The Buyside Fireside: Moats, Canadian Small-Caps, and Unlocking Value

While many investors chase returns in well-covered blue chips or hot tech stocks, Torin Eastburn of Monte Sol Capital found incredible value in small and thinly traded Canadian phone retailer Glentel Inc. Eastburn noticed Glentel had a strong business depressed below its true value with an upcoming hard catalyst that could end a recent earnings slump. According to Eastburn’s calculations Glentel was worth 27 CAD/share; three months later Bell Canada acquired Glentel for 26.50 CAD/share, reaping Eastburn a 133% return (1272% annualized). We sat down with Mr. Eastburn to discuss his research and valuation on Glentel and how it led to an investment that was quick, safe, and hugely profitable.

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SumZero: What is Glentel, and how did it initially catch your attention as a value investor? What was the market missing at the time?

Torin Eastburn, Monte Sol Capital: Glentel is a Canadian company that operates retail stores and kiosks around the world for a number of major wireless carriers. I first learned of Glentel when Guy Gottfried of Rational Investments presented it at a conference, and his slideshow was posted online. I didn’t invest, but I was attracted by the apparently low valuation, so it I put GLN on my watch list.

When the stock fell from $20 to $12 a year later despite earning about $1.40 per share, I investigated the company more closely. Ultimately I concluded that the earnings headwinds worrying the market were transitory, and that the market was mis-valuing the company.

SumZero: So Glentel’s earnings had dropped, but why did you think this was only a temporary problem?

Torin Eastburn, Monte Sol Capital: In 2013 the Canadian government shortened the maximum length of cell phone contracts to two years, from three. The intent of the law was to increase consumer freedom, but it ended up hurting consumers. Every time a carrier sells a $700 iPhone or Samsung S6 for $200 with a contract, it loses $500. The new law meant the carriers would be providing customers with subsidized phones every two years instead of every three, and thus they would be losing $500 50% more frequently than before. In order to offset these new losses, all the carriers raised cell phone plan rates by $10 per month.

However, because customers were already locked into their contracts, the carriers could not enforce the higher prices until customers signed new contracts. Consumers obviously want lower prices, so many retained their old contracts longer than they otherwise would have, to avoid signing at the new higher price. And since Glentel gets paid by the carriers based on the number of customers it signs to new contracts, Glentel’s revenue per store in Canada declined considerably in the wake of the law change.

The stock declined too, but the longest this effect could last would be three years—the maximum length of the old cell phone contracts. After that, all the old contracts would be expired, and all customers would have new contracts and regular upgrade cycles. The market priced Glentel as if the earnings impact were permanent, when it obviously was not.

SumZero: What key metrics were you paying attention to as your thesis matured?

Torin Eastburn, Monte Sol Capital: The crux of the thesis was that the decline in Canadian contract volume was not permanent. So I was focused on sales and profits in Glentel’s Canadian division. I understood how per-store sales would develop over time assuming Canadian consumers took the longest possible time to sign new contracts. If Glentel’s Canadian revenue was in line with or better than this trend, I felt that would confirm my thesis. The next quarter, customers returned to Glentel stores to renew their plans at a much higher rate than I expected, I think in part driven by a desire to upgrade to the new iPhone.

Revenue was important for testing my hypothesis about how customer activations would play out in the wake of the change in Canadian wireless contract duration. As for valuation, I generally focus on what the economic profits of a business are. I try to think of myself as the owner of the business and ask, “how much profit am I really making?” Usually the best measure is net income adjusted to reflect the true cash costs for capital expenditures, interest expense, and taxes. Companies often add back a number of expenses that I do not. I treat stock-based compensation, amortization from acquisitions, restructuring, and financing costs as recurring cash costs unless there is persuasive evidence to do otherwise.

SumZero: Was execution difficult given the smaller size of the company?

Torin Eastburn, Monte Sol Capital: Yes. Buying and selling illiquid stocks is always difficult. I don’t think there is a great solution other than to stay patient and price-sensitive even when building a position is taking longer than you want.

