eric Mendelson, Co-President of Heico, the world’s largest independent supplier of FAA-approved aerospace parts, has underscored the importance of this type of setup:

I think our greatest competitive advantage is the way that we’re structured.  Instead of having one single enterprise where all the decisions end up on one desk, my desk, the decisions are made within Flight Support by roughly 25 really talented people who frankly know more about their spaces than I will ever know.  We are really grateful to have them, their dedication.  They treat those businesses like they own 100% of them. They get very emotional about their businesses, and they each have got incredible growth opportunities going forward in many, many different segments. [1]

With the above in mind, the table that follows highlights a diverse mix of European platforms and accumulators that have demonstrated an ability to generate attractive financial returns over time.

These companies are interesting investment candidates as they combine two attributes: they can potentially invest large amounts of capital at attractive rates of return, and they are sometimes overlooked or underestimated.  In the paragraphs that follow, I discuss there investment opportunity, highlight reasons why the shares can be overlooked,and detail the attributes I look for in specific companies.


How adept serial acquirers redeploy capital

The specialized nature of products in these industries implies that it can be challenging for companies to success fully expand into adjacent markets.  In this way, their organic growth rates can be limited by their intrinsic exposure to inflation-plus end markets.

That said, well run serial acquirers have the potential to tap into other market segments.  While this will happen at a rate of return below that which is organically achievable in an existing business, it can still represent an attractive opportunity. For this reason, one could say that adept serial acquirers have the potential to expand their addressable markets.

Larry Culp, the long-time CEO of Danaher, described what he looked for in markets using criteria that are well defined, but which also allow for considerable latitude:

First,the market size should exceed $1 billion.  Second, core market growth should be at least 5%–7% and without undue cyclicality or volatility.  This excludes Rust Belt and Silicon Valley businesses for us.  Third, we look for fragmented industries with a long tail of participants that have $25–$100 million in sales, and that can be acquired for their products without necessarily needing their overheads.  Fourth, we try to avoid outstanding competitors such as Toyota or Microsoft.  Fifth, the target arena should present a good opportunity for applying the Danaher Business System so that we can leverage our Danaher skill sets.  Last, we look for tangible product-centric businesses. This rules out, for example, financial services.[2]

Some investors question whether companies such as Danaher work to shareholders’ benefit when they engage in such an acquisitive strategy. In my experience, advantaged acquirers do, in fact, create value—not through financial engineering, but through a combination of the following:

·        Targeting smaller-sized companies.  Many attractive prospects are too small to be considered by financial or strategic buyers. In Addtech’s case, acquisitions have, on average, had less than $10 million in sales and roughly 20 employees.

·        Cultivating relationships.  Well run serial acquirers are patient and have identified targets long in advance of them being available for purchase.  Tending to possible deals in informal ways (i.e., lunches with the owners) provides an opportunity for more in-depth diligence than that which is often available in an auction process.  Moreover, it can assist in becoming the buyer of choice when the target eventually decides to sell.

·        Providing investment expertise and resources.  As Halma’s Andrew Williams explains:

Senior management is often a key constraint of the privately-owned companies that we typically buy.  Halma has the expertise and an infrastructure which helps companies grow internationally.  Being part of a larger group mitigates the risk of significant investment by individual businesses.  For example, a large R&D investment,which previously has been considered too risky for a small company, is possible since the risk is manageable at a Group level.[3]

·        Employing a diversified approach.  Companies with high levels of customer concentration are often considered to be too risky to acquire and operate on a stand-alone basis.  As with money management, however, investing in a portfolio of businesses reduces risk.  Many of SP Group’s deals, for example, have involved companies where a single customer accounted for more than 50% of sales.

·        Taking legacy considerations into account.  Sellers sometimes ascribe greater value to seeing their business carry on as an independent subsidiary than hitting the highest bid, which affords a more amiable buyer such as Addtech an advantage over competitors.

