Portfolio Updates

Feb 17, 2017 by Boyles Asset Management in  Ideas

Creston
Creston, a smaller holding, was bought out by its largest shareholder in November. While we were cautious of this shareholder’s intentions, we had been comforted by the presence of unrelated large shareholders, whom we believed would counter such an offer. That comfort proved to be without merit. The 27% premium to the three-month average share price was much too low in our opinion—representing a valuation of approximately 10x free cash flow (which we believed to be below the firm’s earnings power). We voted against the offer. The total internal rate of return (IRR) since the inception of the idea in 2012 (prior to the Boyles launch) was 7.9%; without the impact of currency, the IRR was 14.4%. The modest outcome was impacted by the severe decline in the British Pound; the modest early outcome of an acquisition the company made; mediocre management which, while changed, was unable to generate organic growth; and as mentioned, the modest exit multiple.

Electronic Data Processing
We noted earlier in 2016 that the company was considering strategic alternatives. While we had expected a resolution prior to the end of the year, the process remains ongoing. We hope to hear of a resolution to that process in Q1 2017. Results released in December showed soft revenue with beneficial ongoing cost management efforts. Importantly, the company was able to finally dispose of a property that had been difficult to sell over the years. We believe this was a necessary precursor to a sale of the company.

Zicom Group
Current operating results have been poor due to the overall macro conditions in the marine, oil and gas, and construction industries. Crucially, the company has noted its intention to spin off a cluster of start-up investments that have been cultivated during the last five years. While progress on these investments has been frustratingly slow so far, there are early signs of significant commercial progress in several of the businesses. The company has targeted a spinoff during the next 12 to 18 months. Shares remain quite cheap in relation to tangible book value.

BrainJuicer Group
Shares performed quite well in 2016, contributing significantly to our performance during the year. The decline in the British Pound during the year provides a tailwind to reported performance, given that a substantial portion of the business is outside the UK. Growth, beyond currency impacts, also seems to have accelerated. Importantly, the company’s launch of an advertising agency called System1 Agency in 2016 seems to have progressed well. The company is adding meaningful talent investment in this business. Any success with System1 Agency would provide significant upside well beyond the base case that continues to drive our thesis, and supports the current portfolio allocation.

Echelon Financial Holdings
Shares performed poorly during 2016, as it became evident that the company’s expansion in Europe was indeed foolish. Our, and others, calls to moderate this expansion over the years we’ve owned the shares went unheeded. The sale of that business (announced during the summer) at a large discount to book remains subject only to local government approvals. Echelon shares continue to trade at a discount to tangible book value. Upside is dependent on the performance of new management in the company’s core business, and is acceptable, given that downside protection is quite formidable at recent share prices.

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This post has been excerpted from the Boyles Asset Management Q4 2016 Letter to Partners.

[us_separator] The content of this website is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, principals and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated on this website. This summary is meant in no way to limit or otherwise circumscribe the full scope and effect of the complete Terms of Use.

My Investment Thesis on Credit Acceptance

Feb 22, 2016

Investment Thesis

  • CACC is a defensive business with a very solid moat, good growth prospects, and great capital allocation. I don’t think the multiple reflects those qualities – the stock is undervalued
  • CACC trades at a low multiple despite delivering high growth and compounding capital at high rates
    • CACC trades at a ~9.1% forward earnings yield on an earnings stream that should grow at least in the mid-teens for the next 4-5 years
    • CACC has produced mid-teen ROICs for 20 years and continues to deliver returns in line with historical norms while operating in a near-trough pricing environment, suggesting upside to earnings
  • CACC will beat sell-side estimates for NTM earnings given trends in unit growth and pricing
    • They grew unit volumes 40% YoY in Q3 & 33% in Q4, but growth expectations are very modest: those volumes will translate to earnings above expectations for the next two years as CACC collects
    • CACC is also underwriting business profitably but is doing so at the low end of its historical rates of return, suggesting that current earnings are not representative of the business’s true earnings power
  • Potential Risks:
    • Concerns around CACC approaching full market penetration are overstated
    • There is regulatory risk, but the potential impact to profitability will likely be marginal, not existential
  • In a conservative base case, I think CACC should trade at ~$305 or ~50% above current value
    • In a bear case, I see limited downside given attractive entry multiple, defensiveness, and continued growth at above market rates: over the long term, CACC should outperform. But, if the auto cycle turns meaningfully negative, CACC could face temporary growth challenges or increased provisions

