Moat in the making
This post is about buying a particular stock. I’m ready to go steady with it. I’m not ready to fully tie the knot.
As with last week’s post, my object is to use a specific stock as a case study. The idea of this post will be to look at the thought process behind the purchase; to reflect on the main considerations.
I wish to make clear that I am not recommending anyone purchase this stock. I may have bought it, but I may decide a month from now that it was a mistake or it is not working out as I expected. I may sell it. What is important about today’s post is that it talks about a specific stock purchase. I’m not talking in generalities.
Two types of companies
This cutesy ‘going steady’ metaphor captures an important element in my portfolio strategy. My stocks are for the most part split between two main types. Type 1 are solid growth companies with high owner earnings. These stocks currently make up over 70% of the portfolio. The other, type 2, is what I call solid growth with expected high owner earnings. The key word here is expected. These are stocks that I think are on their way to becoming a type 1 company. Should the company graduate to type 1, I will think about a serious long term relationship. For example, I currently hold one type 1 stock that I’ve owned for 24 years. That’s tying the knot.
The type 1/type 2 distinction is my own.
Type 2 companies typically have market capitalizations of less than about $10 billion. They represent companies with entrepreneurial management with vision and with most of their substantial personal net worth invested in common shares of the company. Typically, company founders are still running the company. They are substantial companies. They are definitely not flyers.
Moat in the making
Type 2 companies may not have a broad moat, or any moat, when the initial investment is made, so long as the investor is convinced a substantial moat is in the making. There is room for a small number of these companies in an investor’s portfolio.
What I have described as a portfolio strategy is something that overarches ideas on diversification and balance. See below for link to post on portfolio strategy.
Reflections on diversification
Over the last few months I was thinking about selling First Quantum. See last week’s post here. During those months a Canadian company that is in the e-commerce payments processing business came to my attention. At first blush it seems to be in the financial sector. At present 9% of my portfolio is in that sector. So, I needed to think about diversification and avoiding undue concentration in one sector. On reflection it seems more to the consumer/commerce finance side but not lending.
Since I have a 9.36% portfolio holding in Amazon, a consumer company, there is a certain overlap with an existing holding. In fact, Amazon is amongst other things, a payment processor. On balance I don’t think my new Canadian payments-processor company will lead to undue concentration and lack of diversification.
Reflections on balance
With any addition or subtraction from a portfolio one needs to consider how the stocks in the portfolio will work together. It’s like putting together a sports team. The players’ strengths and weaknesses must complement each other so the team is stronger than the sum of its parts.
The main consideration for stocks is the business correlation between the companies in the portfolio. One asks, how does inflation/disinflation/deflation impact each company? If one thrives in an inflationary environment, perhaps this company can offset one that might suffer. How is each company’s business impacted by interest rates? How is each company affected by consumer confidence or recessionary conditions? Simply looking at price correlation does not address this issue. Price correlation is the lazy person’s way of dealing with balance.
It strikes me that the e-commerce payments processing business would be particularly vulnerable to a recession but would not be impacted by interest rates in the same way lenders and borrowers are. It would also not be vulnerable directly to either inflation or deflation. Most businesses are hurt by recessions but, if financially sound, can ride through them. Very few businesses are like bankruptcy trustees whose business picks up in business downturns.
Intangible assets and economic goodwill
The company I have bought has a price to book value of 5.4. Its balance sheet shows $19 million of tangible assets and $1.9 billion of intangible assets and goodwill. You might choke on those numbers. To understand them you need to understand the difference between accounting goodwill and economic goodwill.
Warren Buffett says: “…You can live a full and rewarding life without ever thinking about Goodwill and its amortization. But students of investment and management should understand the nuances of the subject. My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission.” 1983 Berkshire Hathaway, Chairman’s letter to shareholders, quoted in (Buffett/Cunningham, The Essays of Warren Buffett: Lessons for Corporate America. 1998) p171. (Emphasis added)
The best business
The best business is a royalty on the growth of others requiring little capital itself. This is what Warren Buffett told John Train who interviewed him for a book published in 1980 titled The Money Masters- Nine Great Investors: Their Winning Strategies and How you can Apply Them (Train, 1980).
I like that idea. Many businesses need massive infrastructure to operate. They have property, plant and equipment. They have research facilities. They have inventories and all the rest.
Then there are businesses that only need offices, computers and staff. I think here of insurance brokers, trucking brokers, real estate brokers and so on. They are middlemen. Providing seamless pay-in and payout capabilities to merchants with their customers strikes me as being a middleman.
Last week, using part of the proceeds of the sale of First Quantum, I bought a 4% portfolio position in Nuvei. It trades under the symbol NVEI on both the Toronto Stock Exchange and NASDAQ. It has a market cap of US10.4 billion. It says: “Our proprietary platform provides seamless pay-in and payout capabilities, connecting merchants with their customers in over 200 markets worldwide, with local acquiring in 46 markets. With support for more than 530 local and alternative payment methods including cryptocurrencies, and nearly 150 currencies.”
The company is about twenty years old. The CEO is Philip Fayer who owns 27.9 million multiple voting shares which represent 22% of equity and 37.1% of votes.
The company operates in a very competitive business sector. There are lots and lots of payment processing companies worldwide. The company has no moat. Its TTM return on capital is a modest 6%. Its capital spending runs around $27 million per year. But, it’s free cash flow is many multiples of that.
I was able to buy it at a 23% discount to Morningstar’s estimate of fair value.
I don’t know if it will ever grow into a type 1 company. It has the potential. The fact that it has built the book of business it has at present speaks to the entrepreneurial skill of Philip Fayer and his team. He is only 43 years old. The business of payments processing is very competitive. I don’t find that offputting. If a company can make good money in a competitive business that speaks to combination of business edge and the management skill. I’m content with a 4% portfolio weighting while I watch to see how the company evolves. A year from now I will know the company much better than I do today.
My investment process in buying a position in Nuvei involved thinking about the type of company it is. Clearly it is not a moaty Warren Buffett enterprise. But, over the next five years or so it has the potential to become one. I reflected on whether the company added to the diversification of my portfolio and how it affected the balance. I like the fact it makes decent free cash flow, well in excess of its capex needs. I’m happy to have a 43 year old entrepreneur with a real track record look out for 4% of my portfolio. After all, he has a massive amount of his personal net worth tied up in the company. Our interests are aligned.
To read up on Warren Buffett’s idea of owner earnings see this post:
For more on portfolio strategy see my post here.
For a deeper discussion of balance see the Motherlode Section 36.05 Balance between sectors. Also see a post on diversification and balance
To read further about intangible assets see my post here:
You can reach me by email at email@example.com
I’m also on Twitter @rodneylksmith
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