Buy the Owner-Operators
“One of the Rothschilds is said to have observed that if he could be sure of transmitting [or passing on to the next generation] a quarter of his capital, he would settle for that,” John Train writes in Dance of the Money Bees. “Alas, he probably didn’t make it.”
The Rothschild in question well knew how hard it is to preserve wealth. History is full of tales of fortunes lost. And if you needed reminders, there are memorials to lost fortunes everywhere. “There are so many great families whose former grandeur survives only as an echo, in the names of museums, converted mansions, streets and towns,” Train continues. “Their descendents don’t have it anymore. Taxes, inflation, expropriation and rising costs have pulled them down.”
Even so, some family businesses have made it work for a long time. As OOs, they have a better chance of doing something extraordinary than the hired-gun CEO. As Damon Runyon had it, “The race may not always be to the swift nor the victory to the strong, but that’s how you bet.”
In that spirit, I’d like to re-visit two of the stocks I have recommended in Capital & Crisis: A.O. Smith (NYSE:AOS) and FEMSA (NYSE:FMX). The founding Smith family for years kept a watchful eye on AOS. At FEMSA, the founding family still owns nearly 40% of the shares.
There are parallels between the two of them that I find striking. Each was able to sell off what was once the main business of the firm. A.O. Smith sold its electric motor business to Regal Beloit. FEMSA sold its iconic beer brands to Heineken. Both businesses are better as a result of these changes, as I’ll show you.
In business, rigidity is a liability, sometimes fatally so for the business. But here, both firms showed remarkable flexibility and a willingness to change to take advantage of market conditions.
At AOS, the sale of the motor business to Regal netted AOS about $390 million in cash and about $175 million in Regal stock. What remains is a vibrant water heater and filter business. AOS addresses the growing need for safe water around the world. AOS makes water heaters that help bring clean hot water into homes and businesses. It also helps reduce energy consumption, as AOS makes energy-efficient water heaters. Some models, such as its solar-based water heating systems, are nearly self-sufficient.
Another exciting aspect to AOS is its business in China, which is now 15% of sales and has grown 25% per year over the last five years. It started a similar business in India last April. These are the long-term engines that will drive growth at AOS.
This year, the water business could generate $230 million in EBITDA (or earnings before interest, taxes, depreciation and amortization). So the company trades for roughly 8.5 times EBITDA. This is a reasonable multiple to pay for such a quality business and is slightly below takeover values. (AOS sold its inferior motor business for over 8 times EBITDA.)
Plus, if AOS continues to grow as I think it will, then the valuation will look really cheap in hindsight. But at today’s price, you are not paying much for growth. And when you consider that super-strong balance sheet, there is potential for more good things down the road.
Now let’s look at FEMSA. Essentially, FEMSA has three businesses. It owns 53.7% of Coca-Cola FEMSA, 20% of Heineken and 100% of OXXO. Coca-Cola FEMSA is the largest Coke bottler in Latin America and the second largest in the world. Heineken needs no introduction. OXXO is a fast growing retail chain, whose stores are akin to a 7-Eleven. Over the last 12 months, OXXO opened over 1,000 new stores and now has over 8,000.
OXXO is the crown jewel. But again, the great investment appeal in FEMSA is what you get for the price. A sum-of-the-parts valuation shows the shares are worth at least $60 per share. The control premium reflects the fact that FMX owns a controlling stake in the company. Its shares are worth more than minority shares. Control premiums are usually at least 20%. The 12 times for OXXO is less than WalMex, which is growing not nearly as fast.
I believe these investments will increase in value, in particular OXXO. By the end of 2011, net asset value (NAV) could be at least 10% higher, or $66.
Both AOS and FMX are good businesses, and the OO component means that they will make a thoughtful choice with how they invest their cash. I’m content to be patient.
This brings me to another interesting point Steve Bregman, a portfolio manager at Horizon Asset Management, makes about OO stocks. “Most of the time, they are not actually good stocks,” he says. “They often produce their returns in very brief episodes. And these idiosyncrasies are poorly regarded by most investors such that I think relatively few probably wind up holding the shares long enough to benefit from their longer-term superior returns.”
Moreover, stocks routinely move 30% or 50% in a year for no particular reason. There is a lot of randomness and noise involved. Because of all this, you should be willing to buy the stock more than once, as it is unlikely you’ll catch the bottom. As Bregman says: “The mere accident of when I happen to get to my desk or return from vacation or happen on what I think is a bright new idea shouldn’t decide in large measure [my] investment result… Stocks vary a lot.”
The full fruits of those fantastic OO investment returns come to those with patience and persistence.