Valuation Methodology

  • In a conservative base case (key assumptions & drivers are below,) and a modest multiple for a business growing at least in the mid-teens, I arrive at a value of ~$305/sh.
    • I use 15x FY1 EPS – a premium to the current multiple but still cheap given per sh growth prospects
    • Given growth, defensiveness, and market position, I think a 10% discount rate is adequate

Mike Miller - CACC(17)

Key Metrics Summary
Mike Miller - CACC(17)

Business/Market Overview & Investment Rationale

Business & Market Overview

  • The auto finance market is large, fragmented, and for most companies, very competitive
    • Most lenders operate in a highly competitive landscape, bidding for business around clear market rates of return based on varying risk profiles
    • CACC is well positioned competitively vs. both subscale and established lenders
  • The market is also highly cyclical, but CACC has a long history of underwriting discipline
    • The auto loan industry has gone through multiple cycles, starting in the early 90s after CACC’s IPO
    • CACC has been affected by market cycles, but it has effectively priced its business throughout cycles
      • CACC can do this because they operate a unique lending model with limited competition

Key Investment Drivers

  • Dealer holdback is a profitable, differentiated model
    • CACC’s model aligns interest between the dealer and the lender, resulting in improved credit quality
    • Without real competition, CACC has pricing power, driving attractive ROAs & ROEs
  • CACC’s model is much more profitable than peers and requires less leverage
    • CACC has a consistent history of delivering attractive ROAs & ROEs but other lenders do not
    • Peers trade at bad multiples, reflecting the risk associated with their highly leveraged earnings stream, which I believe weighs on CACC’s multiple while CACC is very conservatively financed
  • With current spreads (CACC’s pricing on their loans) near historical lows, LTM earnings understate the true earnings power of the business
    • Spreads are below their historical norms suggesting CACC’s earnings power isn’t fully reflected in recent results
    • In addition, recent growth has been very positive, well above that of the past 3 years, which if it continues, would drive considerable earnings outperformance
  • CACC is highly cash generative & deploys capital effectively – driving superb results on a per share basis
    • FCF doesn’t reflect true cash generation capability because of high degrees of reinvestment
    • Aggressive buybacks (1/2 the shares since 2001) amplify already attractive ROEs and should continue to drive well above market EPS growth
  • Attractive reinvestment opportunities over the next 3-5 years: unclear how long the runway will be in the long term but outcomes skew positively
    • CACC has ample near-term runway to grow – it’s long-term runway will be an inverse function of credit availability in subprime
    • But given that the size of CACC’s TAM is inversely correlated to the profitability of low ROA, highly leveraged peers, I think outcomes skew positively over the long term
  • Regulatory risk is real, but the company is prepared, the product is valuable – the market appears to have overcorrected
    • CFPB focus will likely increase costs, not eliminate the business
    • CACC is well positioned relative to peers to deal with the potential of more stringent regulation

Mike Miller - CACC(18)

The Auto Finance Market is Large, Fragmented, And For Most Companies, Very Competitive

  • The market for US auto financing is huge (~$1 trillion dollars) and relatively fragmented, particularly in used car lending
    • ~60% of auto loans are for used vehicles
    • ~20% of total loans taken are subprime (<600 FICO) or deep subprime (<500 FICO)
      • The market for subprime and deep subprime are ~$160Bn and ~$36Bn, respectively (Q3 2015)
  • Credit Acceptance represents a very small portion of the market, providing <2% of total used auto loans and ~2% of the total loan volume for subprime and deep subprime

