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A long bet paid off big…can Sarma replicate that magic again?

While Warren Buffett believes that diversification is for investors unsure of finding quality companies, smart investors can make large, concentrated investments. Today’s FA Alpha Daily will highlight how Karthik Sarma of SRS Investments hit the lottery with Avis Budget Group (CAR), and the upside of the rest of his portfolio.

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Warren Buffett has had great success over his decades as an investor thanks to his unique and well-thought out investment philosophy. His particular philosophy covers many approaches and disciplines, but one of his thoughts in particular comes into focus today.

One of his strategies around asset allocation is that diversification is for investors who are unsure about the quality of the companies they are investing in.

Diversification isn’t a major part of his strategy for that very reason. Since he is very confident in the margin of safety of his investments, he doesn’t want to be diversified. Rather he wants to make concentrated bets, and hold them for a very long time.

For Buffett, this strategy has led to success not just in the long term, but it has also allowed him to steadily post growth in book equity as well almost every year. This growth in book equity is something that he regularly highlights as it is key to his investing style.

However, not everyone is as blessed as Buffett is when it comes to making concentrated investments with consistent gains every year.

For smart concentrated investors other than the Oracle of Omaha, they still end up with big wins, just a bit lumpier than Buffett’s tend to be.

A great example of this is SRS Investments. Karthik Sarma, who runs the fund, earned $2 billion last year, a total in excess of far better known players like Steve Cohen and Izzy Englander from Millennium.

His massive gains came thanks to an 11-year long bet on Avis Budget Group (CAR) which culminated in him owning 50% of the company’s stock.

When the stock finally took off due to severe car scarcity in 2020 and 2021, he finally reaped massive gains.

While Sarma and SRS had the smart lottery ticket that finally hit after over a decade, let’s use Uniform Accounting to see if the rest of the fund’s holdings are set up to reproduce his performance at the top of the list in the future.

Economic productivity is massively misunderstood on Wall Street. This is reflected by the 130+ distortions in the Generally Accepted Accounting Principles (GAAP) that make as-reported results poor representations of real economic productivity.

These distortions include the poor capitalization of R&D, the use of goodwill and intangibles to inflate a company’s asset base, a poor understanding of one-off expense line items, as well as flawed acquisition accounting.

It is no surprise that once many of these distortions are accounted for, it becomes apparent which companies are in reality robustly profitable and which may not be as strong of an investment.

Contrary to what one might expect with the market correction in the past few months, most of SRS’s largest holdings remain in a better position than you would expect.

The average as-reported ROA among SRS’s top 15 names is a poor 0%. In reality, though, these companies perform more like a profitable company, with a 12% Uniform ROA.

One of the fund’s largest holding Netflix (NFLX), for example, doesn’t return a below average 9%. It actually provides drastically stronger returns, at a 50% Uniform ROA which takes into account their strong tailwinds from the pandemic as well as an increased content catalog.

Some of their other investments are also much stronger than they appear. For example, ZoomInfo Technologies (ZI) does not have 2% returns. Rather, as a company with a strong competitive position, it has an 81% Uniform ROA.

Furthermore, Dynatrace (DT) doesn’t have returns below cost of capital of 3%. Rather, they have immensely strong returns of 56%.

Largely, once we account for Uniform Accounting adjustments, we can see that many of these companies are strong stocks that are priced to grow at strong rates or are fairly priced.

These dislocations demonstrate that most of these firms are in a different financial position than GAAP may make their books appear. But there is another crucial step in the search for alpha. Investors need to also find companies that are performing better than their valuations imply.

Valens has built a systematic process called Embedded Expectations Analysis to help investors get a sense of the future performance already baked into a company’s current stock price. Take a look:

This chart shows four interesting data points:

  • The Uniform ROA FY0 represents the company’s current return on assets, which is a crucial benchmark for contextualizing expectations.
  • The analyst-expected Uniform ROA represents what ROA is forecasted to do over the next two years. To get the ROA value, we take consensus Wall Street estimates and we convert them to the Uniform Accounting framework.
  • The market-implied Uniform ROA is what the market thinks Uniform ROA is going to be in the three years following the analyst expectations, which for most companies here is 2023, 2024, and 2025. Here, we show the sort of economic productivity a company needs to achieve to justify its current stock price.
  • The Uniform P/E is our measure of how expensive a company is relative to its Uniform earnings. For reference, average Uniform P/E across the investing universe is roughly 24x.

Embedded Expectations Analysis of SRS paints a clear picture of the fund. The stocks it tracks are strong, but the markets are already pricing them in for similar levels of growth.

Just as the fund has analysts expecting average ROA to increase to 16%, the market is also pricing these companies to grow their economic profitability to 16%.

After a couple of challenging years due to pandemic related headwinds, Planet Fitness (PLNT) is poised to make a return with analyst expectations of 33% ROA and market expectations of 35%.

However, a company like ZoomInfo (ZI) could also provide some dramatic upside for the SRS portfolio just as Avis was able to do. With the market implying only 32% Uniform ROA, analyst expectations of 50% ROA could be their next big ticket to large gains.

This just goes to show the importance of valuation in the investing process. Finding a company with strong growth is only half of the process. The other, just as important part, is attaching reasonable valuations to the companies and understanding which have upside which have not been fully priced into their current prices.

To see a list of companies that have great performance and stability also at attractive valuations, the Valens Conviction Long Idea List is the place to look. The conviction list is powered by the Valens database, which offers access to full Uniform Accounting metrics for thousands of companies.

Click here to get access.

Read on to see a detailed tearsheet of the largest holding in SRS.

SUMMARY and Avis Budget Group, Inc. Tearsheet

As SRS Investment Management’s largest individual stock holdings, we’re highlighting Avis Budget Group, Inc. (CAR:USA) tearsheet today.

As the Uniform Accounting tearsheet for Avis Budget Group, Inc. highlights, its Uniform P/E trades at 18.4x, which is below the global corporate average of 24.0x, but around its historical average of 18.1x.

Low P/Es require low EPS growth to sustain them. In the case of Avis, the company has recently shown a Uniform EPS decline of 132%.

Wall Street analysts provide stock and valuation recommendations that, in general, provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Avis’ Wall Street analyst-driven forecast is for EPS to decline by 970% and 15% in 2021 and 2022, respectively.

Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Avis’ $208 stock price. These are often referred to as market embedded expectations.

The company is currently being valued as if Uniform earnings were to grow by 8% annually over the next three years. What Wall Street analysts expect for Avis’ earnings growth is below what the current stock market valuation requires through 2022.

Meanwhile, the company’s earning power is below the long-run corporate averages. Also, cash flows and cash on hand are slightly below total obligations—including debt maturities and capex maintenance. Moreover, intrinsic credit risk is 240 bps. Together, these signal moderate operating and credit risks.

Lastly, Avis’ Uniform earnings growth is below its peer averages, but is trading in line with its average peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

This portfolio analysis highlights the same insights we use to power our FA Alpha product. To find out more visit our website.

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