Grey Poupon Investing

Most professional equity investors like to own high-quality businesses. Early in our academic training and careers, we’re taught to find and hold quality. Since the definition of quality can differ between investors, I like to use examples to illustrate and clarify how I define quality. Throughout my career, I’ve used Oil-Dri (ODC) as an example of the type of high-quality business I like to own. Oil-Dri is a little-known small cap company that I’ve owned several times throughout the years. After first recommending its stock in the mid-90s, Oil-Dri remains on my possible buy list today.

Founded in 1969, Oil-Dri is a market leading producer of sorbent material. As management once joked on a conference call, their products suck, or more appropriately, absorb. They’re best known for their Johnny Cat and Cat’s Pride cat litter. Their products are also used for animal health, purification, agricultural chemical carriers, and floor absorbents. If you have a cat that uses a litter box, you’ll know a large percentage of their products must be replaced. As a result, revenues and cash flows are relatively consistent.

Oil-Dri has significant barriers to entry. Many of its products are heavy, such as cat litter. With clay (the main ingredient in their products) resources and processing facilities on the east and west coast, Oil-Dri can efficiently distribute nationally. Furthermore, because its mines have long reserve lives and its facilities are established, Oil-Dri does not need to battle through the difficult permitting process required to grow capacity (good luck opening a dusty clay mine or processing facility in today’s regulatory environment).

Oil-Dri is closely held by the Jaffee family. As discussed in Closely Held Premium, I don’t apply closely held discounts to businesses that I believe are being managed well. In my opinion, the Jaffee family has done a good job over the years, and as a result I have not applied a closely held discount to my valuation. Management runs the business for the long-term, using free cash flow to invest in new innovative products such as its most recent, Fresh & Light cat litter. I appreciate management’s willingness to grow organically, and if needed, report a poor quarter when it’s in the best interest of the company.

Despite having a lumpy quarter from time to time, Oil-Dri’s annual cash flow is relatively consistent and abundant. As a result, Oil-Dri has a strong balance sheet with more cash than debt. Due to their strong balance sheet, Oil-Dri doesn’t need “help” from The Wall Street Locusts (no sell-side coverage). The balance sheet is even stronger than it appears due to cost accounting. I believe the company’s land and mineral rights (278 million tons of reserves) are significantly undervalued relative to its balance sheet value.

So that’s a quick example of a high-quality business I like to own – high barriers to entry, strong cash flow, strong balance sheet, consistent revenues, established, and a long history of good management. These are characteristics most high-quality investors gravitate towards, right? We’ve all seen the presentations. The portfolio manager says, “I like high-quality stocks…” And then the manager provides an example, says “great franchise” two or three times, and then opens it up for Q&A. I could do the high quality presentation in my sleep. It’s very easy and is always a crowd pleaser.

Although I like great businesses as much as the next investor, there’s a serious and underappreciated problem with high-quality strategies – there are times when quality can be very expensive. If you spend your entire career focused on a narrow set of high-quality investments, what do you do when quality becomes unjustifiable from a valuation perspective? Lower your return requirements? Increase your growth rates? Play along with the relative value game and knowingly overpay? In my opinion, to own high-quality today some sort of compromise is most likely being made. To make an expensive high-quality investment appear rational, investors may tweak their valuation rules and variables.

Instead of manufacturing opportunity or violating valuation discipline there are other options. The option that makes the most sense to me, and the option I selected, is refusing to overpay. While rational, refusing to overpay has some minor drawbacks, such as unemployment. Another option is to change the investment mandate to allow for flexibility. When I speak with managers who agree with me regarding valuations, they’ll often point to their mandate that directs them to remain fully invested. This may be true, but there’s nothing in an investment mandate that prohibits a manager from requesting flexibility. I believe managers would be surprised how understanding clients can be when asking for flexibility, especially when it’s being used to protect client capital. Another option to consider is increasing the number of businesses that qualify as buy candidates. While I’d love to fill a portfolio full of companies like Oil-Dri, I know that’s not always possible depending on the premium investors are applying to high-quality businesses.

In past posts I’ve discussed the risk of groupthink and conformity. In addition to how investors are positioned, I believe conformity is also prevalent in how investors define quality. When most investors are learning the basics of investing, they’re usually taught a strict definition of quality. High returns on capital, high margins, consistent growth, recurring revenues, high barriers to entry, excellent management, and so on. In my opinion, this all too popular definition is constraining and limits opportunity.

I believe the definition of quality is as crowded as the current rush into quality stocks. I suggest considering a broader definition that includes certain cyclical stocks. Last week I wrote about Rent-A-Center and consumer discretionary companies and stated that I believe they’re cyclical businesses. Labeling a company as cyclical doesn’t necessarily mean they’re not good businesses and should be avoided. It simply means their operating results can be more volatile over a profit cycle. If Company A (non-cyclical) and Company B (cyclical) both generate $1 billion in free cash flow over 10 years, does it make sense to exclude Company B from your opportunity set just because its profit cycle was more volatile? I don’t think so.

In my opinion, there are several advantages of investing in cyclical stocks. First, many investors refuse to own them, so cyclical stocks often sell at more reasonable valuations than less cyclical businesses (there really aren’t “non-cyclicals” as all businesses are cyclical to some degree). Furthermore, cyclicality, or the natural fluctuation in a company’s operating results, can increase stock volatility and eventually create opportunity.

While I’ve owned and follow many cyclical businesses, there are some caveats.  First, they must have a strong balance sheet. I have no interest in seeing a cyclical stock I own go to zero. Second, it’s critical to normalize cash flows when valuing a cyclical business. Don’t get overly excited by the boom and don’t get too depressed during the bust. Know the expected operating margin range and what to expect. The key to making money in a cyclical stock is buying and surviving the troughs. Rarely if ever does it makes sense to buy cyclicals near peaks (see energy 1997, 2008, and 2014). Lastly, cyclical business results are more volatile, so it’s important to adjust required rates of return accordingly.

For those investors who lift their noses as they walk past cyclicals, feel free to keep on walking. One of the reasons cyclicals are often priced attractively is many investors’ definition of quality is so exclusive and closed-minded. I call this “great franchise” mindset, Grey Poupon investing. While Grey Poupon investing may sound and appear sophisticated, investors who ignore other spreads are really missing out!

In my opinion, given the current price of high-quality, Grey Poupon investing doesn’t appear sophisticated at all, but hazardous. As stated in the past, I believe high-quality is one of the riskiest sectors of the market currently. Last week, Illumina (ILMN) provided a good example of high-quality valuation risk. Illumina is a high-quality provider of genetic products and services used for genetic analysis. Illumina has everything an investor in high-quality businesses could want. Nevertheless, after preannouncing lower than expected preliminary Q3 results, its stock declined 25%. At 50x earnings, there wasn’t room for disappointment.

I don’t consider myself an investment snob. I’ll go where the value is as long as the investment fits my quality criteria. I believe an overly exclusive definition of quality can increase risk and reduce potential returns. In my opinion, selectively considering cyclical businesses for purchase can improve flexibility and broaden an investor’s opportunity set. Although my entire opportunity set remains unappealing (cyclicals and non-cyclicals), I believe in many cases cyclical stocks are less overvalued than the ultra-expensive Grey Poupons.