Mike Miller - CACC(19)Mike Miller - CACC(19)

  • Most lenders operate in a highly competitive landscape, bidding for business around clear market rates of return based on varying risk profiles
    • Competitive risk-adjusted rates of return have pressured ROAs for CACC’s competition

Mike Miller - CACC(19)

  • CACC is well positioned competitively vs. both subscale and established lenders
    • As the regulatory landscape evolves, compliance costs will pressure the margins of smaller players, many of whom are in-house financing arms at dealerships (that don’t report to agencies)
    • In addition to regulatory pressure, rising rates will pressure NIMs for CACC’s established competitors, who have much lower ROAs, potentially increasing the demand for CACC’s loans

Mike Miller - CACC(19)

The Auto Finance Market is Highly Cyclical; However, CACC Has a Long History of Underwriting Discipline and Collections Execution

  • The auto loan industry has gone through multiple cycles, starting in the early 90s after CACC’s
    IPO and profitability attracted more capital to the space

Mike Miller - CACC(20)

  • And while CACC has been affected by market cycles, it has effectively anticipated its ability to collect on its loans
    • In the past 22 years, CACC has only overestimated collections by more than 2% on two occasions: 2001 and 2007 (reported collections of 95.6% and 96.2% of expectations, respectively)

Mike Miller - CACC(20)

Note: Before 2001, the maximum reported collection was 100%, so the average is understated.

Mike Miller - CACC(20)

Dealer Holdback is a Profitable, Differentiated Model

  • Most lenders underwrite by bidding against one another in competitive auctions; after underwriting, the dealer is removed from the equation. This is problematic because:
    • The dealer has no economic incentive to put the customer in a car he/she can afford
    • Traditional underwriting is very competitive, which results in subpar returns on assets
      • With low ROAs, lenders have to employ significant leverage to generate attractive ROEs, which in a cyclical industry, can be dangerous
  • CACC has a unique model that aligns its interests with dealers, reducing credit risk on its loans
    • CACC provides an advance on the amount financed (principal + interest) to the dealer, which covers the cost of sale and provides a small profit. CACC provides that advance in exchange for the right to collect a 20% servicing fee on the total collections balance
    • From the dealer’s perspective, there is an immediate profit, net of the vehicle expense, but most of the dealer’s return comes from the customer’s payments on their loan (called holdback)
      • The dealer is therefore highly incentivized to put the consumer in a car he/she can afford

Mike Miller - CACC(21)Mike Miller - CACC(21)Mike Miller - CACC(21)

  • CACC benefits from a significant incumbent bias and effectively no competition
    • CACC is in effect the lender of last resort – they step in for the portion of the population that traditional lenders fail to address. This is a very difficult position to disrupt
    • Because most of the dealer’s profit is based on a promise – that CACC will service the loan and make payments to the dealer – there is little incentive to move to an unproven player
  • As a lender of last resort, CACC has control over its pricing, which drives above-market IRRs and ROAs on a risk-adjusted basis
    • CACC is exposed to the auto cycle to some extent because the size & profitability of their underwriting universe is effectively the vacuum created by traditional lenders
    • Within that space, CACC has demonstrated the ability to underwrite profitably for ~30 years

Mike Miller - CACC(21)
Mike Miller - CACC(21)

CACC’s Model is More Profitable Than Peers and Requires Less Leverage

  • CACC has a consistent history of delivering attractive rates of return on both total capital and equity capital but other lenders do not
    • The competitive dynamics of the underwriting process have not been favorable to most lending companies, but CACC has underwritten profitably throughout the majority of its history
    • CACC is very conservatively financed with both 1) diverse funding sources spread out over various maturity durations and 2) significant excess borrowing capacity on many facilities

Mike Miller - CACC(22)Mike Miller - CACC(22)

