Credit Acceptance Corporation (CACC) Update pt 2

In the month since I posted my rationale for trimming my position in CACC, the stock has fallen just shy of 20%, and I recently began adding back to my position at $192. At these prices, modest growth is part of the thesis, so I haven't added in a really big way yet. I'll add in phases on the way down assuming no other major changes to the situation.

Additional Valuation Thoughts

My prior posts on CACC contain more background (post 1, post 2), but I thought I would lay out some additional thinking on the current valuation below.

CACC has $2.8b of capital which currently earns 12.7% and costs 5% (weighted after tax, per their Q2 PR), which includes 2.65% for the $2b of debt after tax. If we assume they don't grow or shrink and just dividend out that 12.7% in perpetuity, that leaves $14.4 per share for the equity after tax ([12.7% *$2.8b - 2.65% * $2b] /21mm shares) which makes $200 13.9x earnings (7% yield).

This ignores changes to returns on capital, interest rates, growth (or shrinkage, e.g., from a hit to capital by regulators), or changes to their capital structure. 

• Regarding ROIC, this business is cyclical, and on average CACC has earned closer to 14% on capital over the last 10 years or so (more thoughts on this 14% are below). Using this ROIC and assuming an $150mm hit to capital from regulators (see post 2) brings the multiple to 13x. 
• How are CACC's earnings are impacted by rising rates? Given the loan rates are not really interest rate sensitive, but the liabilities are, rising rates is a negative. In 2006, when the 10y treasury yield was 4.7% (vs 2.1% now), their cost of debt after tax was 5.6%. Using the above math and assumptions ($150mm hit to capital, and 14% ROIC) with this cost of debt, results in $12.30 in earnings and a multiple of 16x. On the other side of the coin, a rise in rates could improve the competitive environment because folks can achieve more reasonable returns elsewhere without extending down the risk spectrum into subprime auto, drawing capital out of the market. I cannot quantify this impact though.
• Adding in modest growth assumptions makes the stock look quite reasonable in either of the interest rate scenarios above. For example, in the less favorable high rate environment above, 5% EPS growth and a 10% discount rate (along with the 14% ROIC, $150mm capital hit assumptions) gives $240/share value. I think this scenario is pretty conservative.

It is reasonable to be concerned that the business is becoming more commoditized, and therefore 14% ROICs are a thing of the past. I don't think this is the case. I think this is a niche product that is hard to sell well. Over the years many people have gone broke by skating on too thin of ice, and this will happen again causing capital to withdrawal. Moreover, CACC "packs a bigger punch" than many other lenders in the market. Most folks take a deal that was going to get done and sweeten it a little, whereas CACC takes a deal that wasn't going to get done and makes it happen. All this leads me to believe this is not a product where the lowest cost of capital (banks) wins, end of story. There's also the possibility that something exogenous to the auto market occurs (e.g., 2008 crisis, large interest rate increase) that causes capital to withdrawal and returns to increase.

As I mentioned in the beginning, modest growth is part of the thesis at these prices, so I haven't added in a really big way yet. I will add in phases on the way down (fingers crossed) assuming no other major changes to the situation.

Disclosure: Long CACC

Basket of Japanese Stocks

Continuing on with providing a description of my portfolio changes since last September (beginning of my hiatus from writing due to fairly limited activity) is a basket of small positions (~1-2% each) in Japanese stocks purchased in October/November of 2014. I was pleased to locate these ideas from an individual on the corner of Berkshire and Fairfax message board. Below is a brief description of the rationale for each purchase, as well as the current situation and performance to date.

• Joban Kaihatsu (Ticker: 1782): At the time I purchased it, Joban had compounded book value per share over the prior 5 years at close to 15%, and it traded at 61% of book, 0.7x EBITDA, and 1.7x the average of several years FCFE. Currently it is trading at 478 JPY, which is 80% of book, 2.4x EBITDA, and 5.2x FCFE (5Y average). The return to date has been 56% in USD, and 73% in JPY.
• Fujimak (5965): At the time I purchased it, Fujimak had compounded book value per share over the prior 6 years at 10%, and it traded at 41% of book, 1.3x EBITDA, and 7x the average of 5 years FCFE. Currently it is trading at 790 JPY, which is 41% of book, 1x EBITDA, and 7x FCFE. The return to date has been 2% in USD and 3% in JPY.
• Tokyo Radiator Mfg (7235): At the time I purchased it, Tokyo Radiator had compounded book value per share over the prior 5 years at 9.9%, and it traded at 45% of book, 0.7x EBITDA, and 9x the average of 5 years FCFE. Currently it is trading at 645 JPY, which is 50% of book, 1.2x EBITDA, and 6.7x FCFE. The return to date has been 14% in USD and JPY.
• Car Mate Mfg (7297): At the time I purchased it, Car Mate had compounded book value per share over the prior 5 years at 9.6%, and it traded at 45% of book, 4.8x the average of 5 years FCFE, and had a negative enterprise value. Currently it is trading at 645 JPY, which is 43% of book, 6.8x FCFE, and the enterprise value is still negative. Due to a spike in cost of goods sold, EBITDA turned negative over the trailing twelve months, which is concerning and warrants closer monitoring of this company's progress. The return to date has been -1% in USD and flat in JPY.
• Nansin (7399): At the time I purchased it, Nansin had compounded book value per share over the prior 5 years at 13%, and it traded at 40% of book, 2.3x EBITDA, and 2.6x the average of 5 years FCFE. Currently it is trading at 400 JPY, which is 36% of book, 2.1x EBITDA, and 2.9x FCFE. The return to date has been -11% in USD, and -1% in JPY. 