To appreciate the potential for serial acquirers to extend their addressable markets and profitably invest capital over decades, consider the track record of Halma, highlighted in the table below.

 Why serial acquirers can be misunderstood and overlooked

Given these companies’ ability to invest substantial amounts of capital at attractive rates of return, what makes them worth considering, in particular, is the relative paucity of interest from other investors. In my view, this stems from three factors: their acquisition-oriented nature,their complexity, and Wall Street’s convention to exclude future acquisitions from forecasts.

Acquisition-oriented nature

Many investors pass on acquisitive companies as a rule.  After all, research by McKinsey concluded that only about one-third of deals create value, while two-thirds are value neutral or value destructive. [4] Don Keough, a director of The Coca-Cola Company from 1986 to 1993, provided an insider’s view of the self-sabotaging dynamics that allow bad deals to move forward:

In the field of mergers and acquisitions, multi-million, even billion-dollar deals get under way, and the momentum builds, the rivalries among the players come to the fore, the game—a game it becomes—goes ahead, no holds barred.  Someone is determined to win! They can taste it!  All the cash lying on the table, all the supposedly solid rationale behind the deal, all the people involved—nothing matters except winning!  “I want my way,”says the biggest ego in the room!  There are dreams of being in the press conference spotlight and big headlines in the Wall Street Journal. It's all too glamorous, and we convince ourselves that the numbers do add up—even when they are about as sound as astrological predictions.  The “animal spirits” that John Maynard Keynes wrote of are more powerful than most business people would like to admit.

Look at the recent dreadful fits—Daimler and Chrysler, Time Warner and AOL, Kmart and Sears, Quaker Oats and Snapple.  Should these really have ever happened? [5]

Lending further weight, many well-known money managers, who indirectly act as teachers and mentors to those learning the craft, rightly caution against investing in acquisitive companies.  When I was a teenager, the first book I read on the subject was Peter Lynch’s One Up on Wall Street, where the long-serving manager of Fidelity Investments’ Magellan Fund wrote, “acquisitions, in general, make me nervous. There's a strong tendency for companies that are flush with cash and feeling powerful to overpay for acquisitions, expect too much from them, and then mismanage them.”  

Indeed, no small number of serial acquirers have ended up offering rich pickings to short-sellers.  Jim Chanos, founder of Kynikos Associates, explained their appeal:

We're just drawn like moths to the flame, I guess, to companies in crummy businesses that decide to tell the Street that they're actually growth companies by virtue of playing acquisition accounting games in terms of valuing the assets and/or spring-loading by having the target companies hold off business in the interim period between announcement of the deal and the closing of the deal so they look better once you fold them in.  And so, we love those kinds of stories, the roll-ups, or as they been deemed, the “platform companies”. [6]

In this area of the market, a broad-brush approach will likely underperform.  Knowing this, many market participants simply don’t look here.  But, lo and behold, this often creates opportunities for those who are willing and able to sift through such companies using a tailored lens.


When serial acquirers are actively working to improve their underlying profitability in parallel with on-going, surface-level deal making, it’s more likely to be overlooked than at, say, a company that produces carpet flooring.  There are just considerably more moving parts.  

In the case of Lagercrantz,for example, the company improved its gross margin from 20% to 36% over 15 years as sales of their own products (as opposed to third-party products) rose to over half of the group total, compared to almost zero at the start.  

Future acquisitions not factored in

One quirk in the way that many analysts think about firms such as Addtech is that while they are happy to account for investments that find their way into current spending,working capital expansion, and capex, they do not consider future acquisitions.  Although this is reasonable in most cases, it seems short-sighted in those instances where, as with Addtech, acquisitions are an integral component of a firm’s capital allocation strategy.