  • With subpar ROAs, competitors employ significant leverage to deliver favorable ROEs
    • I see the combination of leverage and cyclicality in the subprime market is dangerous for CACC’s competitors, which over time, should create opportunities for CACC

Mike Miller - CACC(22)Mike Miller - CACC(22)

  • However, applying so much leverage to a space that has been highly cyclical puts those earnings at risk, which is reflected in the multiple
    • I believe the poor earnings quality of peers and the associated multiple weighs on CACC’s multiple
    • While most of CACC’s peers’ earnings are peaking and decelerating, CACC’s rates of profitability are neartrough and accelerating – I don’t think CACC’s premium multiple reflects that dynamic fully

Mike Miller - CACC(22)Mike Miller - CACC(22)

With Current Spreads Near Historical Lows, LTM Earnings Understate the True Earnings Power of the Business

  • Spreads, which are a proxy for CACC’s IRR on a loan, are currently below their historical norm
    • Spreads have been somewhat volatile but typically trend within 3% of the mean
    • The spread (return) CACC can deliver on its capital is typically an inverse function of the ease of credit in subprime

Mike Miller - CACC(23)

  • At current spreads, a 400bps improvement in CACC’s incremental spreads (a return to the mean) would result in a 12% improvement in earnings power
    • Spreads have been somewhat volatile but typically trend within 3% of the mean
    • Operating leverage has put downward pressure on spreads (CACC can now write more business at lower rates to the same level of profitability,) but trends still suggest the business is under earning
  • In addition, recent trends demonstrate that growth is not slowing but accelerating, which provides visibility to further earnings upside

Mike Miller - CACC(23)Mike Miller - CACC(23)

CACC is Highly Cash Generative & Deploys Capital Effectively – Driving Superb Results on a Per Share Basis

  • CACC has there uses for its cash flow, providing substantial flexibility in FCF deployment
    • 1. Underwriting: Extending advances to dealers – the core business
    • 2. Loan Purchases: Buying existing loans and servicing them (done when returns are attractive)
    • 3. Buybacks: CACC evaluates all capital decisions vs. the expected return of buying back their stock
  • CACC’s FCF conversion appears weak, but only because so much capital is reinvested to grow the business: steady state FCF conversion would be close to 80%, implying ~30% FCF margins

Mike Miller - CACC(24)

  • These three uses of cash present different return opportunities depending on the market environment, and CACC has demonstrated the ability to effectively redeploy its FCF
    • CACC’s flexibility in FCF deployment is one of its most important competitive advantages
  • Capital allocation track record demonstrated in EPS growth and buybacks
    • CACC has bought back 50% of their stock since 2001

Mike Miller - CACC(24)Mike Miller - CACC(24)

Attractive Reinvestment Opportunities Over the Next 3-5 Years: Unclear How Long the Runway Will be in the Long Term but Outcomes Skew Positively

  • Given the size and fragmentation of the industry, CACC still has growth ahead of it at <2% market share for used car loans
    • The market for subprime and deep subprime finance (below 600 FICO score) is currently ~$200Bn or 50x of CACC’s current book of business (~$4Bn)
      • From this perspective CACC’s runway seems very, very long
      • A snapshot of the 2013 subprime ABS market demonstrates how small a share of total volumes CACC represents and how important the continued profitability of Santander, Ally, and other highly leveraged peers is to shaping CACC’s market opportunity

Mike Miller - CACC(25)

  • But eventually, the pace at which CACC adds dealers will decline as they approach full market penetration; however, there is ample runway in the near term from this perspective
    • The number of dealers matters because it is through the dealers that CACC distributes their product
    • CACC currently has ~8mm dealers on their network; that is out of a total market of dealers of ~55k
    • Mgmt points to 55k as their TAM, but the real number is probably closer to 30-50% of that, proportional to the nonprime & subprime market
      • That suggests CACC can only double the dealer base 1-2x, assuming attrition – more than enough runway for the next few years
  • Offsetting the eventual trend in slowing active dealer growth, growth in volume/active dealer should improve over time
    • These volumes should grow above the market for used vehicles, driving topline growth
    • Volume/active dealer is highest in markets where CACC has operated the longest, demonstrating the value of the product and accelerating utilization over time
  • The full market penetration is a moving target because the size of CACC’s addressable market will fluctuate with the credit environment
    • Given that CACC’s value proposition of guaranteed credit approval, the size of their market will grow in periods of contracting credit

