Performance:
Performance is laid out in the table below:
Investment Program:
The hallmark of the Owls Nest Partners approach is the purchase of industry leading growth companies when a temporary headwind has recoiled the fundamental growth drivers and compressed its multiple. This typically happens as hot money “renters” exit and drive the price down. There is no such thing as a free lunch: we can only access high quality business models with liquid and strong balance sheets, proven management and a long runway of growth and margin expansion, if we accept that our companies will appear “catalyst-less” and therefore may be dead money for some time. Of course, the offset to this cost is that these moments are (ironically perhaps) when a company can invest in its own business with the highest returns, and there is wonderful optionality associated with a well-run, shareholder friendly, cash-laden company that is able to aggressively put money to work during a temporary headwind.
It is our belief (and experience) that our future outperformance will not be driven by any economic or market forecasting prowess but instead by ten unique investments, each playing out over time. We perceive these investments to have modest downside due to high quality and low expectations, and very significant upside as growth and margin expansion return in spades. We seek reasonable ballast and diversification within the portfolio as a result of our natural conservatism (strengthened by our co-investment alongside clients), an unwillingness to think we can predict markets or economies, and a predisposition to avoid crowded trades and instead invest in temporarily out of favor areas.
1 Past performance is not indicative of future results. All returns are presented gross of fees and are preliminary, unaudited, figures that are subject to change. Actual client returns may be different from returns presented herein.
2 Please see the Disclosures at the end of this document for information regarding the benchmark.
Holdings as of 6/30/2019:
We ended Q2 2019 more than 99% invested in ten companies. The current holdings are as follow (in alphabetical order):
Median Total Debt/Market Cap: 4.6%
Median Market Cap: $5,059 million
1Past performance is not indicative of future results. All returns are presented gross of fees and are preliminary, unaudited, figures that are subject to change. Actual client returns may be different from returns presented herein.
Quarterly Attribution:
During the quarter, our gains were a collective effort as nine of the ten companies we own were positive contributors. Our largest gainers were Goosehead Insurance (GSHD), Avalara (AVLR), and Ensign Group (ENSG). GSHD is discussed below, and AVLR and ENSG were discussed in our 2018 review letter http://bit.ly/2018_Company_Overviews). These three were responsible for about 75% of the quarter's performance. Although each of these companies released somewhat stronger than anticipated Q4 results and 2019 guidance, nothing remarkable drove their stock performance. Each also continues, in our opinion, to have a very long runway of growth. Also positively contributing, in order of largest impact to smallest, were FLIR Systems (FLIR), Allegiant Travel (ALGT), Ross Stores (ROST), Floor & Decor (FND), Grand Canyon Education (LOPE) and Fastenal (FAST). Affiliated Managers Group (AMG) was our lone detractor.
Portfolio Adjustments:
We did not sell any positions during the quarter. As usual, we added to or trimmed some positions based primarily on fundamental developments or market action. We used available cash and proceeds from some position size reductions to enthusiastically add a new position, Goosehead Insurance.
Goosehead Insurance Inc. (GSHD):
Where do we start?
Huge industry? Yep, maybe ~$320 billion.
Jacked-up competitors incapable of responding? Big time, since enormous, entrenched dinosaurs will be inexorably ceding share for decades to come.
Great management, culture of innovation, and alignment of interest? They’ve been able to attract and develop talent, energy and technology to the point that they resemble an SEC football team playing a middle school team (harsh but supportable) and their net worth is almost entirely vested in the long-term outcome of the company and its stock.
Capital efficiency, cash generation and no future need to tap the capital markets? Although young, the company generates cash to the point where they have already declared special cash dividends, and all growth is entirely organic and self-funded.
Resilient business model that is not dependent on a strong economy, or predicting the economy, interest rates, weather patterns, etc.? Whatever else people may defer in tough times, they will insure their homes and cars. Their lenders will see to that even if common sense doesn’t.
A great fit for Owls Nest Partners, leveraging our specific structural advantages of capacity constraint, concentration, and in-depth primary research? Yes, and almost perfect given their size (<$1B market cap at entry), differentiated business model, and accounting nuances that require reported earnings to dramatically understate their earnings power.