In the Partnership’s January 2018 letter, I discussed how Wall Street often gives short shrift to the capital investment opportunities of adept serial acquirers and ends up underestimating the rate and duration at which free cash flow per share can grow.  Revisiting this argument, at the time that letter was written, the consensus 2020 sales estimates for Addtech and Assa Abloy were SEK 9 billion and SEK 83 billion, respectively.  Today, they are SEK 12 billion and SEK 101 billion, a 25% rise versus an aggregate 5% increase for the firms that comprise the MSCI Europe index.

When considering the potential for growth via acquisition, it is important to make assumptions on an internally-generated-cash-only basis. That is, excluding any benefit the company may receive from accessing cheap equity or debt in the primary markets. Ignoring aspects of reflexivity in a serial acquirer’s playbook leads to severe consequences if its market standing deteriorates.


Attributes of successful serial acquirers

When assessing these companies, I spend my time evaluating the thoughtfulness of their acquisition strategy, their ability to operate efficiently, and their approach to capital allocation.  In my experience, these three factors define the difference between firms that consistently create value and those that are less predictable.  Here’s more specifically what I look for.

Qualitative foundations

Making acquisitions is easy—it’s everything that takes place before and after that presents the challenge.  To succeed through M&A, companies need to have certain foundational elements in place before a transaction takes place.  They should be able to clearly answer questions that tend to be more muddled when looking outward than when growth is being driven organically. Questions like, “What are our values?” “How would we describe our culture, our infrastructure, and our performance measurement system?” and “Who oversees due diligence, onboarding, and integration?”

I recall a conversation with Johan Sjo, the former CEO of Addtech, that gave me the impression that the firm’s managers know precisely how to make an acquisition, onboard the team, integrate their systems, and run staff through training at the Addtech Academy.  As Johan explained:

The managers are looking for an “Addtech” feeling to know whether the target is a cultural fit.  They might come back from a diligence meeting with, “the company fits on product, market, culture, and ambition,but is weak on pricing and working capital.” They are explicitly trained to find these things so the team can better know what to do.  

A big red flag is to come back with: “The company is good at a, b, and c, but we don’t trust the owner—there’s something fishy.” If that is the case, we can start calling around to industry contacts to find out if this person is trustworthy or not. What can happen is, someone works as a salesperson, comes up and in the process, collects many supplier relationships, then leaves to start his or her own company.  If someone has done it once, that person will often do it again.  Having that fingertip feeling is vital in management’s conviction on what to buy.  

When there is a cultural fit, presenting Addtech in a way that the target trusts us—that we can guarantee how they will operate as part of our group—becomes essential.


Operational excellence

Once acquired, subsidiary companies operate in a relatively decentralized manner, with individual business units being empowered to quickly make pricing and investment decisions.  This affords them the continued advantages of a small company.  

Even so, it’s constructive for executive management to marshal oversight, guidance, and communication within the group.  This entails:

·        A standardized control environment: Group management must be able to drill down into the financial performance of individual businesses.  Because acquirees rely on all sorts of reporting mechanisms, serial acquirers need to have well-developed systems for onboarding companies and ensuring apples-to-apples comparisons across the group.  

·        Thoughtful financial targets: When selecting KPIs, it’s sensible to choose those that can be consistently used by everyone—from warehouse managers to board members—to make the right decisions.  Addtech simply uses a ratio of gross profit over working capital. This is quite practical and approximates ROTCE with respect to its business.

·        Learning from one another: Managers benefit from talk across the group.  Addtech’s Academy offers courses for staff on sales, negotiation, and project management.  While a lot of these are available from outside consultants, its beneficial that many of these are taught by Addtech managers themselves.  Unlike outside consultants, they have credibility inside the firm which makes it hard to back away from what they teach.  In the breaks, employees gain from sharing information on customers, products, and suppliers.

Yes; this seems simple.  It utilizes the same, seemingly pedestrian processes that most firms employ. But as Johan explained, “Understanding that it is the operation of the entire system, as a system, that is required to make it work and that operating the same way for a decade also helps drive home the difficulty of executing.”  It is the aligned set of activities that contributes to the advantage, not any particular step in the process.