Mike Miller - CACC(25)

Regulatory Risk is Real, but the Company is Prepared & the Product, Valuable

  • CFPB focus will likely increase costs, not eliminate the business
    • This is a high value product – people need cars in America, and, in addition, CACC is one of the few lenders who offer deep subprime borrowers the opportunity to rebuild their credit
      • I see the CFPB closing access to subprime auto financing as unlikely in a nation where you literally cannot live without a car in many geographies
    • The criteria for aggressive lending that have been previously scrutinized center around uncollateralized, rollover installment loans – not straight-forward, asset backed finance
  • Equifax, an unbiased but influential industry player, recently articulated the importance of subprime lending in a study on the industry
    • They also note the dangers of potentially restricting the current industry, which could result in less reliable (and potentially dangerous) sources of credit for consumers in need

Mike Miller - CACC(26)

  • Regulation, therefore, will likely influence CACC’s cost structure more than its model but robust compliance is already a part of the business
    • Having operated in nation-wide collections for years – and collections is a very regulatory-intensive industry – CACC has significant experience in working constructively with regulators
    • Paired with their scale and anticipation of more scrutiny, their model should prove durable to change
  • CACC is well positioned relative to peers to deal with the potential of more stringent regulation
    • If the space were regulated, ROEs for CACC could be pressured, but regulation would push lower ROA lenders out of business.
      • CACC is the only operator who could potentially sacrifice profitability for volume (although they haven’t before), and are therefore the most resilient to regulatory change
      • Small dealers that offer in-house financing or other small lenders (who collectively represent a considerable portion of the subprime market) do not report to the credit bureaus and would be more likely targets of regulation
  • Increased regulatory scrutiny could actually benefit CACC by impairing margins for subscale or lower ROA competition, forcing those firms to withdraw products, increasing CACC’s TAM

Mike Miller - CACC(26)

Appendix

Dealer Interviews: Key Takeaways

Background: These are notes from my conversations with dealers following my write-up, which was based on public information and conversations with CACC IR. I had ~25 conversations in total, and ~15 of them were very substantive, meaning I had the opportunity to ask all of my questions.

Confirmed Assumptions

  • (+/-) MARKET IS VERY COMPETITIVE FOR LOANS: Choosing a lender is a very economic decision. Dealers have tons of options. Dealers need CACC when they can’t get financing done through typical providers
    • For most lenders the process is hyper competitive – some have 20+ financing partners
    • Dealers think very hard about the value proposition of their financing partners
  • (+) BUT WITH THE HOLDBACK, BRAND/TRUST MATTER & CACC DOMINATES: CACC is a very good operator and their brand is valuable. The importance of trust, speed of execution, and collections reliability really matters when using the holdback approach (dealers won’t get paid for 1-2 YEARS later, so the promise from CACC is important)
    • CACC has a significant advantage in the holdback market in brand value and pricing
    • Trust, speed of payment, and pricing. On brand value, CACC appears to be the most trusted name, with
    • Westlake coming in second, then a new company called Go in 3rd
    • CACC pays the fastest and offers the best pricing for depending on inventory
    • Generational bias towards CACC (old dealers love them) – this may be a long-term risk

