January 4, 2017 David Kim
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 “Prosperity knits a man to the World.  He feels that he is ‘finding a place in it’, while really it is finding its place in him.”

  • The Screwtape Letters, C. S. Lewis

Dear Partner,


For the quarter ending December 31, 2016, Forage Capital (“the Fund”) returned +4.1%, net of all fees and expenses compared to +3.8% for the S&P 500 Total Return Index.  The two largest contributors to performance this quarter were ODFL and MRC; the two largest detractors were OAK and SELF.  From inception on July 14, 2016 to year-end, the Fund returned +3.4%, net compared to +4.8% for the S&P 500 TR Index.  Around 54% of the fund’s assets were in cash at year-end.  The other 46% was unevenly allocated across 11 stocks with a median market cap of $9bn.  Lofty valuations and the absence of meaningful, sustained sell-offs within the universe of businesses I find investable, have confounded my efforts to put more capital to work during these first 6 months of the fund’s life.  Considering our significant cash allocation, should the broader averages continue their quiescent ascent, the fund’s performance is highly unlikely to keep pace.


It appears I goofed in purchasing Global Self Storage (SELF) last quarter.  I was enticed by the prospect of a responsibly capitalized REIT rolling up and applying easy operating aid to a fragmented landscape of mismanaged self-storage properties in 2nd tier markets that seemed relatively insulated from excess capacity, and was further encouraged by persistent open market stock purchases by Mark Winmill (the CEO) and Board Members.  But then, in the Holiday Spirit of giving, on the day before Thanksgiving the Company stealthily announced an agreement to purchase, at an egregiously inflated valuation, a self-storage entity in which Mark had a substantial personal ownership stake.  Investments in small cap companies like SELF (~$35mn market cap) are primarily jockey bets and I’ve learned through expensive mistakes that the slightest whiff of value-thwarting self-dealing is usually reason enough to punt.  I sold all our shares at an 11% loss.



This trinity illustrates the path to wealth everlasting: purchase, at a sane price, a company whose unique capabilities allow it to earn a return on capital that exceeds that capital’s cost against an opportunity set vast enough to consume meaningful reinvestment.  The box labeled “moat” is the only one with three outbound arrows because absent a sustainable advantage that repels determined competitors, today’s profitability is ephemeral and tomorrow’s growth is destructive.  And without understanding an enterprise’s excess return-enabling edge, we can’t confidently ascribe value, so it follows that price-to-value assessments are moot. That sounds droolingly obvious when articulated, I know.  But in practice I’ve found that, rather than consider these three factors in balanced unison, many investors subordinate the foundational pillar of moat, casually corralling it as addendum to an alternative angle of attack….


Isolated faith in huge, dynamic markets provokes our basest instinct to extrapolate a company’s growth rates with little consideration for why, besides some sense that what it does tangents some buzz word nourished trend, the company is uniquely positioned to sustainably capture value.  On the flip side, well-intentioned TAM estimates, circumscribed by our limited imaginations, often underestimate the extent to which an enterprise with a capably managed moat can profitably carve innovative niches, redefine use cases, and trespass orthogonal markets: early in its corporate life, Google believed its primary revenue source of licensing its search engine to online portals could be supplemented by an advertising sideshow that might constitute 10%-15% of its revenue at some point; Dwight & Church’s baking soda (Arm & Hammer) was first marketed as a baking ingredient before it blessed laundry detergent, deodorant, toothpaste, and other consumables; that brick & mortar bookstores once represented Amazon’s primary competitive threat seems quaint in retrospect.


Whether assessing value-accretive market share gains in an established market or potential surplus capture in an embryonic adjacency, we’re usually better off starting from the inside and working our way out (understanding the moat that enables profitable participation in an expansive market), rather than the other way around (holding a high conviction view on an industry trend and buying stocks that “play” on that trend). It’s the difference between, say, owning Netflix because you think its flywheel of [subscriber growth/engagement, recommendation engine relevancy, and intelligently bid/created content] offers a sustainable competitive advantage over alternative entertainment providers, and doing so primarily because you’re confident that streaming video will continue taking viewership share from linear TV (we don’t own NFLX). But given that a stock cares not why you own it, do the reasons matter?  Here’s a fictitious, half-way credible stock pitch I whipped up:


Here’s a fictitious, half-way credible stock pitch I whipped up:


“Company X is a small, branded snacks company based out of California with a long but unremarkable history. Unremarkable, that is, until now.  Its newly branded additive-free energy bars are capitalizing on the erumpent appeal of healthy organic snacks, which are rapidly stealing share within the perennially stodgy, low growth convenience goods category.  Following two years of 18% compounded growth, revenue during the most recent year catapulted 80% higher, but even so, the Company’s total sales make up just 1.5% of a $16bn organic foods market that I expect will grow by low-to-mid teens percent for the foreseeable future.  Although the stock price has quintupled over the last year, a 5% market share in five years equates to 7x today’s revenue and, assuming the company holds its margins and the stock holds its current low-30s multiple, a 7-bagger in the stock.”


You’ve likely heard many versions of this cheesy pitch, whose extrapolative allure anesthetizes the pressing discomfort of not knowing why this enterprise, in particular, is well positioned to compete in what seems a crowded, barbarously competitive landscape with few entry barriers.  To me, it looks like a “pass.”


But so, Company A is actually Monster Beverage, the addressable market is alternative beverages, and all the facts of that pitch were true when I passed on the stock in 2005 (back when it was called Hansen Natural), grimacing from the sidelines as it zig-zagged a route from ~$2/share to its current price of $45.


Passing on this stock was clearly wrong. But was it unreasonable? To me, Monster was a middling juice company that hit pay dirt capitalizing on a feverish but likely transient fad in a congested field of undifferentiated competitors, including one dominant energy drink brand and two traditional soft drink incumbents with the marketing heft and privileged retail shelf space to capture whatever surplus materialized. This narrative held more sway with me than another, more hopeful one about a talented management team steering yet another energy drink brand to broad consumer awareness.


While I could have speculated on Monster’s growth rate’s persistence, unable to discern the Company’s edge, let alone the sustainability of its end market, I almost certainly would have mistaken innocuous hiccups for death-impending gasps and fumbled during inevitable bouts of weakness, like when the stock sold off by nearly 70% as it did between ~September 2007 and ~June 2008 on decelerating revenue growth and margin contraction, and even assuming I’d held to June ’08 through gritted teeth, I’d probably have been relieved to exit the stock when it recovered 30% two months later or nearly doubled from its lows 6 months after that. In my shaky hands, this >20-bagger was always an illusion.


As I compare Monster’s current trailing 12 month financials to those of 2005, it’s now glaringly clear that the company has created tremendous value – pre-tax unlevered profits have increased by $1bn on $4.2bn in incremental assets, the Monster-branded beverage line has multiplied, and distribution has flourished, and while I still, a decade+ and 2,000% later, cannot profess much greater confidence in the forward sustainability of whatever advantages enabled these results, my befuddlement reflects more the limits of my own understanding.


I don’t want to hide behind “value lies in the beholder’s eye” but I largely will, because although treating stock ownership as a vigilant journey requires trendline-transcending conviction in some enduring fundamental musculature, the stuff that resonates – I mean, really seeps into one’s marrow – as value-sustaining, is colored by personal biases and experiences that elude systemization, and what seems limpidly obvious to one rational investor is often received by another with a skeptical squint.3 This hippy dippy bluster is not to say that frameworks don’t matter; they yield few answers but evince necessary questions. I’m just saying that within those frameworks, the plausible story arcs we invent and negotiate, the degree of credibility we assign to each, and the resulting confidence needed to carry a position over time, is a personal endeavor. To the extent investment skill exists at all, this must be so: too much systematization (a formulaic approach from start to finish) yields performance that is easily replicated; too little of it (trading on gut) yields no assurance of replicability at all.


1) A company’s equity value is the PV’ed sum of cash flows available to shareholders.  But how does a company maximize this value?


2) By investing lots of cash at really high returns for a really long time.  But how?


3) By fostering unique advantages that competitors find difficult to replicate.  Like what?


4) Those advantages typically fall into a few general buckets – supply side scale economies that enable a low-cost advantage, customer captivity (switching costs, search costs, habit), and network effects (which borrow some elements of both).


