We have been fortunate over the years to have had numerous opportunities to learn from value investing thought leader Paul Lountzis, President of Lountzis Asset Management. Paul is a well-known value investor in the mold of Warren Buffett. In fact, Paul evaluated several companies for Warren Buffett when he worked at Ruane, Cunniff & Goldfarb, one of the most successful and well-respected investment firms worldwide. Paul spent nine years, with the last five as a partner, at Ruane Cunniff before starting Lountzis Asset Management in 2000. During his more than 25 years in the investment industry, Paul has developed an intimate understanding of how to identify and invest successfully in wide-moat businesses.
In this exclusive thought leader session, Paul shares his insights into wide-moat investing and lessons learned from past investments: both successes and mistakes. The latter are often more conducive to the learning process, and for those we are especially grateful to Paul. Included below are two excerpts from the conversation: one taken from a successful investment, the other from a not-so-successful one. The full video of our conversation with Paul Lountzis, including five investment case studies, is available in The Manual of Ideas Members Area.
Learning from Successes
Says Paul Lountzis:
A second example is a much smaller company with a little bit of a different moat that was partially created by their patents and their unique technology, but even more created by the uniqueness of the market in which they were operating. It’s a company called Arrow International based in Reading, Pennsylvania.
I was introduced to it in the early 1990s when they came public and it was led by Marlin Miller, a true visionary and an extraordinary leader. Marlin grew up in the Midwest, was educated at Harvard Business School and was just a first-rate businessperson on every count – analytically, integrity-wise, etc. The company sold medical devices and it was dominated by two major categories. The first was central venous access catheters which in August of 2006 did $250 million in revenue, and specialty catheters that did about $150 million. So $400 million of their $480 million or so in total revenue was these two areas. They had some unique technology – the Arrow-Howes catheter, the Arrowgard and so forth, and some others. They had these catheters lined with antibiotics and other things to prevent infection, and they were much higher priced than the traditional, cheaper catheters. It also had multi-lumen catheters and so forth.
The important point here was that even though in many cases the prices of their products had very limited pricing power, and in some cases the price of their products declined annually, because of their significant market share on a global basis within central venous access catheters which was maybe a half a billion dollar global market, and they might’ve had 50% of that market. And in the specialty catheter space, another equally-sized market, they probably had about a third of that market. The marketplace itself enabled them to face limited competition long term because of the overall sizes of their markets, the markets they were participating in, and the size of the competitors with whom they were competing.
Outside of Cook Medical, a private company in Indianapolis, many of their competitors or companies that could be competitors such as Johnson & Johnson [JNJ], CR Bard [BCR], Medtronic [MDT], and others were simply uninterested in entering that area because the market size was simply not big enough and their penetration of that market was so large. They would rather have just purchased Arrow International to enter that market and then run it through their own existing sales force by cutting cost through removing or eliminating a large portion of R&D and sales.
Interestingly, it took me a long time to gain a comfort level with Arrow. However, eight or nine years after I met Marlin in the late 1990s, the stock was selling for nine times earnings whereas most other medical device companies were selling for double that. They were viewed as too small, they only had a $25 million R&D budget, very small and dwarfed relative to Medtronic, CR Bard and others. However, they had a unique niche, and in speaking to Marlin Miller where a lot of insights came and he help me better understand what their real moat was that many of their competitors – CR Bard, Johnson & Johnson, Abbott Laboratories and others were frequently calling him because they were interested in his product lines and in his business.
From that perspective, I felt that Arrow was something that I should delve into. I met with Phil Fleck, their head of R&D. I assessed and evaluated their products. I evaluated and visited with their competitors and their competitive products. I spoke to many of their customers to gain an understanding of the industry, the market size, and what was unique about them. In doing so, we made the purchase of Arrow in the $17, $18 range and held it for six, seven years until it was acquired by Teleflex [TFX] in early 2007 for $45.50 per share. I might also add, the company had zero long term debt, was very conservative in every way.
