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One of the most important tasks of the Fairlight investment team is identifying and considering the risks inherent in the investments we make. Across the market there are many different approaches to measuring and managing risk, however at Fairlight we define risk as the probability of permanent impairment of capital (i.e. losing money). In an attempt to reduce the risk of permanent capital loss, the Fairlight investment strategy only invests in quality companies; a determination we make qualitatively by searching for companies with long track record of profitability, conservative balance sheets, strong competitive positions and purchased at a reasonable price. Generally, these characteristics are matched with a steady, predictable earnings profile, however this is not always the case.
One shortcut that quantitative quality indexes use is to lean on low earnings variability as a formulaic input into a quality assessment. While low earnings variability is theoretically an attractive trait, the flipside of this from a risk perspective is that variability and randomness breeds resilience. A company that faces no challenges may become fragile compared to the company that must adapt to a changing environment. As investors we try to remain aware that sometimes low variability can lead to hidden risks, and as we demonstrate with portfolio holding Landstar Systems below, sometimes high earnings variability can counterintuitively lead to lower overall risk.
Thanksgiving Turkeys and low earnings variability
One way to illustrate the potential hidden risks associated with metronomic earnings growth is the Turkey illusion cognitive bias, first proposed by philosopher Bertrand Russell. Consider a turkey, earmarked for a Thanksgiving feast, who is well fed at the same time every day. As each day passes, the turkey’s confidence in its future wellbeing and the accuracy of its mealtime prediction increases. As Thanksgiving approaches the turkey has confidently forecast several decades of consistent feeding into its spreadsheet model only to find that at the point of maximum certainty it is not fed, and instead slaughtered. Investors relying solely on past patterns of low earnings variability in companies might be akin to the Thanksgiving turkey assuming it will always be fed, highlighting the importance of understanding the nuance of each company.
The trucking company that owns no trucks
One portfolio holding that demonstrates the sometimes-counterintuitive nature of risk and volatility is Landstar Systems, a US based logistics company. Despite Landstar being classified from a sector perspective as a trucking company, it owns no trucks. Landstar generates revenues by providing a marketplace that connects two highly fragmented parts of the trucking ecosystem. One side of the network is 50,000 truckers (90%+ of whom are sole traders or “CEOs on wheels”) who rely on Landstar to provide them routes that maximise the utilisation of their truck and enable them to work flexibly on their own terms. On the other side of the network is hundreds of thousands of businesses who rely on Landstar to connect them with the massively fragmented trucker market when they require freight moved from A to B. In the center of this network is Landstar’s 1,200 agents who are incentivised on a commission basis and own and manage their own small businesses under the Landstar banner in a decentralised structure.
Volatile short term revenues but strong structural tailwinds over the long term
Landstar takes a fixed percentage of each load moved across its network, meaning its revenues are ultimately driven by two variables; 1) number of loads and 2) the price per load. Both variables are cyclical in nature (see Figure 1), with volumes influenced by the overall economy and price by the supply/demand dynamics in the trucking industry.
Figure 1.
As a result, Landstar’s revenues can be volatile and unpredictable over the short term, however we can conclude with reasonably high certainty that over the long term, the volume of goods moved by truck in the US and the price charged for the service will be higher than today.
Volatility builds resilience
Given the uncertain short term environment that Landstar faces, it has had to build a business model that is resilient to variability and randomness. When we assessed the risk of the business, the following factors underpinned our conclusion that the probability of permanent impairment of capital over a long term time horizon was perhaps lower than appreciated by the market:
• Decentralised model: Landstar’s army of agents all operate as their own decentralised small businesses, meaning they are more agile than large organisations with the ability to make rapid decisions and pivot quickly when faced with a changing environment.
• Limited operating leverage: Landstar takes a commission of agent revenues, meaning it has limited fixed costs. When revenues decline, costs also decline in lockstep protecting profit margins and ensuring the business is profitable regardless of the macro environment.
• Strong balance sheet: Landstar uses no debt, eliminating financial risk.
• High cash flow conversion: Landstar itself does not own any trucks, meaning capex requirements are low and the business is cash flow positive at all points in the cycle.
• Reasonable valuation: Despite its strong financials and long-term structural growth tailwinds, during 2022, Landstar was trading on a low teens earnings multiple/7% free cash flow yield.
The Fairlight View
The process of evaluating and measuring risk is a complex one and it is our view that risk ultimately cannot be captured by one metric or figure. At Fairlight we seek to invest in quality companies available at a reasonable valuation, generally because the market underappreciates some aspect of the business. In the case of Landstar, the market’s narrow focus on equating low earnings variability with risk meant that a business with, in our view, low risk of long-term capital impairment once all nuances in the business were considered was available at an attractive price.