Opting for quality and selling struggling businesses (TRTN, YELP, CHEF)

I’ll start this letter off with some decisions I made this week that reflect a general theme in my portfolio for the last few weeks – removing run-up businesses with headwinds, adding high quality businesses with a year plus of tailwinds. Here they are:

– Sold CHEF after earnings
– Bought more YELP after earnings and TRTN going into earnings

Low quality businesses have surged in 2021. Low quality is a matter of semantics, but I’ll throw it to the great Eddy Efelbein (PM of an ETF I own, CWS, as well as a newsletter author who is a must read for me) to explain. From his last letter:

By quality, we refer to a company’s overall financial strength. The problem with the quality factor is that no one can agree on the precise definition. Still, even without the exact definition, we have an idea where quality lies.

(As a side note, I’m a little skeptical of how some of these factors are created. I think the process can be overly mechanistic. For example, I’ve discussed in previous issues how the value factor has slowly become a finance and energy factor. I’m not even sure a small-cap factor truly exists.)

Here’s an example of the quality factor. This is a chart of Fidelity’s Quality Factor ETF (FQAL).

More precisely, this is the ETF’s relative strength, meaning It’s FQAL divided by the S&P 500. In simple terms, if the line is rising, then high-quality stocks are beating the market. It it’s falling, then quality is lagging.

The key part of this graph is February to May of last year. That’s when the market started to crash as the coronavirus appeared. Yet FQAL’s relative strength soared. It’s easy to understand why. As everyone was panicking, quality held steady, in a relative sense. When investors get scared, they seek out quality…Since then, quality stocks have lagged consistently. As the rally has gone on longer, it’s become more dependent on lower-quality stocks. A low-quality rally isn’t necessarily a bad thing. Investment dollars need to flow to marginal businesses. The problem is that investors have become very tolerant of stocks without much going for them. 

There are a ton of ways of measuring quality (and you can look at FQAL prospectus if you want more on that index above), but for me personally it’s a few things:

– How managers allocate capital (stock buybacks, dividends, reinvesting in business, pay off debt, etc.)
– Business moat (what does competition look like? what does industry look like?)
– Current financial profile (leverage? cash on balance sheet? debt maturities coming?)
– Future financial profile (are shareholders being diluted over time? is the company becoming more levered? cost of capital?)
– How reasonable expectations are (what does business have to do to meet future cash flows implied by stock price?)

Let’s start with CHEF. The company issued a significant amount of equity last year and has not posted a great quarter in my opinion since I bought it. There are some encouraging signs if you read between the lines in calls, but clearly there are a ton of headwinds and it’s going to take more than 2021 to get back to 2019 profitability. Here’s a snapshot from Q4 earnings:

Net sales for the quarter ended December 25, 2020 decreased 34.0% to $281.7 million from $426.5 million for the quarter ended December 27, 2019. Organic sales declined $177.4 million, or 41.7% versus the prior year quarter. Sales growth of $32.6 million, or 7.7%, resulted from acquisitions. Organic case count declined approximately 47.4% in the Company’s specialty category with unique customers and placements declines at 29.2% and 45.8%, respectively, compared to the prior year quarter. Pounds sold in the Company’s center-of-the-plate category decreased approximately 41.4% compared to the prior year quarter. Estimated deflation was 0.4% in the Company’s specialty categories and estimated inflation was 1.6% in the center-of-the-plate categories compared to the prior year quarter.

Gross profit decreased approximately 42.5% to $58.9 million for the fourth quarter of 2020 from $102.4 million for the fourth quarter of 2019. Gross profit margin decreased approximately 311 basis points to 20.9% from 24.0%. Gross margins in the Company’s specialty category decreased 648 basis points and gross margins increased 87 basis points in the Company’s center-of-the-plate category compared to the prior year quarter. Gross profit results include a charge of approximately $4.8 million related to estimated inventory losses from obsolescence due to impacts of the COVID-19 pandemic.

Notably, they didn’t issue 2021 guidance because of uncertainty around COVID. The company is far away from 2019 on revenues and margins. This in itself isn’t a problem, but the stock has more than doubled since I recommended it and is closing in on 2019 levels:

All decisions in my portfolio have to be comped against opportunity costs. I own companies that issued amazing 2021 guidance (see my post on CROX) and had 2020s that were head and shoulders above 2019 (PYPL, NOW – see my post on Q4 here, NET and more). Many of these companies have really good tailwinds from supply / demand imbalances (ex. TRTN (Q3 post here) benefitting from a shortage of shipping containers and low interest rates giving it a lower cost of capital). CHEF doesn’t have any of these things going for it. The surge in the stock price makes expectations higher and the fact that it diluted equity holders means more shares have to get you to a higher value than before when revenues and profits were higher.

Warren Buffett has said time and time again some iteration of “Watch the business, not the stock.” Many businesses I’m watching that are center of the storm for COVID are recovering but still impaired. As a private owner, I wouldn’t pay as high a price as in 2019, especially if the managers had sacked the company with a ton of debt and issued equity. Yet, if you had watched the stock, you would think things were going swimmingly. 

In contrast, there are businesses where things are going swimmingly and deserve to re-rate relative to 2019. These are what some people call “COVID enabled” names, which to me just really means the pandemic unlocked some part of their business that resulted in higher margins or a better outlook.

– For YELP (a name I haven’t written about but is on my list), the pandemic forced them to lay off a large portion of their local salesforce and bump up efforts to invest in self-serve, driving margins up as self-serve now is a larger portion of business (remember, on a self serve customer, the cost to acquire the customer is zero). It also drove their home and local services business as more people looked to improve their homes and bought homes. Don’t take my word for it though – management is buying back stock and expecting higher EBITDA margins versus 2019 for 2021

– For TRTN, everything I wrote in this post from last quarter remains true. There is a shipping container shortage right now as China (the largest manufacturer of containers) limits product and demand continues to surge as e-commerce grows and demand for other products that are shipped returns. Supply chains are still disrupted because of COVID, which is one reason why freight rates have spiked – I recommend this short article on Maersk’s earnings for an overview of what’s happening in shipping right now. Ports are so crowded many shippers turn away with empty containers rather than wait in line. Meanwhile, Triton’s cost of debt is lower than 2019 due to rates going to zero and high investor appetite for yield. They have called this out as a major cost savings, as they refinanced a large portion at lower rates. TRTN also is buying back stock and I expect will raise dividend. Knowing all this, which stock – CHEF or TRTN – has outperformed in the last six months?

Yep, CHEF’s return has doubled Triton’s for no reason I can think of other than speculation in the worst quality stocks. I bought CHEF originally since I thought expectations were way too draconian – with the price now close to triple what it was then, I can’t back that recommendation anymore. CHEF despite weathering the COVID storm and managing liquidity well through the crisis is facing headwinds; TRTN has the wind at its back.

I think now is the time if you want to reallocate your portfolio to get out of the low quality names you bought during COVID because of low expectations (remember, my analysis back then was legitimately “Which companies have enough cash and low enough expenses to just survive”) and get into the names that have better margins and better expectations because COVID unlocked or strengthened aspects of their businesses. You can buy companies today posting record quarters and great outlooks with lesser expectations than companies that won’t beat 2019 till 2022 at the earliest.