Read the Calls, Not Just the Numbers
Screens are great- but worthless without an understanding of the business model
There are a handful of companies whose conference calls we highly recommend reading every quarter including Starwood Property Trust (STWD), Fastenal (FAST), Texas Instruments (TXN), and Costco (COST) – these are managements who are very focused on long-term value creation and they often discuss several themes playing through the economy.
They also focus more heavily on how their operating model works for the long game. These are straight shooters who will readily admit: “We focus on many products, markets, and customers – not every market is great all the time, and here’s how we invest in times like this.” Normally, the first 10-12 pages of a company’s 10-K report will explain the business model and point to factors that benefit or detract from results. It often explains who large customers and suppliers are and how the sales process and manufacturing process works. It will also normally give very specific risk factors that are important to be aware of as items that can go from bad to better or great to awful and impact results.
It’s also important to recognize that often when a company’s results look ugly at first glance on many basic ratios that computer screens run that’s when there may be more opportunity and value if you understand what is impacting the results and what the company’s operating model is doing.
One of the most informative conference call statements we have seen was Barry Sternlicht of Starwood 8 explaining why his REIT was buying property in early 2018:
“So I do believe in one of the things we all talk about is that our book value is dropping, another place where sweeping computer programs generated looking at our company would misunderstand what’s happening. What’s happening is we are actually lowering our fixed – our payout ratio. We are increasing our property book, it throws depreciation on to our balance sheet. The strategy to be able to conserve cash if we ever needed to, because we won’t have to pay it out, we won’t when we started out being 100% interest income, 95% of all taxable income have to be distributed.
But now that we have this property book, we have the depreciation shield. But the negative impact is it’s driving our book value down, which is different than our peers. But it’s actually an asset because the assets are appreciating, not depreciating. But that takes more [than] a computer screen to figure out.”
As informative as it is, this quote did not mention all of the advantages of STWD’s strategy. In prior years, and in a low interest rate environment, STWD often had a tough time keeping money at work because loans would prepay through refinancing. Idle cash was earning nothing, so low-duration mortgage loans were keeping more cash on the balance sheet as it flowed back more quickly than it could be redeployed. There were also rent increases and more diversification for the portfolio. But, he was correct! The peer group only bought loans and often did it with 30–90-day borrowing and earned the interest spread. STWD had lower income because it matched the duration of investment with financing and now it had property being depreciated that also lowered earnings. Flash forward, STWD has seen its rents increasing at 10% y/y rates. It refinanced the loans on the property multiple times at lower rates and pulled out cash to invest in other areas. The ROI has been incredible – but the stock was being punished for breaking with industry norms.
Many other companies are in similar situations – where investors relying on computer screens will flag the company as having problems, but taking time to understand the business model will reveal that the company is actually in the process of generating significant value. We will examine APD and TXN as examples of companies in this situation.