Q&A: Osowsky Capital Sees Lingering Value in Bed Bath & Beyond

SumZero asked Daniel Osowsky, long-time SumZero member and founder of Santa Monica based Osowsky Capital, to discuss his recent investment into retail giant Bed Bath and Beyond (BBBY:US).

Since Osowsky posted his long recommendation on SumZero in late 2014, the stock has appreciated a meaningful 14% (18% annualized). According to Osowsky, there's still room for more. We sat down with Mr. Osowsky to discuss what he saw in the home furnishings chain and his disciplined approach to investing which allowed him to take advantage of the opportunity.

For background, Osowsky Capital, LLC is a registered investment advisor that manages individual, high net-worth, client accounts. The fund takes an opportunistic and concentrated approach to value driven stock selection. Key attributes of Osowsky Capital include its alignment of interests, account transparency, and simple and low fee structure. Since joining SumZero in 2013, Daniel has posted five investment pitches up an average of 29% (33% annualized), none of which have produced negative returns.

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SumZero: What about Bed Bath & Beyond was initially attractive you?

Daniel Osowsky, Osowsky Capital: I like to keep things very simple: good free cash flow, strong balance sheet, high returns on invested capital, able management and a business with a defensible niche. Throw in a cheap valuation and you’ve got my interest.

SumZero: Why did this opportunity exist? What was the market missing?

Daniel Osowsky, Osowsky Capital: In the afternoon on June 25th 2014, I saw headlines that Bed Bath & Beyond stock had fallen nearly 10% on weaker than expected comparable store sales growth and margins. Their results actually weren’t that bad, and yet it was trading at ~10x free cash flow with a pristine balance sheet. In contrast, the broader market was trading at nearly ~20x earnings.

I read the company’s press release and reviewed my notes from prior years. After waiting for over a year, BBBY had finally hit a price that I felt reflected an attractive risk-reward. Shortly after the market opened the next morning, BBBY was a 6-7% position for my Aggressive-class clients with a cost basis below $56.

SumZero: How is the thesis playing out thus far?

Daniel Osowsky, Osowsky Capital: BBBY has continued to perform well, with good execution and smart capital allocation. That said, the bigger driver in rerating the stock ~30% higher was the change in investor sentiment. Should a growing business with great free cash flow and high returns on invested capital trade at ~10x free cash flow? I didn’t think so and Mr. Market came around to my view.

Keep in mind, Mr. Market is sometimes crazy. It’s very possible in an alternate scenario that BBBY could have reported the exact same results and the stock would have been 30% lower. I would actually have preferred this as the company would have bought back even more stock and the eventual recovery would have been much, much greater.

SumZero: You mention that the original founders of the company are still deeply involved in the operations of the company. Given their advanced years between them, are you confident in the company’s plans for succession?

Daniel Osowsky, Osowsky Capital: I actually like older owner-operators. As Buffett likes to joke, it’s hard to teach a new dog old tricks. There’s a lot to be said for experience. Plus, maybe with their age and low stock price it incentivizes them to find a buyer for the company. Despite management’s involvement, running the stores remains a decentralized activity where the store managers have a lot of control.

SumZero: What about competition from online retailers like Amazon?

Daniel Osowsky, Osowsky Capital: What’s interesting is that Bed Bath’s prices, when combined with their 20% off and their $5 off, couponing strategy, (which on first hand observation, are used by almost all customers) are actually comparable or cheaper than Amazon’s prices on many items. Part of Bed Bath’s business model is that customers go in, use up their coupons, and then they’ll buy a few items without the discount. While Bed Bath’s gross margins have been declining slightly since 2011, a large part of this was to offer more coupons. Given that their prices are now comparable with Amazon, I would be surprised if they face significant margin pressures in the future.

The other aspect of the online risk is that customers are shopping online more because of convenience. Bed Bath has been slow to providing a good online presence which currently represents less than 1% of their sales. In recent quarters management has been making new IT investments to address this shortfall including new online interfaces and a direct to home shipping infrastructure (e.g. free shipping on orders over $49 or reserve online and pick-up in store). The near-term downside from these investments is that it makes their margins appear worse than it should be in the future.

Given that Bed Bath has held up well so far without a strong online presence, it’s possible that their IT investments can actually be a tailwind in the future as they have a lot of room for incremental sales from users that prefer online shopping. For example, while Williams-Sonoma’s store-based sales have been steadily increasing over time, their e-commerce operations have taken off and now represent 45% of their total.

SumZero: Is BBBY stock still attractive at today’s prices?

Daniel Osowsky, Osowsky Capital: At the current price (~sub $72), I think it’s possible for the stock to grow at a ~10%+/- CAGR over the next 3-5 years. How many stocks have a ~7-8% free cash flow yield where management uses all of the cash to buy back stock? Not many. If you throw in a little multiple expansion and organic growth it’s pretty easy to see a teens CAGR over the next 3-5 years. That said, would I buy the shares at this price? No, because I like to wait for really fat pitches.

SumZero: Recently Bed, Bath has taken out debt to repurchase shares. What do you make of this move?

Daniel Osowsky, Osowsky Capital: I think the debt funded stock repurchase was intelligent. The company previously had no debt, and now their balance sheet is barely leveraged (less than 1x EBITDA). If management hadn’t done it, the company would have been ripe for an activist to step in. Whenever you have a company with a big net cash balance and a high free cash flow yield, there’s a lot of potential for attractive financial engineering especially in such a low interest rate environment.

