“Buy low, sell high” is the jokingly obvious motto of investors, but for Tom Fogarty, CFA (formerly at Dreman Value Management) it was “sell high, buy low” with his 2014 short position on Hertz (NYSE: HTZ). Fogarty noticed a variety of company events going on with Hertz, including a CEO with sketchy accounting practices, a spinoff of a subsidiary, an acquisition of a competitor, and activist interest from billionaire Carl Icahn. Seperately, these events had created a bullish atmosphere surrounding the car rental company, but together they seemed to be creating a perfect storm of a short opportunity. Fogarty turned out to be right in a way that most investors only dream of.
After posting a short recommendation on Hertz to SumZero in September 2014, the stock took an immediate nose dive. In less than a month Fogarty reaped a 27% return (just over 99% annualized). We sat down with Mr. Fogarty to get some wisdom and insight from this remarkably successful trade that the market didn’t see coming.
SumZero: What about Hertz initially caught your attention as a value investor?
Tom Fogarty, CFA: Two years ago, Hertz announced it was acquiring Dollar-Thrifty, consummating the deal on November 19, 2012 and marking the completion of a multi-year industry consolidation from nine to three major competitors.
When I first started shorting Hertz, the consensus narrative was very persuasive—consolidation would lead to more pricing power, operational changes would improve profitability, and the spinoff of HERC [Hertz Equipment Rental Corp.] offered potential financial engineering and value-creating divestiture possibilities. I’d researched and passed on Hertz several times over the years, never quite sure whether it was actually profitable in an economic return sense. But I like a good consolidation story as much as the next guy, and the industry had consolidated from nine to four firms since I’d last analyzed it, so I thought it was worth a look as a long. When I got around to calibrating the stock price to consensus estimates, I’d done enough initial work to see that a willing suspension of disbelief was the most likely valuation drive.
SumZero: You’re saying the market was fooling itself on the valuation of Hertz?
Tom Fogarty, CFA: I think the price ran ahead of the fundamentals for a number of cognitive/behavioral reasons. The “consolidation leads to pricing power” rule of thumb usually works, and it was validated by rising gross prices. Net pricing was improving too, but not nearly as dramatically. Also, this was partially helped by depreciation rates on the Hertz fleet that seemed inadequate given used car price trends. Additionally, both Hertz and Enterprise seemed determined to keep taking market share in the other’s primary market. I also suspected activist involvement attracted investors that didn’t fully grasp how effectively management’s subjective estimate of residual car values controls earnings in the short run. Used car prices were still unusually high following the supply shock caused by plummeting new cars sales in the crisis, which was starting to abate.
SumZero: So the used car market has an effect on the value of Hertz shares?
Tom Fogarty, CFA: Used car prices don’t have a consistent relationship with HTZ’s share price, but management can influence the timing of the economic impact hitting the income statement. The balance sheet isn’t marked to market, and HTZ’s exposure to used car prices varies over time. When I submitted the Hertz short idea to SumZero, the fleet was mostly “risk vehicles” that Hertz owned outright, with full exposure to the gain or loss realized at the time of resale. More recently HTZ has shifted toward more program cars, which means the car manufacturer guarantees residual value.
If management estimates that falling used car prices are going to rise again, they don’t have to increase the depreciation of the fleet. If they are wrong, then the income statement reflects earnings that will later turn into losses when the cars are sold and the carrying value is reconciled with market value. Comparing depreciation with various industry sources and HTZ’s supplemental disclosures, it seemed to me that its depreciation rates weren’t adequate to keep the fleet’s book value reasonably consistent with market value. I reckoned management decided to make the gamble that used car prices would rise and kept more cars in the fleet than it actually needed. If this strategy didn’t pay off for them, at least it would delay the true-up losses until 2014. I figured 1Q or 2Q 2014 would be a bloodbath, but this didn’t work out since HERC spin-off announcement was positive distraction and with the delayed financials; there wasn’t much evidence yet.
SumZero: Simply looking at the stock chart for Hertz from September to August 2014 , the execution of your idea on SumZero looks like a classic case of “sell high, buy low”. Why did the timing of this trade work out so well?