An independent approach to capital allocation

Compared to companies that steadily grow organically by doing one thing very well (e.g., ultra-low-cost airline Wizz Air), adept serial acquirers should keep a more flexible capital management policy.  Their capital needs are, by nature, more difficult to predict. This is at odds with policies that forecast-driven sell-side analysts or income-oriented shareholders might desire.

Comments from Jeff Noordhoek, the CEO of Nelnet, sum up what’s involved:

We are continually faced with five choices: invest in existing operations for future growth, acquire or start new businesses, pay down debt, pay dividends,or repurchase stock...  We intend to invest our capital in businesses that will generate positive cash flow, grow profitably over time, and hit the appropriate risk-adjusted returns on our invested capital. If we can’t accomplish those goals, we will either wait until we can, or return capital to our shareholders in the form of dividends and stock repurchases. [7]

Independence from forecasts is key.  I hesitate with companies that maintain fixed dividend payout ratios, which can stifle value creation, or that communicate five-year revenue targets incorporating to-be-acquired sales, which can promulgate loose capital spending.  


Putting it all together

Serial acquirers are an interesting hunting ground.  Often overlooked, many of these companies are able to compound investors’ capital at a rapid clip.  Yes, investing here with a broad-brush approach will likely be unrewarding.  But, by viewing these companies through a discerning lens and taking a focused approach,I hope to be successful foraging in the field.

[1] Heico Corporation (HEI) Q3 2018 Results – Earnings Call transcript

[2] Anand,Bharat, David Collis, and Sophie Hood. "Danaher Corporation." HBS Case 708-445, Feb. 2008.

[3] Halma plc 2013 Capital Markets Day transcript

[4] Bekier,Matthias, Anna Bogardus, and Tim Oldham, “Why Mergers Fail,” McKinsey Quarterly 4 (2001)

[5] Donald R. Keough, The Ten Commandments for Business Failure (New York: Penguin, 2008),95.

[6]  Chanos, Jim. “Alpha chatterbox – Jim Chanos and the art of short selling.” Interview by Matt Klein. Financial Times, April 2016.

[7]  Nelnet, Inc (NNI) 2017 Letter to Shareholders


January 2021

Many of the companies I follow could be described as low-end disruptors.  These businesses compete successfully against established industry incumbents by reconfiguring their value chains to produce a product or service in a fundamentally different way than peers.  

Take Ryanair, for instance.  The company’s management understood the industry-standard hub-and-spoke route network model. Yet, they deliberately chose the heterodox approach of flying point-to-point to increase the number of trips that each plane could complete per day, thereby reducing average unit cost.  The associated savings were then passed on to customers through shockingly low prices. It’s what Clayton Christensen described as “disruptive innovation” and what Hamilton Helmer neatly called a “counter-positioning strategy.”[1]

Low-end disruption does not target making good products or services better; it is not the realm of “new and shiny.”  Winning low-end disruptors stay ahead of larger competitors using several tactics: they focus on just one customer segment; they deliver a basic product or provide one benefit better than incumbents do; and they back everyday-low-prices with super efficient operations to keep costs down.

Case studies from various industries include Dollar Tree, Geico, and Vanguard Group.  Less well-known examples from Scott’s portfolio include Wizz Air, an ultra-low-cost airline, Booker, a food wholesaler, and Hilton Food Group, a meatpacker.  

The first illustration of a low-end disruptor I was exposed to was La Quinta Inns.  Peter Lynch, who had been an investor in the stock, nicely described the company’s winning approach in his 1989 book, One Up on Wall Street [2]:

The concept was simple. La Quinta offered rooms of Holiday Inn quality, but at a lower price. The room was the same size as a Holiday Inn room, the bed was just as firm (there are bed consultants to the motel industry who figure these things out), the bathrooms were just as nice, the pool was just as nice, yet the rates were 30 percent less… How was that possible?...