How does one build a differentiated brand that translates into a sustainable edge and under what conditions will that brand’s extension into other product lines succeed?  Why are some brands more successful at nurturing habitual consumption than others?  Will Harley Davidson’s brand remain just as relevant 10 years from now amid shifting demographic patterns?  Can and will Google disintermediate OTAs the same way OTAs disintermediated offline travel agencies?  Can commercial insurance carriers disintermediate traditionally sticky broker relationships as personal lines underwriters have?  How do the scale advantages of an integrated PBM model compare to an independent one in the context of a consolidating value chain?  Which content providers, if any, will capture equivalent economics across a comparably large audience outside the traditional MVPD bundle and why?  How does an enterprise cloud provider foster user lock-in in an increasingly modularized computing environment? 


Et cetera.  We might curtail such concentricized involution at the early stages of investigation by, for instance, at least starting with a high degree of conviction that the end market a company serves (or hopes to serve) will exist in meaningful form 10 years hence, which lack of conviction, as mentioned earlier, was a key reason for passing on Monster.[4]  My anti-Monster is PPG, a soundly capitalized century+ old global[5] coatings manufacturer that has averaged low-teens unlevered after-tax return on capital over the last two decades[6] and whose stock I toe-holed at 15x trailing earnings after the Company pre-announced disappointing 3Q earnings on volume weakness in Europe, where it had previously witnessed relatively strong growth.


Our increasingly abstract daily experiences are still mostly framed by a tangible backdrop that’s remained invariant for generations. The building honey-combed with apartments like the one you woke up in, the twin-aisle you boarded and the car you reluctantly drove across the cast-iron bridge segueing to your childhood home for the holidays – all that infrastructure and its attendant complex weave of subcomponents are coated with complex concoctions of resins, additives, pigments, and powders that extend their useful lives and offer various functional and aesthetic benefits.


Salient among PPG’s stable of products: infrared-reflecting / solar-energy deflecting pigments applied to metal siding, roofing, and other architectural components that reduce a building’s air conditioning costs; single-component coatings that delay corrosion on metal substrates, cutting labor and inventory carrying costs for heavy-duty OEMs who have traditionally relied on a 2-coat system; “strippable” coatings systems that allow airlines to repaint aircraft with the original base primer intact, reducing downtime by up to 40%; and light weight fuel tank and fuselage sealant with nearly half the prior generation’s density that can shave up to 2,200lbs off the weight of a wide-body, yielding considerable fuel savings.


The Company’s competitors and industry structures vary by vertical, with architectural (where PPG is #2 by revenue behind Sherwin-Williams in the US and Akzo Nobel in Europe), general industrial (#2 behind AkzoNobel), and auto refinish (leading player along with Axalta) relatively more fragmented than automotive OEM, aerospace, and packaging.  Over at least the last several decades, large coatings companies have competed rationally, realizing consistent pricing gains.  PPG pushed through low-single digit price increases even as raw material feedstock costs (70%-80% of the Company’s cost of goods sold) and volumes declined dramatically during 2008-2009, and has mostly maintained pricing over the last 2 years even as petroleum-based input costs faded once again.[7]  But this is almost beside the point.  Price is a deeply subordinate consideration for customers given the nominal cost of coatings relative to the total bill of materials and labor – an OEM might spend $100 per vehicle on coatings and 4x-5x that amount on application, while a collision shop will spend less than $50 of paint on a $2,000 job.  Replacing an incumbent e-coat supplier can shut down OEM plant production for a week, the lost variable profits and reduced fixed cost absorption dwarfing any incremental cost savings from a cheaper coat.


For aerospace, auto OEM, and large auto refinish customers, technology and a reputation for quality and service are among the most important competitive stress points and represent formidable entry barriers.  Market share continues to shift towards large, sophisticated coatings producers who can meet the intensifying technical requirements of OEM customers at global scale, benefitting PPG, which has typically led the industry in coatings innovation, spending more on R&D than Valspar/Sherwin Williams, RPM, and Axalta combined and leveraging that investment across multiple industry verticals.  Manufacturing coatings that consistently cohere to increasingly diverse substrates of exterior vehicle components, enable compact processing systems – with 2 enhanced basecoat layers obviating the need for a primer layer on a 5-layer job and “wet-on-wet” application eliminating a baking cycle – and ensure consistency in outcomes across plants in different regions, is a complex chemistry challenge inscrutable to smaller players with constrained R&D budgets and limited experience, but increasingly demanded by customers looking to maximize throughput while limiting operating costs and capital investment.  As compact processing expands its current 15% penetration within global auto OEM builds, and continues breaching aerospace and increasingly, more fragmented general industrial markets, incumbents with demonstrated technical leadership should continue gaining share.