In aggregate the basket is up 10% in USD and 16% in JPY. This is versus -3% for SPY including dividends since 10/31/2014 (+5% from the bottom of the short sell off in mid October). So satisfactory results to date, although not stellar because the positive performance is really due to 2 of the 5 names. These stocks still appear quite cheap, so I do not have plans to sell yet.

I have gone back and forth, but I currently have left the JPY exposure unhedged. As shown above, this has cost me a material amount.  My main reason for remaining unhedged is that it is expensive to hedge (although it has turned out to be more expensive not to hedge to date).  Additionally, aside from very large cash on these companies' balance sheets, currency movements affect these businesses in fundamental ways that I don't think is exactly 1 for 1 with the current market cap of the company. Lastly all currencies decline, and I don't know which ones will decline faster or slower than others. I no doubt will continue to cogitate on this reasoning.

I will continue to hold each of these stocks as they remain quantitatively cheap.

Disclosure: Long 1782.JP, 5965. JP, 7235.JP, 7297.JP, 7399.JP

Credit Acceptance (CACC) Update

In the short period I have owned it, CACC's business has continued to perform remarkably, and I continue to be very impressed with management.

In the last few quarters CACC has experienced solid loan growth and performance with relatively minor spread concessions (due to modest term extensions). Importantly, they have also shown growth in loans per dealer (5.8% YoY in Q2 2015), which previously had been declining sharply. Management uses this metric to monitor industry competitiveness (increasing loans per dealer indicating declining competitiveness). A few other notes:

• Q2 2015 adjusted return on average capital: 12.7% (compared to peak of 18.7% in 2010, and last cycle trough of 11.2% in 2008)
• Q2 2015 spread on origination: 24.1% (compared to 2009 peak of 35.3%, and last cycle trough of 21.4% in 2007)
• Q1 and Q2 2015 YoY loan unit volume increase: 28.4%, 30.6% 
• Collection forecast variances continue to be positive
• After having the FTC complaint resolved without incident, no additional changes have occurred on the legal inquires (DOJ and Massachusetts AG)

In short, they are firing on all proverbial cylinders. 

The stock has risen quite a bit more rapidly than I would have expected. At $250, it currently trades at 18.4x management's adjusted earnings per share (Q2 2015 TTM).

At these levels, the market is pricing in a fair amount of growth and franchise value into the stock, which is probably reasonable. I still fear regulatory issues and the possibility that they could send the stock tumbling. As I've followed the industry more though, the fines that are coming out of the CFPB and DOJ seem manageable for CACC. I've seen fines ranging from $25mm at Honda to $100mm at Ally. If one assumes an $150mm (I assume higher than others in the industry to be conservative, not because I think CACC is "worse" than the others) hit to capital due to a regulatory fine, it trades at 19.8x (150mm fine at approximately 14% returns on capital and 21mm shares is $1 per share in earning power reduction).

All this considered, I sold a large percentage of my position at around $206 (average cost of $125). I still own a non-trivial position, but it is only in the 2-3% range. However, I have and will continue to consider adding to my position because it is rare that I find something I feel I understand reasonably well with a management team as strong as this one. Clearly to date, selling shares has been a mistake.

Disclosure: Long CACC

Berkshire Hathaway (BRK.B)

With U.S. markets continuing to rise, my activity has been fairly limited since my last post. However I have made some moves, and this will be the first in a series of posts summarizing changes to my portfolio since last September.

First up is Berkshire.

Berkshire has been a very large part of my portfolio since May 2011. While not dirt cheap today, it is certainly not expensive and I have added to it recently below $140. It currently represents a whopping 25% of my actively managed portfolio.

I won't go into any back story around Berkshire's history or current businesses here.  I'll focus on valuation. Buffett provides pretty good clues as to how he thinks about Berkshire's value. There's a huge amount of discussion in the investment community around valuing Berkshire, along with a great variety of approaches. Below I discuss one such approach that is simple and logical to me. It goes without saying, but any investor should come to terms with whatever valuation approach(s) they use and be comfortable with the valuation. Shares trade in the $144 range, and Buffett's buyback threshold is currently $119 (120% of BVPS).

Buffett has two key quantitatve valuation metrics, the first relating to the insurance companies, and a second related to its operating companies. The figures for 2014 YE:
(1) investments per B share: $93.42
(2) operating income per B share: $7.23

A simple, logical, and I believe a conservative approach to value Berkshire is to tack a multiple onto (2) (representing the approximate value of the non-insurance subsidiaries) and add (1) (the the approximate value of the insurance companies) to the resulting figure. Using a 10x multiple on the operating income results in a value estimate of $166 (see post publish edit below). The operating earnings are pre-tax, so a 10x multiple is around a 6.5% post-tax yield, which is reasonable regardless of interest rates, given Berkshire is also likely to grow, albeit at a much slower rate than in the past. I think this approach is fairly conservative because it ignores material adjustments to the upside such as superior capital allocation, long-term shareholder oriented and rational culture and, as I discuss below, this approach arguably understates the value of the insurance subsidiaries.