We even could have started with the shocker that this is the unusual holding to make us real money in its debut quarter, since we are usually a little early and pleading for your patience (and additional dollars).
Instead of all of those points, we’ll start with the fact that this is a holding can save you money as well as make you money!
Goosehead is revolutionizing the distribution and servicing of personal lines insurance – primarily homeowner’s and auto. The company was born out of the frustration of Mark Jones, then a senior partner at Bain. When he and his wife “simply” wanted to insure a small portfolio of residential investment properties, they encountered a tangled nightmare. Why so little choice even though there are literally thousands of property and casualty insurance companies? Why was the choice between a captive insurer like Allstate with only one product to sell or a local independent agent with only a handful? Why did getting hold of your agent require tracking down someone on the golf course? Why was the agent’s technology so antiquated that new quotes or updates took so long? Why could no one effectively and holistically serve someone with properties in multiple states? And so on, and so on.
Mark was in a unique position to figure out the problem. As a consultant to some of America’s largest companies, he recognized the deadly complacency and unwillingness of the leading players to disrupt their profitable models. Additionally, Mark was the partner in charge of global recruiting at Bain. He knew firsthand the challenges and importance of recruiting talent, and he knew that personal lines insurance sales and service was about as low as possible in the pecking order of careers for young people. Not one to look away from an exciting and potentially enormously profitable challenge, and with the personal balance sheet to build a business the right way from the ground up, Mark (and his wife!) set about building a revolutionary model focused on providing the best service, the best value and the best experience for its clients and a culture that could attract young, ambitious, tech-savvy people by, as the T-shirts say that they give away at recruiting events, “Making Insurance Sexy!” And that is what he’s quietly done over the last 16 years, and we don’t think anyone or anything will get in the way of this company becoming a giant in the industry even though, before today, you had likely never heard of it.
There are basically four lenses through which you need to view Goosehead to fully appreciate the value, uniqueness and defensibility of its model – from the perspective of: (i) the end customer/homeowner; (ii) the players in the real estate brokerage and lending ecosystem who are the leading referral sources; (iii) the insurance agent, and; (iv) the insurance carrier.
Insurance carriers are “committed” to markets much like most active managers or hedge funds are “committed” to the companies in which they “invest”. They look at their portfolio, feel they need more of certain risk, try to acquire it, then hope for the best and then dump it when some other risk seems more interesting or when they realize they misunderwrote it and it has become a money loser to run away from and pin on some scapegoat who’s been sacked. As a result, a carrier offering the best value in one market is unlikely to be offering the best value in another. And the carrier offering the best value today is unlikely to be doing so years from now, as it lightens up on that risk and/or someone else decides it’s a risk they want. The key to Goosehead is their representing over 80 insurance carriers and, hence, their unique ability to exploit this fact for the benefit of their clients.
Approximately 60% of homes are covered by captive insurance carriers who sell their product exclusively. Allstate, State Farm and Farmers are the best known of the captives. They are, in our opinion, to the insurance industry what Woolworth’s was to general merchandise or Blockbuster was to video distribution. In the interest of time, let’s just say, that even if the customer service and claims handling of the captives were better than the others – and they aren’t as evidenced by low Net Promoter Scores – it’s just common sense that one would get better pricing when choosing from 80 carriers rather than one. They will continue to yield share for years until the pain gets too great, at which point they will broaden their distribution, and the only logical way to do so would be, by the way, to ink a distribution deal with Goosehead.
The remaining 40% of the homes in America are generally covered by carriers selling through local independent agents. This model makes sense but is most commonly stuck in its 1950’s iteration devoid of scale and technology and is generally populated by tech-phobic 60 year-olds who are upset that their son has no interest in going to work every day of his life in a small office in their home town trying to sell a commodity product with a technique that hasn’t changed since dad got in the business in 1982. Most independent agents represent only a handful of carriers and their ability to best serve clients is compromised to some extent by the need to meet quotas with each carrier or risk losing that relationship. These agents are generally pillars in their community and good people, but their ability to match the expectations of today's tech-focused, demanding, impatient consumers is minimal given their platforms.