La Quinta had eliminated the wedding area, the conference rooms, the large reception area, the kitchen area, and the restaurant—all excess space that contributed nothing to the profits but added substantially to the costs. La Quinta’s idea was to install a Denny’s or some similar 24-hour place next door to every one of its motels. LaQuinta didn’t even have to own the Denny’s. Somebody else could worry about the food. Holiday Inn isn’t famous for its cuisine, so it’s not as if La Quinta was giving up a major selling point. Right here, La Quinta avoided a big capital investment and sidestepped some big trouble. It turns out that most hotels and motels lose money on their restaurants, and the restaurants cause 95 percent of the complaints…

Where was the niche? I wanted to know. There were hundreds of motel rooms at every fork in the road already. [The CFO Walter] Biegler said they had a specific target: the small businessman who didn’t care for the budget motel, and if he had the choice, he’d rather pay less for the equivalent luxury of a Holiday Inn. LaQuinta was there to provide the equivalent luxury, and at locations that were often more convenient to traveling businessmen. Holiday Inn, which wanted to be all things to all travelers, frequently built its units just off the access ramps of major turnpikes. La Quinta built its units near the business districts, government offices, hospitals, and industrial complexes where its customers were most likely to do business. And because these were business travelers and not vacationers, a higher percentage of them booked their rooms in advance, giving La Quinta the advantage of a steadier and more predictable clientele.

Nobody else had captured this part of the market, the middle ground between the Hilton hotels above and the budget inn below. Also, there was no way that some newer competitor could sneak up on La Quinta…prototypes of would-be hotel and restaurant chains have to show up someplace—you simply can’t build 100 of them overnight, and if they are in a different part of the country, they wouldn’t affect you anyway…


Rather than attempting to appeal to a broad audience, La Quinta optimized its business to address a specific customer segment. In turn, this led to a materially different way of delivering the service. The power of this business model is easy to appreciate—joking about business travel, my old boss Burkhard liked to say, “All hotel rooms look the same once the lights are switched off.”


The predictability of low-end disruptors

For me, an attraction of low-end disruptors is their resiliency in the face of competition from the old guard.  In short, the value capture of their disruption is predictable.  Geico, Vanguard, Ryanair, and Dollar Tree are each in different industries, but they are all generally alike in their approach to growing share and creating value.  The success of these and similar companies, together with an understanding of why the system works at a micro-level, give me comfort that other businesses that employ this model will likely be successful as well.  

Where does this resiliency come from?  If disruptive companies target a high-price-point, high-gross-margin product, both incumbents and fast followers have a powerful incentive to compete.  In contrast, incumbents tend to ignore low-end disruptors—at least initially—because they play in the industry’s smallest profit pool.  “Let them take it,” incumbents say, which is rational—after all, their most loyal and profitable customers want something more.

Consider the battle between Ryanair and Lufthansa, which was once Europe’s largest airline.  In 2002, Lufthansa Chairman Wolfgang Mayrhuber remarked that, “No, Lufthansa doesn't need to descend to the no-frills level, like British Airways did, to compete with the low-cost airlines.”  He didn’t believe that the low-cost carriers were a threat to the company’s enormously profitable business traffic. Wolfgang dismissed Ryanair as “little more than an operator of ‘ping-pong’ flights between secondary airports.”

In his characteristically profane language, Ryanair CEO Michael Leary responded, “[Lufthansa] says Germans don't like low fares. How the @#$%&! do they know? The Germans will crawl @#$%&!-naked over broken glass to get them!”

If and when incumbents mount a counteroffensive, it typically doesn’t work.  Because they have a higher cost structure, setting off a price war hurts themselves more than the challenger.  Alternatively, launching low-cost businesses of their own generally fails because institutional imperatives prevent them from fully committing to the strategy, which is a necessary ingredient for success.  