And it illustrates how moats are not always created by the company, but sometimes can be created by the industry in which they compete, and the market in which they compete. They did have some unique patents and some unique technology, but that wasn’t the real moat in this case. The real moat was their leadership position in a market that simply wasn’t that large and it would not have behooved their much larger competitors to try to enter that market on their own.
Wide-Moat Case Study: Paul Lountzis on Arrow International
Learning from Mistakes
Says Paul Lountzis:
And, finally, another mistake dating back into the late 1990s and early 2000s was Mattel [MAT]. Mattel had
made Jill Barad the CEO and she had been very successful building the Barbie brand to well over a billion in global revenue as an outstanding product manager and then leader of that group.
However, when one becomes a CEO, not only do they need to be great operationally, they need to be very strong on the capital allocation side. Those are two areas that we really focus on with companies, first, their ability to maximize the operating capabilities of the business as great operators, and secondarily to wisely and prudently allocate that capital. There are very few CEOs that are good at both.
At the time, 1999-2000, Mattel was a $4 billion, $4.5 billion enterprise, tremendous, tremendous brands. The Barbie brand, Fisher-Price toys, Hot Wheels, and many other outstanding brands that appealed to children around the world. Jill Barad at that time had never really been in a CEO position and had been focused almost exclusively on Barbie. We felt that their brands, their global reach, and the power of their consumer products within the infant and children’s categories were significant competitive moats. Many of these brands had been around for decades and kids always enjoyed playing with them.
However, what we didn’t anticipate was a capital allocation decision that Jill Barad made. She purchased The Learning Company which had $800 million or so in revenue, paying over 4.5 times revenue or $3.5 billion to acquire it. And when the challenges arose and became evident, I believe it was the third quarter of 1999 or 2000, when The Learning Company was supposed to earn $50 million and they lost over $100 million. And their losses continued to grow ending that year, I believe it was 1999, with over $280 million dollars in losses.
Here was an example of, while the company had outstanding brands and strong moats through those brands, excellent global distribution tied in with as Mr. Buffett calls it, the share of mind with children. They loved Hot Wheels, and Matchbox, and Barbie. These are iconic brands and powerful brands. What we didn’t anticipate was her purchase of a company for which they had very little knowledge and for which they grossly overpaid. Ironically, Bob Eckert came in several years later, who is an outstanding capital allocator having come from the Kraft [KRFT] operations within Phillip Morris in Chicago, and ended up selling the business to the Gores brothers, The Learning Company, for virtually nothing.
And so the point being, while we assessed the moats of the products and the businesses they were operating, we did not adequately anticipate nor understand the importance of capital allocation, and how this misallocation fundamentally impacted Mattel in such a terrible way – the stock had risen to as high as $40 in 1998 and subsequently declined to as low as $9 after the challenges at The Learning Company.
We had purchased the stock in the low twenties after it had declined from $45 to $21, $22, $23. However, we did not again anticipate the challenges on the capital allocation side with The Learning Company. They didn’t do their homework, they didn’t understand what they were buying, they didn’t understand the lack of systems, and their products lacked loyalty. Even though they had Reader Rabbit and some others, we just didn’t realize all those things. As a result, we hung in there. We didn’t have the courage or conviction to step up and buy more of it at $9, $10 or $11, unfortunately. And after holding it for a few years, we ended up selling it right around cost to a little above cost. But in terms of opportunity cost to our clients, it was clearly an unsuccessful investment.
Wide-Moat Case Study: Paul Lountzis on Mattel (MAT)
Shai Dardashti, managing director of The Manual of Ideas, had a wide-ranging conversation with Paul Lountzis a few months ago, in which they explored aspects of wide-moat investing, among other topics. We share here Paul’s insights into Progressive Insurance, a wide-moat business in the rather commoditized insurance industry, and UnitedHealth Group, a leader in the health management organization (HMO) industry:
Paul Lountzis Explains the Auto Insurance Industry and Progressive Insurance (PGR)
Paul Lountzis Explains the HMO Industry and UnitedHealth Group (UNH)