SumZero: What key metrics should investors be paying attention to, aside from the obvious top and bottom line results?

Daniel Osowsky, Osowsky Capital: Comparable store sales. Free cash flow. Margins. Management’s intentions with free cash flow (in Bed Bath and Beyond's case, probably more buybacks). Nothing out of the ordinary!

SumZero: Where else do you see value in the market today?

Daniel Osowsky, Osowsky Capital: I’m finding incredibly little value in the market right now so I’ll tell you about my largest position: Cash. I’m sitting on ~65-85% cash depending on my client accounts. Why? If the fat pitches aren’t here, I’m not swinging.

I like to wait for stocks with at least a 20% CAGR over 3-5 years (so at least ~70% upside). I think a lot of investors are fully invested today because they’re mandated to or they’re psychologically unfit to go against the crowd. For most firms, if you hold ~20%+ cash, you clients start walking out the door.

SumZero: Does this mean your are as selective with your clients as you are with your stocks?

Daniel Osowsky, Osowsky Capital: Absolutely. I’m very lucky that my clients are patient and understand the bargain hunting mentality. If you have a time horizon less than 5 years, I’m not for you. Plus when you have a performance fee only cost structure, which is one of two choices I offer, clients know that while I’m not getting paid to sit and wait, I am doing what I believe is the right thing to do. Honestly, I look forward to the day when I’m 100% invested in mouthwatering bargains.

As I tell my clients, if there were 5-10 stocks that I felt had 100-200% upside and little risk of permanent loss, I would be 100% invested right now. The cyclicality of human nature has not changed. I bet I’ll get those opportunities in the next 5 years and maybe a lot sooner.

SumZero: Is the Bed Bath thesis representative of the Daniel Osowsky investing style?

Daniel Osowsky, Osowsky Capital: Absolutely. Investing is all about 1) Defining your circle of competence, 2) having patience and 3) being aggressively opportunistic.

How do you define your circle of competence? I generally restrict myself to companies where I think it’s tough to lose money. How do you lose money investing? Generally losses come from at least one of three categories: 1. too much debt, 2. a lofty valuation or 3. business risks. If a company has 4x net debt to EBITDA, I’ll pass. If it’s trading at 25x earnings, I’ll pass. If they have customer concentration issues, I’ll pass. If they don’t generate lots free cash flow (there goes almost the entire E&P sector) I’ll pass. If management has a history of making dumb acquisitions, I’ll pass.

So by inversion, I felt it was hard to lose money on BBBY at the price I paid. Balance sheet risk? BBBY had a net cash balance sheet when I bought it and now it’s under 0.3x net debt to EBITDA. Valuation risk? At 10% free cash flow it was comparable to the yield they traded at during their low in the 4Q’08. Business risk? All businesses have risk, but BBBY’s are manageable. No customer concentration issues, a growing top-line, and management actively returning all free cash to shareholders.

SumZero: How has your approach evolved over the years?

Daniel Osowsky, Osowsky Capital: My clients sitting on ~65%+ in cash may not believe this, but I used to be more conservative with my investments. My circle of competence was much narrower so I focused on small caps trading around liquidation value or stocks with a very low price to normalized earnings. That approach definitely works. Over time, I’ve started paying up for quality businesses.

SumZero: What is your investing background and who are the investing mentors/heroes?

Daniel Osowsky, Osowsky Capital: Before I launched in 2012, I was an analyst at Ivory Capital, a long-short equity hedge fund based in Los Angeles, and before that I was an analyst at Imperial Capital, an investment bank focused on distressed situations. Prior to Imperial, I worked at a private equity firm called Celerity Partners. Along the way I was also mentored by Goldstein Advisors, a family office in Los Angeles. All of these experiences we’re different and critical to helping me evolve my current investment approach. I was very lucky to have received the generous mentorship I did at each stop along the way.

With regards to heroes, I have two. First, my Dad. It’s impossible to summarize how much impact a key role model can have, but one key event was when I was in high school and he gave me Roger Lowenstein’s biography of Warren Buffett. It changed my life. My Dad also brought me to my first Wesco Financial meeting where I learned about Charlie Munger. Charlie Munger quickly became my second life & investment hero.

SumZero: As a professional investor, what advice would you give to someone interested in pursuing investing?

Daniel Osowsky, Osowsky Capital: Don’t do it, unless you love it. Instead, take your analytic skills and find a company with a high return on invested capital and a multi-decade runway. Apply for any job openings that you might enjoy, or as Buffett has said, “the key to life is to figure out who to be the batboy for.” Companies that fit this profile abound: Google, Core Laboratories, Costco, Ross Stores, Oracle, CH Robinson, GEICO, etc.

This begs the question, why tell people to avoid the investment industry? A couple of reasons. Investing is a hyper-competitive industry. In order to succeed in investment management, you must be a fanatic. I love thinking about stocks every day and would do it regardless of pay. As a matter of fact, I took more than a 50% salary cut when I started Osowsky Capital. Find a job where you can tap dance to work!

Second, the majority of investment managers underperform the market each year. Unless you’re a fanatic where you love looking at companies and you would do it even through periods of underperforming the market, I would advise a different career path.

Third, it wouldn’t surprise me if investment returns in the coming decade are much lower than the historical average. If that’s the case, you’re also swimming against the tide. Unless you love it, do something else.

SumZero: Thank you, Daniel. Terrific interview. Great chatting with you and best of luck with the position and the fund going forward.

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