In the Q3 letter, I wrote about the attractiveness of “invisible companies” that lay outside the vortex of indexing. I have also written about the benefits of being a small fund, allowing us to pursue the broadest range of investments, and have paid homage to Marc Andreessen’s “Why Software is Eating the World” thesis. During the fourth quarter, I found myself thinking a lot about backhoes of all things.
Some people follow Kim Kardashian on Twitter; I follow investors and people who post anything and everything about Charlie Munger, Mohnish Pabrai lectures, and links to Howard Marks and Murray Stahl essays the moment they drop. It was through Twitter (I wish I could give better attribution) that I came across a 1996 column by venture capitalist Bill Gurley, “Backhoes Don’t Obey Moore’s Law: A Story of Convergence.”1 I had never read this 20-year-old article before, but it instantly resonated. In the age of dial-up internet, people could see the future of connected computers and the benefits of the broad availability of high speed internet, but Gurley effectively diagnosed that the bottleneck to realizing the utopia of computers connected with broadband would not be the computers, but rather the ability to lay the pipes which would enable the connections. Unfortunately, backhoes only improve at 12% per year, far more slowly than computers.
Obviously, the evolution of the internet and the passage of 20 years answered many of the questions posed in the article, but as I look at new and existing investments, I now try and understand what might be the metaphorical “backhoe” for the given situation that will delay convergence or the demise of an existing product. The common narrative of our times is that virtual reality, 3D printing, self-driving cars, blockchains, and drone delivery will transform industries. Fortunes will be made and fortunes will be lost. Often the mispricings we exploit exist because the market is over-emphasizing the speed at which change will happen, and underestimating the earnings power of the incumbent business.
I believe that one of our holdings – Fiat – is a situation where the market is/was forgetting about the backhoes. Over the course of the fourth quarter, we substantially added to our Fiat position (which we have owned for 3+ years) for two reasons. The first reason was “backhoe” related. Fiat has underinvested in self-driving cars. If that is not “bad” enough, there is a vision of the future in which the model of individually-owned cars will go away as Uber and self-driving cars converge. Why own a car when it is not used 96% of the time? Just hail a self-driving car on your smartphone and avoid the cost of ownership. In this draconian scenario for the legacy of auto manufacturers, fewer cars are sold, and the ones that are sold are made by technology companies, not car companies. For a futurist, Fiat is one of the most disadvantaged auto manufacturers. As a value investor, I don’t think it matters, there are “backhoes.”
The futuristic vision of car ownership being replaced by an Uber-like fleet of self-driving cars has several likely backhoes. One of the best examinations on the issues facing autonomous cars is this presentation by Frank Chen of Andreessen Horowitz. There is a massive leap that has to be made from today’s “assisted driving” cars, which have advanced cruise control and can parallel park, to a “fully autonomous” car that does not even have a steering wheel and will never be driven by a human. Highway driving is relatively easy, but city driving is more complicated; sunny days are relatively easy, but snow-covered roads are more challenging. A self-driving car that works 99% of the time but still relies on occasional human intervention is not the real game changer; 100% reliability is necessary to change the paradigm. To get to 100%, outlier events such as navigating construction and accidents must be overcome. Other challenges/backhoes include contextual challenges of programming a car to drive alongside other humans. There are also cyber security challenges to prevent hackable cars, cost challenges to make them accessible to consumers… I could go on, but suffice it to say, there are many challenges.
Ultimately, I think the real backhoe for fully autonomous cars will be regulatory. Even after all of the technical challenges are overcome, I can hear the well-intentioned regulators and legislators acknowledging the potential of fully autonomous cars while still encouraging caution and taking a “wait and see” approach. Yes, there will be early adopter cities and even states, but a self-driving car that only works in San Jose and Michigan on sunny days is not that valuable, and hardly a death blow to Fiat. Chris Urmson, who ran the Google autonomous car project, has estimated it could be as long as 30 years before we have fully autonomous cars. When I synthesize all of the potential challenges to self-driving, I am certain that the impact on sales will not be material in the next five years, which I consider our investment horizon.
Another common argument against owning any of the auto manufacturers is that auto sales in the U.S. have reached “peak SAAR” (Seasonally Adjusted Annual Rate). Clearly, a low margin and high fixed cost business will see earnings decline as volumes decline. Current volumes are 18M per year and The Great Recession saw SAAR fall to as low as 9M units per year. Every monthly sales report is probed for weakness and evidence that peak SAAR has been reached. I think the most likely scenario is a plateau. The U.S. auto fleet is as old as it has ever been at 11.6 years, and with 264 million cars registered, even at 18M units per year, the fleet is still aging. When adjusted for population growth and fleet aging, current SAAR looks sustainable. Having driven in a few 12-year-old cars, I am skeptical that SAAR will decline rapidly, barring a very large shock to the economy.
“I Am Not Believing” – Actually, I Am
If we put aside the autonomous car threats as substantially outside of our investment time horizon and posit that “peak SAAR” may actually be plateau SAAR, what do we have? Fiat’s CEO Sergio Marchionne laid out an ambitious five-year plan in 2013 that outlined substantial improvements in margins and volumes. The plan was a PowerPoint tour de force which included the revitalization of Alfa Romeo and, more importantly, a road map to profitability, plus a swing from almost $10B in debt to $5B in net cash by the end of 2018. My four-year-old daughter has a simple and profound way of speaking. She will often say, “I am not believing,” which is shorthand for completely dismissing what you are saying. No discussion is to be had after she declares that she is “not believing.” Well, the market’s reaction in 2014, 2015, and 2016 has been “I am not believing” to Sergio’s plan. The consensus “cool kids” dismiss the plan despite dozens of changes at the auto manufacturer, which have included spinning off Ferrari, gaining access to Chrysler cash, improving margins, changing the vehicle mix to emphasize more profitable SUVs made under the Jeep brand, and a joint venture in China.
Ultimately, the decision to double down on Fiat was driven by the fact that 2018 is just around the corner. Most investors think about “forward earnings” where they are looking at the current year or the following year – only a minority of investors look two years out. Thus 2017 marks the point where the majority of investors and analysts stop ignoring 2018. Fiat was trading at less than 1.5X 2018 plan numbers last fall. Something had to give. Real companies that are debt-free don’t trade for 1.5X earnings – even if the earnings are a year away. I know I am supposed to say something conservative like, “I think we can earn an attractive return on our investment,” but the reality is that if Marchionne and team continue to execute and the new car market does not fall off a cliff, I think we can earn multiples on our investment and, as a result, made Fiat a 10+% position. I am believing.
1 Moore’s Law refers to the observation by Intel co-founder Gordon Moore that the number of transistors per square inch in a dense integrated circuit had doubled every 1-2 years since their invention (i.e., technological advancement shrunk transistor size so that twice as many could fit onto a chip), and the subsequent prediction that this trend will continue into the foreseeable future.
This post has been excerpted from the Greenhaven Road Capital Q4 2016 Letter.
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