As it relates to the insurance companies, the obvious question is why does (1) represent the value approximation when it only considers the assets, ignoring the liabilities all together.  After all, the economic value of equity is market value of assets minus the fair value of liabilities. So shouldn't the liabilities financing the investments be subtracted from (1) to derive the net equity? Of course we should, but the key thing to note is that the fair value of the liabilities isn't even close to the GAAP value shown on the balance sheet. The reason is that Berkshire has a tremendous  group of insurance companies. Specifically they have generated an underwriting profit (before a dime of investment income is considered) for 12 years straight. And over the past 4 decades they have consistently delivered money ranging from extremely cheap (less than 30 year treasuries) to better than free (profitable underwriting). Importantly, this "float" is not only long enduring (i.e., it doesn't mature or amortize like a regular liability because it is constantly replenished), it has grown at rapid rates. Lastly Berkshire has a strong track record of reserving for its obligations.

Since Berkshire's liabilities have largely been better than free and long enduring, one could reasonably argue that they are not just overvalued at the GAAP amounts, but are literally on the wrong side of the balance sheet, or more conservatively are worth 0. And hence, getting back to market value of assets minus fair value of liabilities, the value of the insurance companies are worth at least the investments and cash (market value of assets minus 0). Here I ignore other net insurance assets (excluding goodwill), which are positive. This approach also ignores growth in float (i.e., the present value of additional free money to be received in the future). In his 2014 shareholder letter, Buffett stated that he does not expect significant growth in float in the future, so this seems like a reasonable assumption.

I have heard some argue against this math because the liquidation value of the liabilities is their face value shown on the balance sheet. This is totally wrong for the simple reason that if the liabilities are arguably sizeable assets on a going concern basis, why would any rational manager pursue a course of action that not only destroys the asset value, but converts them into huge liabilities?  More concretely, a manager could
(a) Unintelligently put the liabilities into runoff and pay someone to manage them. This would still convert an asset into a liability, which is irrational. But the liability would still be worth way less than face because it would be cheap money and payments would stretch years. Or
(b) More logically sell the business /transfer the liabilities at something close to fair value. If the liabilities are an asset to us as a going concern, why wouldn't they be for someone else?

I've heard other arguments such as the fact that the assets the liabilities fund must earn low returns to defease the liabilities, so therefore one cannot simply zero out the value of the liabilities. While I understand Berkshire must hold some capital to protect policy holders, which is a yield drag, I don't think the assets are at all relevant to the valuation of the liabilities. If someone wants to haircut the value of the assets separately based on one's own asset return hurdles, by all means. I would note though that my understanding is that Berkshire does not sell policies with unlimited liability, so Berkshire has chopped the tail of the loss distribution to where it knows it's worst case scenario. I think it may be for this reason that Buffett has stated minimum cash balances he will hold. Haircutting the value of this minimum cash could possibly be reasonable, but I currently don't make any adjustments myself because I think there's enough conservatism baked into zeroing out the liabilities (rather than adding additional value given the expectation of underwriting profit) that it probably more than washes.

Buffett and Munger

Investors in Berkshire must also be comfortable with Buffett and Munger's respective ages. Obviously their passing will be a huge blow. The stock will also most likely fall significantly, as it reasonably should given simple math, and the value they add. Overall from an investment standpoint, this is not a huge concern for me. For one thing, the valuation above does not consider any premium for superior capital allocation or other "Buffett premium", even though I think there should still be a a capital allocation premium absent Buffett and Munger. I think this because, Berkshire is uncommonly disciplined, rational and shareholder oriented. And they mean it, rather than pay lip service to it. Capital allocation aside, culture runs deep in organizations and all along Buffett has put good incentives in place for managers (and board members), so I expect that Berkshire will still manage to thrive after Buffett and Munger.

Conclusion

In conclusion, I think Berkshire, with a value of at least $153 (see post publish edit below) and price of $144, is an attractive investment right now. Particularly when compared to general market valuations today. Further, I think succession risk, while not to be dismissed, is minimal given Berkshire's culture and current valuation.

Post publish edit: Regarding valuation, I actually think it also makes sense to subtract around half of Berkshire's deferred tax liabilities. This comes to $13 per B share, bringing the estimate to around $153 ($166-$13). How did I come up with half? Very subjectively. Berkshire's DTL relates primarily to capital gains and accelerated depreciation in BNSF and the utility businesses. These are both liabilities where payments will stretch many many years. The capital gains are arguably worth close to zero because Buffett does not tend to sell core holdings.  In any event, treating them like a 30 year zero coupon bond, discounted at the 30 year treasury rate of 3.05% gives a present value of around 45% and I rounded to 50%.

Disclosure: Long BRK.B