Editor's Note: The following is an excerpt available exclusively at TheStreet.com from an interview originally published by Value Investor Insight.
"There are only two types of companies," says money manager (and
contributor) Arne Alsin. "Those with problems and those that are going to have problems."
Alsin, who started Alsin Capital Management in 2001 after winding down a successful family money-management business, isn't the pessimist that statement implies. "I just wait for premier companies to temporarily falter and disappoint," he says. "I'm an opportunist."
Investors today are overreacting more than ever to short-term influences, Alsin says, creating plenty of opportunity to find deeply discounted bargains.
On what specific metrics do you typically focus?
I think the number one variable in the investing equation that Wall Street overlooks is margin leverage. Most investors focus on leverage from sales growth, which is relatively easy to figure out and everybody looks at that. But in the great organic growth stories, such as
Bed Bath & Beyond
, a lot of the share-price upside has come from these companies increasing operating and net margins as they grow.
Home Depot has gone up roughly sevenfold in the past 13 years and margin leverage -- their net margins grew from 4% to 7% -- has been responsible for fully 40% of that gain.
Margin leverage tends to go along with a company having an enduring competitive moat. When I think of the great organic growth stories, it's rarely based on some breakthrough product. The products are often simple but the source of the greatness is in the execution, which is reflected in the operating statement. Wal-Mart is just flat-out better across the board -- distribution, procurement, laying off SG&A across a larger base of revenue.
In the aggregate, that dynamic is what produces and reinforces the moat. If you get this type of company early enough in the story, which is what I try to do, you will get a tremendous amount of appreciation from both sales and margin growth. I just think that's the most overlooked source of big money gains I can think of.
There certainly appears to be room for margin improvement with your first specific pick, CarMax
is far and away the number one used-car superstore chain. The idea from the beginning was to create a model that is the antithesis of the way the used-car industry typically operates. CarMax has no-haggle sale and trade-in prices, all financing terms are clearly disclosed, their salespeople are not paid on the gross profit of each sale, and you're not handed off to "closers" who try to upsell you a bunch of things you don't want.
The competitive environment for CarMax is one of the most attractive I've ever seen. The industry is highly fragmented, made up of tens of thousands of small competitors, and there's no real number two doing things the way CarMax is. They have a substantial competitive advantage in that every lot has four to five times the inventory of the typical used-car dealer. If they don't have the exact model you want, they'll go on Carmax.com right there at the dealer and you have 20,000 cars to pick from. You can generally get the exact model, color and options you're looking for and they'll ship it between locations. No competitor can match that level of choice.
Another source of their moat is technology. They have a sophisticated inventory and pricing system that enables them to accurately price their sales and trade-ins. Wal-Mart tried a pilot project in Texas that tried to copy the CarMax model but abandoned it because it was too difficult. You have to be completely in this one business to do it well.
I also see their high customer satisfaction as a reinforcing competitive advantage. They're growing quickly because people learn about the model and appreciate the way the company is doing business.CarMax's position and upside, in my opinion, are very similar to Home Depot's back in the early 1980s.
Is the used-car business, in general, very attractive?
It's a viable product in that the consumer gets the benefit of buying a one-, two- or three-year-old car without suffering the major degradation in value he does when he drives a new car off the lot. The greatest amount of value depreciation comes in a new car's first year, so the value proposition is better with used cars.
Also, if you look at the long-term data, new-car sales oscillate wildly depending on the state of the economy, while used-car sales are amazingly consistent. They change little from year to year and are surprisingly independent of the overall economic environment.
Is the organic growth story intact here?
CarMax is still early in its growth cycle. They're currently in 17 states with a total of only 67 superstores. They generate ample cash to fund organic growth and the current plan is to expand square footage by roughly 17% per year, which they've been executing on. Although their story isn't as widely known as it will be, the existing business is extremely well accepted -- same-store sales grew 10% last quarter year over year.
So if you're conservative and assume even 3% to 4% same-store sales growth while they're opening new superstores, you've got very impressive top-line leverage. They'll do $6.2 billion to $6.3 billion in sales this fiscal year, ending in February, and I expect that to double every four to four-and-a-half years for the foreseeable future.
What about margin improvement?
This is not a business that will mature at a 2.2% net profit margin, which is where they are now. When you look closely at things like how gross margins have evolved and the levels of variable expense, you can understand why operating and net margins have been steadily improving year after year. Certain important expenses won't grow in lockstep with the top line. Just one example: They have four locations in Los Angeles and they're going to grow that base. The L.A. basin has more than 10 million people. When you first go in with two stores, advertising costs a largely fixed amount, which then gets spread across a bigger base of revenue when you go to four, then six, then eight stores. CarMax is easily at least a 4% net-margin company.
At around $28 per share, how are you looking at valuation?
My estimate of CarMax's "margin-equilibrium" rate of earnings is around $2.55-$2.60 per share this year, so the stock is trading at only an 11 times P/E -- remarkably cheap for a company with this potential. This is currently a $3 billion market value company, but over the next four or five years I expect it to be worth $10 billion.
At the time of publication, Alsin's firm was long CarMax and Wal-Mart.
This excerpt is from an interview published in the Nov. 30 issue of
Value Investor Insight
newsletter. For more information on
Value Investor Insight
, please visit
www.valueinvestorinsight.com. To comment on this article,
Whitney Tilson is the co-founder and Chairman of Value Investor Media, Inc., and co-Editor-in-Chief of Value Investor Insight. He also for the past six years has successfully managed a number of value-oriented hedge funds, and recently launched two mutual funds.
John Heins is the co-founder and President of Value Investor Media, Inc., and co-Editor-in-Chief of Value Investor Insight. Prior to starting VIM, Mr. Heins was Senior Vice President and General Manager of America Online's Personal Finance business.