In the end, it was clear which company best understood the air travel opportunity.  By 2014, Ryanair and its peers had captured 40% of the intra-European market.  At that point, faced with intense shareholder pressure, Lufthansa’s newly appointed CEO, Carsten Spohr, unveiled a strategic plan that relied principally on an expansion of the group’s low-fare operations, known as Germanwings—a radical departure for an airline that had long cultivated its image as a premium brand.

But the effort backfired.  The operation cannibalized passengers from the pricier Lufthansa business at a time when the group’s overall revenue growth had stalled.  “The perception is that Lufthansa is trying to juggle too many balls at the same time,” aviation industry consultant John Strickland noted at the time.

After suffering years of losses, the German airline announced this past April that it would shutter its Germanwings brand.  Today, Lufthansa’s market capitalization is roughly half its December 2000 level; Ryanair’s, in contrast, has tripled over the same span.

Reflecting on Lufthansa’s failure to defend itself against Ryanair, I’m reminded of Egon’s warning in the popular 1984 film to his fellow Ghostbusters, Ray and Venkman, while using their proton packs for the first time in an attempt to capture a ghoul in the ballroom of a fancy hotel, “There’s something I forgot to tell you.  Don’t cross the streams!  It would be bad.” [3]


European low-end disruptors

The table below highlights eight European disruptors from a variety of industries, as well as an example of what they do differently than the established incumbents.                          


Why low-end disruptors can be attractive investment candidates

The value of a company’s growth is a function of its rate, duration, and associated return on capital.  Out-year growth and return on capital are, broadly speaking, much harder to predict than current-year results.  Consequently, knowledge about the former is significantly more valuable than information pertaining to the latter to investors participating in the pari-mutuel game of the stock market.  The near-term growth rate and return on capital should already be reflected in a stock’s price.

In out-year estimates, market participants tend to apply a generic fade rate to growth that is in line with industry base rates.  If that assumption is wrong, it can create an investment opportunity.  In my experience, the growth profile of low-end disruptors is actually more drawn out, or back-end weighted than that of operators employing other business models.  

An interesting aspect of these upstart businesses, from a public market investor’s standpoint, is that they often need to grow at a measured pace.  This is because they must be careful to keep their unique attributes in place as they grow. For example, Wal-Mart’s decades-long early expansion was predicated on growing outward from its Bentonville, Arkansas base in ever-larger concentric circles, enabling the retailer to preserve its logistics cost advantage.  What’s more, patience is required to educate and stimulate consumers in the lowest-price segment; they will be new to a product that typically relies on word-of-mouth advertising to drive momentum.  

In this way, low-end disruptors are often long-duration, above-average growers.  From an investing perspective, an understanding of this element is more important than the actual magnitude of the near-term growth rate itself.

Consider Hilton Food Group, a meatpacking business, which Scott has owned since our inception in 2015.  Its growth rate today—call it low-teens—is no different than it was back in 2008 when the business first went public.  This is highly unusual.  More often than not, after initially expanding at an untethered pace, a company’s growth rate tends to decay at a steady pace as market saturation is approached.

 The table below details the fade-defying growth profile of Hilton which makes it so special.


How Hilton Food Group reconfigured the meatpacking value chain

Hilton supplies packaged, white-labeled beef products to leading food retailers around the world, including Tesco in the UK, Ahold in Holland, and Woolworths in Australia.  Meatpacking is a tough business.  Production is labor- and capital-intensive.  Moreover, buyers are consolidated and sophisticated.  Grocers, which typically earn a 3% margin, usually rely on a dual-source supply approach to keep pricing competitive.

In response to the various challenges, meatpackers have historically tried to become large and vertically integrated to achieve scale advantages.  In addition, to optimize their fixed-cost utilization, they have sought to expand and diversify their customer base in case they get dropped in favor of a competitor who becomes irrationally aggressive in pricing.  Many also try to develop their own brands to connect with end consumers, with the aim of partially insulating their revenues from pricing competition.