From the consumer’s view, Goosehead represents the next generation of independent agent. To begin with, representing more than 80 carriers and with no quotas for any agent, their agents are able to get the best pricing. Additionally, agents are supported by a large Quality Assurance group at the corporate headquarters to make sure the agent has the correct variety and quantity of insurance and is fully compliant with the carrier guidelines. This is still an industry that needs and values human touch and expertise. Homeowner’s insurance is very nuanced, and the risks can be great. Every homeowner knows of horror stories where some poor soul went with the “too good to be true” price, or didn’t bother to read the exclusions, or bought his insurance directly and then suffered the disaster of learning that they were, in fact, completely without coverage. There are models that have tried to go direct and bypass an agent, and they have failed, no doubt because of this justifiable phobia.
On the service side, Goosehead agents are supported by two US-based contact centers where over 160 licensed agents stand ready to answer questions or quickly update policies during all business hours on either coast.
There is no waiting for a single point of contact to get back to you. All of this manifests itself in staggeringly high Net Promoter Scores and customer satisfaction. This would be a good time for you take a break, go find your most recent “declarations page” (which is what they call your invoice listing your coverages), white-out the prices charged, and then email us asking us to put you in touch with a Goosehead agent in your area.
This is an industry where companies spend billions inefficiently trying to attract end customers. It is unclear why anyone would base their decision as to who should insure their primary asset based on cute ads woefully underleveraging the brilliant actor J.K. Simmons who says “we’ve seen a thing or two” (Farmer’s), cute ads featuring Green Bay quarterback Aaron Rodgers and his dog or James Harden’s beard (State Farm), cute ad’s featuring a fictional character called “Mayhem” (Allstate), or tiresome ads featuring Peyton Manning (Nationwide), but nonetheless the industry spends enormously trying to get that end customer to feel good about them. It’s an expensive and ultimately failing strategy when the product is in many ways commoditized, and the decision is very local and based on value. The other expensive way that agents go to market is buying “leads” from websites. This worked somewhat in the early days of the internet, but these leads have gotten very expensive and consumers have gotten much cagier about the completeness or even accuracy of the information they give and better at avoiding the solicitations from the purchasers of these leads. And then there’s Goosehead, who has never paid for a lead or a referral.
Goosehead brilliantly realized early on that with their broad portfolio of carriers, state of the art cloud-based technology platform built on salesforce.com, stable of highly trained licensed agents available at a moment’s notice and industry leading customer satisfaction, they could go to everyone in the real estate lending ecosystem with a great win/win that addressed pain points in home buying and provided Goosehead with ultra low-cost client acquisition costs. Simply stated, Goosehead agents can approach mortgage lenders, title insurers, real estate agents etc. and say “refer business to us, and you’ll never have another problem at a closing. We have 80+ carriers, so can insure any house in the state including ones with flat roofs in flood zones and whatever else is outside the mainstream. We have someone who will cover that. When there is any sort of issue – whether it’s a binder with the wrong middle initial or the need to adjust the coverage at the last minute because the lender tightened standards or income changed – we have 160 agents standing by in contact centers in which 70% of calls are answered on the first ring, and we have a state of the art platform that can make the changes in the policy and email you updated binders in minutes. No more trying to track down a guy who then has to get something changed from a huge carrier’s ancient COBOL-based systems which can take forever and tank your closing. And with customer satisfaction and Net Promoter Scores that not only lead the industry but are among the highest in corporate America, you’ll look good and be doing your client a favor and earning goodwill.” It has proven a wildly successful and almost unstoppable strategy. That’s how this company that few have ever heard of became the insurance agent on 14% of the real estate transactions in Texas, its most mature market, in Q4 2018. And the cost of those leads was precisely zero.