Tom Fogarty, CFA: SumZero’s Factset Best Short contest just happened to coincide with Carl Icahn announcing his 8% stake and activist intentions for Hertz. I’d been researching Hertz and using the short off and on since late 2013, depending on the price and recent developments. Icahn’s disclosure shot the stock into the low $30s, which seemed like a gift given my prior work. I nearly top ticked it, although I didn't get much traction with folks I'd been keeping up-to-date on it. After all, it was Carl Icahn. I couldn’t imagine anything that would justify sending the stock much higher, but still worried Icahn might have something up his sleeve.
The stock started to drop just a few days after Icahn's announcement. Around that time Hertz announced past financial statements would be restated, the spin-off of HERC was postponed, guidance was pulled completely, and CEO Frissora stepped down. More news started circulating and investors began to comprehend the scale of operational and accounting issues. With no spinoff or guidance, it was hard to ignore that Hertz hadn't been able to report since 1Q14. It also helped that the press picked up on a sell-side estimate that Hertz's fleet needed to be written down $200 million, which was more than I'd used in my analysis but less than I'd feared.
SumZero: One of the main points in your short thesis on SumZero is that consolidation in the car rental industry will fail to meet expectations due to small “quanta of capacity”. What exactly do you mean by this?
Tom Fogarty, CFA: Yeah, that was a silly word to use. My point was simply this, rental car companies can change their capacity in tiny increments, one car at a time in theory.
Industries that consolidate to oligopolies usually see improved returns on capital as a result of higher prices. In many cases, the oligopoly structure results in more restrained capacity growth driven by better coordination among firms, effectively allowing demand to exceed supply enough to increase prices somewhat. Therefore Industry consolidation is always a good thing to bet on, except in the case of Hertz. In other industries like hard drives, containerboard, or railroads, supply capacity additions are measured in billions of dollars and must be added in large chunks (factories, specialized equipment, rights-of-way, etc). Even worse, a company that overbuilds is saddled with excess capacity that it can’t easily get rid of.
Rental cars are fundamentally different. Capacity can be increased in $25,000 increments. Moreover, the long term impact of buying a few too many cars in a particular quarter is negligible, and the fleet can quickly be right-sized by delaying purchases and re-marketing a few more cars than originally planned for a few months. Since there are no lasting consequences from adding a few extra vehicles to try to pick up a few extra basis points of market share, management is more likely to be tempted to “cheat” the oligopoly. Until Enterprise and Hertz reach some sort of detente, there will be minimal ability to raise prices beyond that justified by higher operating costs (such as falling used car values).
SumZero: So why do you think Hertz pursed consolidation in the first place if it wasn’t going to improve pricing power? And further why didn’t investors recognize and act on this opportunity?
Tom Fogarty, CFA: I suspect the acquisition of Dollar-Thrifty was more defensive than offensive. Enterprise had been chipping away at Hertz’s dominant airport market share for a long time.With nearly two-thirds of the off-airport market, Enterprise could take its time and be pretty relentless. Hertz couldn’t fight back on price with the Hertz brand, so it needed a value brand to slow the airport bleed while it invaded Enterprise’s off-airport profit pool.
As for investors, HTZ fit a heuristic that usually works. It took a lot of digging to see a pattern in a bunch of small items that individually didn’t matter to recognize there might be more to the story than the glossy management pitches indicated.
SumZero: That definitely seems to be the case. Other analysts on SumZero had been posting longs on Hertz, both before and since you posted your short idea.
I'm not reflexively contrarian, but I don't hesitate to follow my own thesis when the facts warrant. Given I’d followed the industry before, I thought it would be a straightforward analysis, but It turned out to be a lot of work just to put together a consistent financial statement history that meshed with consensus, particularly reconciling the one-time charges and restatements that seemed to come every year after chairman and CEO Mark Frissora took over in 2007. So, I went through the accounting quality in detail. In addition to my suspicion the depreciation was inadequate, I found other minor issues that were insignificant individually, but as a whole suggested management sometimes made business decisions to maximize accounting optics rather than returns.
SumZero: Are there other industries where consolidation could lead to similar short opportunities?
Tom Fogarty, CFA: I don’t know. This Hertz call isn’t a situation I’d encountered before so I’d guess it’s a pretty unusual situation. I had a mentor who used to say “there’s no silver bullet in investing, you just have to think it through. Every time.” That was sort of preaching to the choir. Given the choice, I prefer to start from first principles and routinely check to make sure conventional wisdom has empirical support.
SumZero: What is your current view on Hertz?