New Insights

  • (+) STICKYNESS: CACC’s program model has significant influence on a dealership and improves retention: there is a training program and a buying protocol
  • (+/-) PROFITABLE IN ANY MARKET: In any market, the CACC program is profitable, but in very loose credit markets, some dealers think they have a better return on time by working with full credit providers (SC, Ally, WFC, etc.) because they can sell vehicle at higher margins
  • (+/-) INVENTORY & COLLATERAL VALUE: A key issue I was unaware of is the importance of appropriate inventory: CACC requires that the dealers buy vehicles below average book value to ensure collateral value (and minimize their credit risk). Matching your inventory to CACC’s program (cheap, US sedans) is essential: this results in a safer transaction for all parties and ensures the customer gets value in his/her purchase.
    • The dealer needs reliable cars, quality vehicles, bought below book (because CACC won’t extend an advance much in excess of book value) to ensure they’ll last the life of the loan
    • In addition to the incentive alignment, the experience is very controlled and ALL PARTIES reduce their risk as much as possible, including the customer
    • CACC creates margin of safety for the collateral value by controlling the buying habits of its dealers: this is unique and reduces CACC’s downside risk materially
      • CACC determines the type of inventory, the price you buy, and the price you sell
    • This model can be limited if you operate in an SUV market, where prices are higher
  • (+/-) NEED FOR HIGH VOLUME: If you are not doing a lot of volume, it’s not worth the effort to participate because CACC sales are lower margin than fully financed auto sales. This can lead to dealer attrition, particularly for marginal dealers, if volumes can’t meet the fixed costs of working with CACC. Smaller dealers have a preference for Westlake or Go.

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[us_separator] The content of this website is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, principals and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated on this website. This summary is meant in no way to limit or otherwise circumscribe the full scope and effect of the complete Terms of Use.

What Concerns Me About CafePress

Feb 23, 2016

We sold half of our position in CafePress.  The reason for this is we are concerned management may not be able to successfully grow the business and because of that reduced visibility, it should be a smaller percentage of the fund.  In the most recent quarter CafePress reported its revenues decreased 30 percent compared to the prior year.  We expected revenues to decline when management stopped using unprofitable promotions and discounts to spur demand but the decrease was greater than we anticipated.

If you recall, the co-founders of CafePress returned in 2014 to turn around the business, planning to first stabilize the business, second optimize it, and third grow the business.  So far the co-founders have been able to stabilize and simplify the business by cutting over 200 product types, leaving CafePress with its 400 best-performing products.  This has resulted in improved gross margins of 40 percent, simplified operations, and improved free cash flows (free cash flow burn rate in the most recent third quarter was $0.8 million compared to $4.9 million in the previous year).  The co-founders are now focused on the second stage of the turnaround which is the optimization phase which can be best described as the phase where the infrastructure is built to grow the business.  For example, CafePress is making investments in engineering and human resources.  Although we appreciate the fact that the co-founders are reinvesting in order to grow, we are less enthusiastic about the fact that they are hiring new leaders from outside the business, which we believe increases risk.

We also believe its primary competitor Zazzle has a better website and better products and have been unimpressed so far with the changes made to the CafePress website and product offerings.  All these factors mean that we find ourselves in the position of not being able to forecast what this business will look like in the next five years which means it should represent a smaller percentage of the fund.

Although reduced, CafePress still represents 5 percent of our fund as of the end of the year.  One of the main reasons we have not reduced our position further is that most of our purchases were made in February of 2015 and we are waiting until February 2016 in order to classify our taxable gains as long-term.  In the interim we believe our downside is protected from the $2.60 per share in cash on the balance sheet as of the end of the third quarter (stock price at end of year is $3.84 per share).

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This post has been excerpted from a letter to partners of Compound Money Fund, LP.

This document is for informational purposes only. It is intended only for the person to whom it has been delivered. This document is confidential and may not be distributed without the express consent of Time Value of Money, LP. The information contained herein is subject to change; however, we are under no obligation to amend or supplement this document. This document is not intended to constitute legal, tax, or accounting advice or investment recommendations. This document shall not constitute an offer to sell or the solicitation of an offer to buy nor shall there be any sale of a security in any jurisdiction where such offer, solicitation or sale would be unlawful prior to issuance of an offering memorandum. An investment in Compound Money Fund, LP involves a substantial amount of risk. Investments should only be made by investors who fully understand these risks and can withstand a loss of their entire investment.