Which gets us to the perspective of an agent. The business model associated with captive insurance agents is a brilliant one – for the carriers. It’s dreadful, however, for the agents, especially anyone trying to get established these days. The carriers force agents to have a storefront, to hire difficult to train and retain customer service employees, use their antiquated systems, sell their limited and often non-competitive product exclusively, sell non-related products like banking, credit cards and investments which are wholly non-competitive, and then, almost pathetically, extend the carrier’s brand at the agent’s expense by sending out tons of mailings which no one in America has opened in the last 10 years. It’s so 1970’s, one almost expects them to make the agents wear leisure suits. But the worst part for the agent is the limitation on scale. For starters, the saturation is horrific (nearly 400 active Allstate agents just in the Dallas metro, for example), and there is no attempt to honor the promise of territory ownership. But worse, a good salesperson gets dragged into management as he or she builds overhead and manages the hiring and firing of needed customer service people and general staff, which limits time spent doing the profitable activity they are good at: selling. The independent agent model is different and better in that the agent can have more competitive products, but they lack corporate support and systems and the overhead and local service distraction is just as real.
The Goosehead model is entirely different in that it separates service (which means everything but claims processing, which the carriers do) from sales, thereby liberating productive salespeople from office management and overhead costs. The Goosehead agent doesn’t need a fancy store front (they typically operate out of shared office spaces at low cost), and they spend nothing on marketing. Instead they just spread the word, seek referrals, take time to get to know prospects and quote them correctly, sell, and repeat with the addition of cross sells at renewals. The beauty of this business is that it’s really just an annuity agglomeration business. With great customer service, cross sell (auto, umbrella), industry leading retention rates and a dose of premium inflation, the profits just pile up on top of the base established the prior year.
Like many proven growth companies, Goosehead is expanding through both corporate-owned offices in markets of high density and franchised offices to cover the rest of the country. The seven corporate-owned offices are the most mature operations and show the power and productivity of the Goosehead platform. Corporate agents are the first to use new technology and tools that Goosehead develops including, for example, a tool that shows on their desktop the transaction volume of every realtor or loan office in their state to make sure they know whom to target. They have a comparative rater that greatly expedites the issuing a quote by linking it to external data sources, so the agent doesn’t have to slow down the process and annoy the potential customer with tons of questions. They are rolling out client-facing technology so potential customers can enter information themselves at their leisure to further streamline the process. And they are armed with that great referral engine that comes with being able to deliver due to breadth, value and service. As a result, corporate agent productivity is more than 3X industry best practices.
The real growth will come from covering the country with franchised agents like McDonald’s did with hamburger joints once they buttoned up that model. As one can imagine, potential franchisees are eager to have access to the technology, the tools and the platform of product. They have an enormous pipeline of potential franchisees, and every day the quality standard is rising. The deal with franchisees is primarily centered around the sharing of commissions. Franchisees get to keep 80% of any first-year commissions earned (around 15% of premium generally compared to 10% at most captives), but the revenue split migrates to 50%/50% upon renewals. Some potential agents bristle and consider that expensive for the support, tools and platform, but the real go-getters understand the potential and the value. There is no shortage of interest, originally from disgruntled captive agents but increasingly from smart, ambitious professionals looking to change careers and have a powerful model behind them.
Goosehead solves real problems for carriers. Those who distribute through independent agents have the massive headaches and costs of dealing with thousands of independent representatives with no standard training, no standard systems, various conflicts, vastly different levels of expertise and no quality control function. Goosehead allows them to have a single relationship with consistent systems and outstanding quality control. As a result, there have been increasingly common instances in which carriers have given Goosehead preferential access to capacity in in regions where capacity was limited and/or paid Goosehead higher commissions than sub-scale independents because of the lower cost of dealing with Goosehead. Additionally, the quality control function that is centralized at corporate uses manual and automated procedures to make sure that every policy is consistent with the latest standards from the carrier and can be easily administered by them. This function has yielded superior underwriting results for carriers which further entices carriers to give capacity to Goosehead and earns Goosehead higher contingency commissions, which is found money based on outcomes that falls to the bottom line. Over the next few years and decades, the power that Goosehead accumulates in this channel will offer very interesting opportunities, although Goosehead is very careful to treat carriers like true partners.