SumZero: What were the biggest risks associated with the trade in your view? Retail of any kind does not seem to be a popular investment in this day and age.

Torin Eastburn, Monte Sol Capital: The largest risk, as measured by potential impact on revenue and profits, was the possibility that Glentel would lose a large customer, specifically Verizon in the U.S., or Bell or Rogers in Canada. This was the risk that other investors quizzed me about most frequently.

But I did not think this risk was large when measured by probability. Verizon was actively gifting U.S. stores to Glentel to manage, while in Canada Glentel sold phones from multiple carriers within the same stores, so any carrier that severed its relationship with Glentel risked losing new customer activations to the carriers that continued to sell through Glentel stores.

In general I think that retailing is a bad business, and especially so now that the internet has automated comparison shopping. But a company can sometimes carve out a profitable niche even in a difficult industry. Cell phone sales haven’t made a big migration to online platforms, I think because transferring data between phones is so complicated and the loss of data can be very painful to the customer. People feel more comfortable letting a professional handle the switch. A trip to the store is insurance against losing all your photos of your kids and having to re-enter your contacts manually one at a time.

So you could argue that cell phone retailing is actually a decent niche. And within that niche, Glentel has shown itself to be the best operator. Customer concentration, i.e. serving just one carrier, is a huge problem for cell phone retailers. But Glentel is one of the few cell phone retailers to have reached sufficient scale to have some customer diversification.

SumZero: How is cell phone retailing not commoditized? How was Glentel differentiated?

Torin Eastburn, Monte Sol Capital: Cell phone retailing is largely but not wholly commoditized. The individual businesses can differentiate themselves through real estate locations, sales techniques, in-store experience, etc. But we did not invest in Glentel because we thought it had a strong competitive moat. We invested in it because its managers had demonstrated that they were the best in the industry via years of impressive growth and profitability. There was no reason to think their operational skills would disappear, but there was compelling evidence to believe earnings would grow materially out of the trough created by the regulatory changes we discussed.

It is possible for one business to consistently outperform another even without having a structural competitive advantage. Despite all the talk about huge moats at Coca-Cola and American Express and See’s Candy and so on, Berkshire Hathaway’s largest holding by far is Wells Fargo, a bank. Banking is a commodity service and a simple business. The customer deposits money and then later on withdraws it. In the meantime the bank lends that money. That’s it.

But even in simple businesses like banking, some companies repeatedly find ways to conduct business more profitably than others. Over time these habits can become institutionalized. Eventually one company will develop a culture of doing smart things while another will not. If you look at two companies in the same industry and one consistently grows earnings and book value per share over the cycle while the other needs to raise dilutive capital every time there is a recession, you know which company is which. Glentel’s fantastic financial track record placed it firmly in the first group.

SumZero: Is this thesis representative of the Monte Sol investing style?

Torin Eastburn, Monte Sol Capital: Very much so. We aim to make very large returns, and we won’t succeed unless we are investing in companies that are extraordinarily cheap, or will be very richly valued by buyers, or both. I have an extremely stringent set of requirements for prospective investments. It reads like a wish list that is too good to be true: I want to pay mid-single digit multiples of after-tax cash profits for businesses that are growing, predictable, conservatively financed, generating 15%+ returns on equity, and run by heavily invested insiders. This list of demands borders on unrealistic. Inevitably it must be relaxed at times to allow enough companies into the portfolio to create adequate diversification. But it provides great discipline by encouraging me to ignore all but the most promising opportunities, and to focus on the really great ones when they do come along.

Glentel ticked all the boxes and we made a large investment. We were paying six times my estimate of the company’s EPS after normalizing for the effect of the new wireless contract length. The business uses very little capital in its operations and has consistently earned returns on equity ranging from 15% to 30%. Insiders owned more than half of the company, giving them a tremendous incentive to prioritize wealth creation over paychecks and perks. I prefer to invest in businesses with competitive advantages that are more durable than Glentel’s, but since Glentel met every other criterion I felt comfortable stretching that requirement.