Whereas technology and global scale are critical attributes in aerospace and auto, local economies of scale and regional brand strength are more significant drivers of competitive advantage in architectural coatings, which constitute around 40% of the Company’s sales.  As you might expect, the global architectural coatings market is also relatively fragmented, with the top 4 players accounting for 40% of a ~$55bn global market. [8]  PPG has been one of the industry’s most active acquirers, and even after having directed nearly half of its free cash flow towards acquisitions over the last decade, mostly within the architectural coatings market, PPG’s #2 global position and 10% market share still offers a long runway for accretive consolidation as procurement cost reductions, back office rationalization, leverage on distribution costs from geographic densification, and supply chain consolidation drive low double digit returns on deployed capital.  Through its most recent acquisition of Comex, an architectural coatings manufacturer with 4,000 stores in Mexico and Central America,[9] PPG is successfully cross-selling legacy products and extending and densifying Comex’s presence in adjacent territories in Southern and Northern Mexico, where Comex is underrepresented.  In its second largest recent acquisition after Comex, PPG acquired AzkoNobel’s unprofitable North American architectural coatings business and delivered mid-teens margins and return on capital within a few years by leveraging transportation, reducing procurement costs, and eliminating duplicative overhead.


Discerning PPG’s cyclical exposure and positioning is tricky given the Company’s diffuse end-markets, [10] not to mention the more general difficulty of calling the top or bottom of any single end market’s cycle and all the noisome rancor that topic provokes; but, I don’t think the Company’s exposures are as uniformly peak-cycle as one might perceive.  I estimate that more readily-apparent cyclically peak ones like US auto OEM production and commercial construction together make up around 15%-20% of total revenue; below mid-cycle or secular growth pockets like Asia-Pac auto OEM, US residential construction, Latam architectural, automotive refinish,[11] packaging,[12] and aerospace constitute another 40%-45%; and I humbly chuck the remaining end markets somewhere in between.  Within the 40% of PPG’s revenue that are represented by architectural coatings, around 70% is tied to repaints, which should be relatively more stable than coating demand driven by new construction builds.  But, I don’t want to overstate the case.  One need only glance at 2008 and 2009, when performance coatings and industrial coatings volumes declined 15% and 26%, respectively, to see that a deep, globally coordinated industrial recession will leave a bruise.  Still, PPG has the balance sheet to withstand a severe downturn and if 2008 and 2009 are any guide, the Company should remain solidly EBIT profitable and churn prodigious free cash flow during troubled times as its earnings trend peristaltically higher by ~high-single/low double-digits per annum over several business cycles.


Thinking critically about competitive positioning can seem about as exciting as watching paint dry (zing!) and it certainly lacks the aureate appeal of “Y% x $TAM” conjurations. But doing so cements a firmer perch on which to plot a company’s probable value capture path and for me, it’s far saner than white-knuckling it this earnings season because, although the specialty retailer that was supposed to comp 8% instead comp’ed 5% on slowing inventory turns, management promised that this unseasonably warm winter – not structurally waning demand for its game-changing moisture-absorbing thermal collection or a busted athleisure trend – was no doubt the true culprit behind mounting fleece supply, and after these margin-crushing clearance sales abate we’re set up for really easy comparisons next year, and so this multiple-compressing sell-off is actually a chance, nay, an opportunity to advantageously add exposure. This way lies madness.



David Kim




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[1] I am speaking of the “ratings moat” in isolation.  Significantly, Nielsen, unlike Moody’s, does not subjectively assign value; it designs the measurement engine and syndicates the collected results.  Moody’s assigns, Nielsen reports.  An important ancillary advantage to Nielsen’s model is that it allows for unique, proprietary datasets that can be tightly fused and repackaged as organically developed analytics or offered as raw material for 3rd-party app development platforms, but I haven’t really thought this through very well and in any case, this potentiality still depends on ratings buy-in.