Waldemar Skarupka is a meatpacking industry executive who has experience working with a range of retailers, long-established meatpackers, and Hilton.  He explained to me some of the difficulties that can arise based on the industry’s traditional approach:

In a normal market, you have the retailer who is pushing for the lowest possible price in a transaction. You have the producer who is pushing for the highest possible price. And they are both hiding facts from each other to win something more than it looks like in the negotiation.

This dynamic often leads to cheating your partner.  Not because they are bad people, but because you see that as the standard market trait. We know that retailers are really negotiating hard. You tend to be pushed to the limit - on production, quality of raw material, shelf life, anything - to have as low a price as possible, and without the customer having the full information.

At some point, they simply start to cheat.  And it can happen on a high level in the organization structure, or sometimes it can happen on a really low level because simply people are motivated by money to achieve some goals.

Indeed, there are numerous high-profile examples of cheating in the sector.  In 2013, ground beef provided by ABP Food Group to numerous UK grocers was found to contain as much as 29% horse meat.  In 2018, an undercover investigation by the UK’s Guardian newspaper filmed workers at a 2 Sisters Food Group chicken-cutting plant changing the slaughter dates on batches of chickens.  The footage also showed workers dropping chickens on the floor of the processing plant and subsequently returning them to the production line.

In response to such issues, Hilton has sought to turn the traditional industry approach on its head.  Rather than attempt to be all things to all customers in an effort to achieve superior scale, the company focuses intensely on serving only a single customer in any given locale.

After describing the sometimes-damaging industry incentives, Waldemar went on to discuss the source of Hilton’s success with Tesco and Ahold:

Hilton was able to offer customers complete trust.  It became like the DNA of the company that they are 100% devoted to the customer. There was no risk that they would share secrets with a customer’s competition.

The element of trust allows for the retailer and the producer to both share much more info than they normally would.  Each are more involved and more aware about the influence of their decision on the whole supply chain. And that's a gain, because then retailers see that when making a decision, and moving from this product to that product, changing the yield, changing logistic cost, changing all the other ingredients of price, the impacts are simply bigger or smaller than they previously understood.

This trust element allows you to share sensitive data and make better decisions.  It really can change the game in the meat business.  Because margins in the meat business are somewhere between 1% and 4% for fresh meat. Through better integration, you can increase your result by 3% to 4%, which means that you can earn money and still be cheaper for the customer.

In essence, by directing all of its efforts toward the needs of a single customer, Hilton can arrange its operations very differently than larger, more established rivals.  Specifically, it can:

·        Co-locate its packing facility at the customer’s main distribution center, reducing transport time and expense.

·        Work with fewer production changeovers, thereby achieving higher labor and equipment utilization rates.

·        Be in a position to be trusted with competitively sensitive promotional plans, which allows Hilton to plan further ahead.  Also, to receive sellout data on a real-time basis, allowing Hilton to change its merchandising mix on the fly to increase product yield.

Since Scott invested in Hilton Food Group in 2015, Robert Watson, Phillip Heffer, and the rest of its founding management team have successfully expanded the company’s customer base to include Woolworth’s in Australia, Sonae in Portugal, and Delhaize in Belgium.  I’m optimistic that their strategy will continue to win over additional new customers in the coming years.  

I was fortunate to observe that something made Hilton special compared to its industry peers.  Getting to know the team there only increased my appreciation for their approach.  I’m hopeful that, within the broad taxonomy of businesses, Scott’s particular observance of low-end disruptors will surface additional investments over time.

[1] Clayton Christensen, The Innovators Solution (Boston: Harvard Business Review Press, 2013) and
Hamilton Helmer, 7 Powers: The Foundations of Business Strategy (Los Altos: Deep Strategy, 2016).

[2] Peter Lynch, One Up on Wall Street (New York: Simon and Schuster, 1989), 177.

[3] Egon, Ray, and Venkman in 1984’s Ghostbusters - https://www.youtube.com/watch?v=wyKQe_i9yyo