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

Torin Eastburn, Monte Sol Capital: I rarely look at specific sectors or themes for investments. Mostly I read buy-side write-ups and watch insider buying to find new investment ideas. Each year I am looking for one or two great investments that I can make into large positions with great confidence that the risk of loss is very low. In my personal experience these opportunities have arisen for idiosyncratic reasons more often than from market disfavor for an entire sector or asset class.

SumZero: Tell me about your investing background and investing mentors and heroes.

Torin Eastburn, Monte Sol Capital: Just like everyone else, I learned 90% of the important stuff from Graham and Buffett. The other 10% is gilding on the lily. I studied the Classics in college and I also view that as an important part of my investing background. That education was essentially a four-year history class in how humanity’s greatest minds have grappled with its hardest intellectual and scientific problems. Investing problems can be hard problems insofar as reality is always too complex to be dealt with using rote formulas. So, I believe that having an education founded on critical thinking rather than rule following has helped me greatly as an investor.

SumZero: How has your approach evolved over the years?

Torin Eastburn, Monte Sol Capital: The foundations are a value focus and a concentrated portfolio. Those will never change. But over time I have developed increased appreciation for predictable businesses and above-average capital allocators.

I find investing in cyclical or discretionary businesses to be very difficult. When I have believed an industry has bottomed or peaked I have often been wrong, even though my research has been thorough. When you invest in an unpredictable business you almost never have a true margin of safety, no matter how severe the apparent undervaluation. So we no longer invest in those kinds of businesses.

Capital allocation is another factor that can be a prime determinant of an investment’s success or failure. As a passive minority investor in public companies, you almost never access the earnings being generated by the businesses you own slivers of. So you are really at the mercy of the board regarding the use of the retained earnings. Their decisions can have a tremendous impact on the per-share value of the enterprise. A single large acquisition or repurchase at a great price will create more value than a lifetime of operational fine-tuning.

But the reverse is true too, of course. We recently made an investment in a company that dominates its industry and is trading for five or six times its earnings. It generates stable and prodigious profits. But the CEO and board chose to spend those profits acquiring a business in an unrelated, cyclical, highly competitive industry, rather than doing the obvious thing and buying back stock. So we sold at a loss.

I’ll use Berkshire Hathaway as an example again. Berkshire has almost $200 billion in sales and is stuffed to the gills with operating managers whom Buffett praises to the moon. Yet how many of them are allowed to make capital allocation decisions? Not one. Buffett reserves that single responsibility for himself because he knows its importance. And he knows managerial prowess and investing prowess are not the same. I often wish that all public companies had Chief Capital Allocators paid solely with restricted stock with a five-year vesting date.

SumZero: What advice would you give to someone interested in pursuing investing?

Torin Eastburn, Monte Sol Capital: Read The Intelligent Investor. Then read every word Warren Buffett has ever written, starting with his partnership letters. If you lack a business education, take Level 1 of the CFA exam to learn the basics of accounting, valuation, and corporate finance.

Start investing as soon as possible. Lose money quickly so that you can experience first-hand the humiliation of being wrong and paying a monetary penalty for your stupidity. Never, ever forget that feeling.

Keep reading and investing. Read everything. Each moment you spend not reading, you lose ground to your competitors who are reading. Undertake a lot of deliberate practice by making actual investments and putting your theses down in writing, even if you’re the only person who ends up reading them. You can’t just buy XYZ because you think to yourself, “this seems cheap”. That is not investing. You must have concrete reasons for believing that your differentiated view is the correct view. You must be able to explain those reasons clearly to yourself and to others. You must have a strong understanding of the unit economics of the business, and a well-reasoned opinion about how they will change in the future. You must know how the private market values businesses in the industry where you’re investing.

Nobody will be good right off the bat. Investing is hard. By definition you are unlikely to beat the market. You stand no chance at all without thousands of hours of practice. But personally I believe it is possible to consistently outperform provided that you have a contrarian temperament and you are eager to put in the work.

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