[2] For example, “brand” is frequently cited as a source of sustainable advantage by many talented investors, an explanation that while retrospectively valid, seems (to me) in many cases prospectively assailable, partly because I think “brand” is often sophistically assigned undue causal significance to symptoms of moat when in fact there are deeper, truer dynamics at play and partly because, well, it just doesn’t resonate with me – for instance, Jim Cramer(a) pitching LULU on the strength of the company’s brand’s “mindfulness” message.  I’m also hopelessly obtuse when it comes to branded restaurant concepts.


  • No arch-browed snark here. I am a fan of Jim Cramer and listen to Mad Money via podcast every morning.


[4] This (existence of a sustainable end market), too, is subject to interpretation.  W.r.t energy drinks one investor may claim that alertness is easily obtained with more cost-effective substitutes like coffee or sleep, while another might retort that busy millennials with saccharine-sensitized palettes have little tolerance for coffee’s bitter taste in relation to its possible function as an energizing chaser/mixer for party nights (this was the sacred job Monster Energy fulfilled on campus when I was an undergrad).


[5] Revenue by region: US/Canada (44%), EMEA (29%), Asia/Pacific (17%), and Latin America (10%).


[6] Over the last dozen years, PPG has divested commodity chemicals and most of its glass sub-segments and now focuses almost exclusively on coatings.  To compute historical returns, I’ve isolated the Company’s coatings, glass, and corporate segments to more accurately reflect the current mix of PPG’s business.


[7] It typically takes around 6-to-9 month for rising feedstock costs to be recouped by higher prices to customers.  More importantly, PPG’s pricing power varies by vertical, with excellent pricing power in the auto refinish space where customers (body shops) are many and fragmented, but less pricing power in aerospace and auto OEM, where customers are few and consolidated.


[8] Another 40% is made up of small, niche regionals, and the remaining 20% is larger regionals.


[9] 6x more stores in Mexico than the 2nd largest competitor and growing at 2x GDP.

[10] For instance, the architectural coatings market disaggregates into residential and commercial, and each of those sub-segments carries a different mix of remodel/repaint vs. new construction depending on geography.  Auto OEM, meanwhile, is pretty evenly split between the US, EMEA, and Asia-Pac.


[11] This is an admittedly tenuous position as there are at least two believable but conflicting trends underlying automotive refinish, whose drivers are unfurling at different and uncertain rates: 1) continued conversions to PPG’s waterborne coating (PPG has thus far converted more shops to waterborne than all competitors combined), a growing and aging vehicle base in the US, and expanding car parcs in emerging markets with burgeoning middles classes, where car ownership per capita is well below where it is in the United States; 2) lower accident frequency due to increasing penetration of a) Advanced Driver Assistance Systems (ADAS), attenuated perhaps by increased distracted driving (texting) and reduced driver vigilance and b) autonomous vehicles.  I’ll keep an open mind but for now, I am placing the greatest weight on “1)” because it is concretely evident now, relies mostly on the creeping but probable grind of demographic change and global economic progress, and its impact on the auto refinish business has thus far outpaced the headwind of ADA systems, which systems will likely take many years to meaningfully infiltrate the US car parc and whose expense makes comparable penetration less probable in emerging countries.  Mass Level 5 AV adoption and a settling of all the attendant regulatory apparatus and mode of transportation reconfigurations is probably at least a decade out.  In any case, advanced coatings participate in autonomous vehicle production, i.e. paint signatures that allow radars to identify and dimension surrounding vehicles, especially dark vehicles that are difficult for sensors to pick up.  Next generation coatings mixed with nano-sized sensors that report real-time infrastructure assessments are especially Jedi.


[12] PPG has recently taken significant share inside of food and beverage cans with its BPA-free epoxy resins,(a)  whose adoption by food and beverage packaging companies is incipient and growing.


  • According to the Mayo Clinic, research has shown that bisphenol A. (BPA) from epoxy resin lining the inside of cans can seep into contained food and beverage, with inimical health consequences for consumers.