Strayer Education: A Mistake?

Feb 23, 2016

We reduced our holding in Strayer Education from 14.1 percent of the portfolio at the end of the third quarter to 5 percent at the end of the year.  We believe Strayer has lower growth prospects and as a result trades at a fair valuation.  It therefore represented too high a percentage of the portfolio at 14.1 percent.  We believe it is more prudent to remain on the sidelines and wait to see if growth begins to materialize before committing a larger percentage of our portfolio to this position.

We also do not see any short-term catalysts on the horizon. We examined job growth prospects in the markets where Strayer’s students are located such as Washington, D.C. and Virginia, and saw no dramatic near term job growth that would drive prospective student enrollment within the most common degree plans at Strayer.

We have also become increasingly concerned that the employee culture is exhibiting signs of decline as the leadership continues to emphasize cutting costs instead of growing the business.  This is placing pressure on existing employees as many are being asked to take on more work.  For example, full-time faculty members are being asked to teach more classes.  Also, many support positions have been eliminated which we believe may have an effect on service quality.  We believe layoffs can profoundly affect the culture of the business, spreading fear among the remaining employees in the organization.  This fear causes companies to contract rather than expand.

Is Strayer a mistake?

As many of you know I have been a champion of Strayer for many years, writing at length in past quarterly letters about the strength of the investment.   My investment thesis was based on the fact that Strayer was the best run for-profit education institution and it avoided the bad practices of other for-profit colleges, such as recruiting students with false promises and loading them up with debt they could not pay back.  I felt many of Strayer’s problems were industry related and that its stock price would recover as investors discovered Strayer did not engage in the same practices as other for-profit schools.

Then employment growth in the United States began to decline and this along with other factors caused new student enrollments to decline by double digits.  This had the effect of shrinking Strayer’s total enrollment from 60,000 students at the end of 2010 to 42,200 students as of the most recent quarter. I had underestimated how quickly enrollments would decline but did not want to react too quickly to the negative news and sell the position. As new student enrollment stabilized in the last year, this gave me further confidence to continue holding our position.  We also gave Strayer credit for proactively seeking new avenues of growth such as their deal with Fiat Chrysler and the new Jack Welch Executive MBA program.  Fiat Chrysler is paying 100 percent of the tuition for dealership employees and Jack Welch Executive MBA enrollments are growing at a double digit rate, both creating more value.  In other words, we thought that their positive steps were balancing the stagnant enrollment environment.

I believe in some respects this investment has been a mistake.  First, I succumbed to the dreaded enemy of all investors – the confirmation bias.  This is the bias which causes investors to stick to their existing beliefs.  I found myself in a position where I was defending this investment, instead of making a detached evaluation.   As we invested in higher quality faster growing businesses my comparisons changed and therefore our decision to reduce our position became clearer.

I continue to have some conviction in Strayer but believe the negative attributes may outweigh the positive attributes.  This is why I reduced the position size.  Strayer continues to trade at a double digit free cash flow yield and has an even stronger balance sheet now that it has repaid all of its debt which protects our downside.

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This post has been excerpted from a letter to partners of Compound Money Fund, LP.

This document is for informational purposes only. It is intended only for the person to whom it has been delivered. This document is confidential and may not be distributed without the express consent of Time Value of Money, LP. The information contained herein is subject to change; however, we are under no obligation to amend or supplement this document. This document is not intended to constitute legal, tax, or accounting advice or investment recommendations. This document shall not constitute an offer to sell or the solicitation of an offer to buy nor shall there be any sale of a security in any jurisdiction where such offer, solicitation or sale would be unlawful prior to issuance of an offering memorandum. An investment in Compound Money Fund, LP involves a substantial amount of risk. Investments should only be made by investors who fully understand these risks and can withstand a loss of their entire investment.

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