Tom Fogarty, CFA: I’ve got HTZ on a watch list for stocks with no obvious potential either direction. I do think new management has plenty of opportunities to improve operations but I think the impact on profitability is contingent on reaching a détente with Enterprise.
SumZero: Is this thesis representative of the Tom Fogarty investing style?
Tom Fogarty, CFA: I’m not always that far from consensus, but it’s pretty representative otherwise: a few big picture insights, analysis of industry economics and modes of competition, double checking conventional wisdom, selective deep dives, and warranted forensic accounting. I also used multiple scenarios to examine the impact of pricing scenarios and competitive dynamic changes, but still couldn’t justify a high probability support for the margins implied by the stock price. I did think pricing power would improve for HTZ, but a lot less than was expected and certainly not enough to meet consensus. Moreover, it was a pretty crowded long with a potentially huge write-off just waiting to drop, which I figured would make people realize that the business wasn’t nearly as profitable as believed.
SumZero: How has your approach evolved over the years?
Tom Fogarty, CFA: I started researching equities on the sell-side, and while I thought I was a value investor, I often had to operate as if good investment results were a function of the most accurate forecast, which was a function of more/better information than the market. That wasn’t a bad way to make clients happy and it might have been a profitable investment strategy thirty years ago. But I couldn’t find much of a relationship between how much “proprietary” information I had and the accuracy of my ideas. In fact, it seemed like the more I knew, the worse I did.
It turns out there’s strong support in showing that after a handful of key data points are evaluated, incremental information doesn’t materially improve the accuracy of judgements involving a degree of uncertainty, but dramatically increases the decision maker’s confidence. I had developed a minor addiction to academic papers on market anomalies in business school. That eventually lead me to behavioral economics and decision science. Looking for practical applications, I stumbled across The Psychology of Intelligence Analysis, a PDF on the CIA’s website by Richards J. Heuer, sometime around 2000. The parallels were immediately obvious and I started approaching investing as a game of probabilities and decision making with incomplete and ambiguous information.
I’m now more of an “expected value investor.” I still do deep fundamental work, but I tend to avoid making calls on just a single high-conviction forecast. There are also behavioral/decision science advantages to this approach. The effort spent acquiring incremental proprietary information and taking a view (especially if there is intractable uncertainty) and building complex models with minute details builds unwarranted conviction, an illusion of control, and sometimes a feeling that the market owes you a good return for your effort. Moreover, once you've staked your ego on an outcome, it's difficult to assimilate contradictory evidence and catch a mistake before you tilt.
SumZero: Tell me about your investing background and investing mentors and heroes.
Tom Fogarty, CFA: I’ve probably read hundreds of investment related books and even more academic papers, memos and white papers. Some of the standouts are Charlie Ellis, Ed Thorp, Peter Bernstein, Mike Mauboussin is awesome on decision science and behavioral economics, Howard Marks, Nassim Taleb, Ray Dalio’s How the Economic Machine Works articulated my intuitive view of credit cycles very clearly, George Soros, Jim Rogers’ analysis of commodity supply and demand applies to many other industries, James O’Shaughnessy’s quantitative research, Monish Pabrai on risk taking and asymmetry and of course David Dreman, who I’ve been lucky to work for twice.
I also read a lot in other disciplines, cognitive psychology, behavioral economics, history, general strategy, sociology, practical statistics, and general audience science particularly complexity and game theory. A few particularly impactful reads were Stephen J Gould on evolutionary biology, The Social Construction of Reality (which is basically the same concept Soros calls reflexivity), Niall Fergusson’s histories from a classical economics perspective, Sam Savage’s The Flaw of Averages, Kahneman’s Thinking Fast and Slow, and Sklansky’s The Theory of Poker.
SumZero: That’s quite a list. Any other advice you would give to someone interested in pursuing investing, aside from doing a lot of reading?
Tom Fogarty, CFA: Expect to be wrong. A lot. Accept that it’s unavoidable, learn from it and focus on improving your process. Keep a journal and review your investment decisions after the outcomes are known. A quick summary, how you decided, your conviction level, emotional state, any reservations or other details that will keep you honest. You’ll start to see what works for you and what doesn't, and can build from there.
SumZero: Clearly expecting to be wrong can lead to situations where you are unbelievably right. Thanks for taking the time to dissect your win with Hertz, and best of luck going forward.
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