Those who know us and our history, know that we value the pattern recognition that comes with experience. Goosehead reminds us of an investment your PM made a couple decades ago in a young company built on a clean sheet of a paper by a former consultant who believed there had to be a better way to solve consumers frustration in a $300B+ industry, and that it would require new technology and a radically different culture. Austin Ligon and his team sought to transform the used car industry, and CarMax has been a great success.[1] For CarMax, sales have gone up 20-fold in the last two decades and gross profit up 35-fold. Last year’s pretax income was ~10X what the market cap of the company was on that snowy day in January, 2000 when its underwriter discontinued coverage and only those who had done the fundamental work, kicked the tires, understood the model and were nimble enough to own small companies were there to buy. Goosehead is unknown today, but it won’t be for long. In fact, it has a huge advantage over CarMax. Building superstores and populating them with hundreds of cars, building reconditioning stations and financing cars requires a lot of capital and limits growth. Goosehead, by contrast, requires almost no capital to grow. Franchise agents pay for the privilege of joining the team and accessing the platform. With less than 1% of the currently addressable market, the only governor to growth is the ability to attract and retain the right people and stay true to culture of innovation that got them here. And the former head of global recruiting at Bain, who owns more than $600M of stock, will be very careful to get that right. Goosehead can grow extremely quickly, but there is no need to rush. No one is close and no one will be able to catch up.
Lastly, we have to discuss how we got the opportunity. In the Q3 2018 conference call, Mark Jones mentioned the obvious – that to the extent they get referrals related to real estate transaction, all other things being equal, a slowdown in real estate transactions would lead to a slowdown in new business generated. Short-term folks did what they do, and the stock promptly fell about 40%. After all, it was below a billion in market cap, isn’t a great trader because insiders own a slug, and looks expensive based on current earnings if you don’t understand the annuity nature of the business model and if you don’t understand how the franchise model works in which Goosehead makes almost no money in year one when it has production costs and receives only 20% of the commission but where it mints money in all future years when direct costs are modest and they get 50% of the commission plus 100% of any earned contingency commissions. But history makes us believe that a company like this, at this stage of its life and in an industry this big will grow rapidly through any slowdown. Don’t forget, the slowdown only affects new business, not the close to 90% that renewed from last year. And a housing slowdown doesn’t affect other referral sources including financial planners and, most importantly, the ever-increasing book of highly satisfied clients. And people focus a lot more on saving money during slowdowns. But all those “investors” who use artificial intelligence to scan transcripts and search for “slowdown” in conjunction with other things, as some do, did what their algorithms told them to do: to sell or short. We thank them. We did our work, and we learned what we’ve shared above from a whole host of sources including all the people we’ve referred to various Goosehead agents saving them lots of money and filling holes in their coverages they didn’t know existed and upgrading their carriers. So, go find that declarations page.
[1] KMX is presented here for comparative purposes only and was not selected on the basis of performance. This is not a recommendation to buy or sell KMX. Owls Nest Partners IA, LLC has never purchased KMX for any portfolios for which it is the investment adviser. The portfolio manager has in the past purchased and sold the stock while at other investment partnerships, however, has not owned this company in any capacity since 2003.
Closing Thoughts:
We love what we do because we spend our time talking to suppliers, customers, competitors, etc., so we can put the mosaic together and figure out the long-game. It’s fun and can drive great financial returns, but it can really only be done most effectively within a concentrated portfolio and with limits to capacity. Which is exactly why we think this analysis applies to our own business. We think we have the better mousetrap that other players cannot compete with because they have scaled and are trying to be all things to all people, which at some point leads to index-hugging and mediocrity. With their size, our larger peers will generate a lot more management fees than we do and will laugh all the way to the bank. But, we believe we will perform much better for our clients, which is the metric we care most about. And in the long run, maybe some very interesting things will happen for everyone.
Thank you for the support and the decision to have your money working alongside ours.
Gratefully,
Philip & the Owls Nest Partners team
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Investment strategies, market conditions and risk disclosures: Notwithstanding the general objectives and goals described in this document, readers should understand that the Adviser is not limited with respect to the types of investment strategies it may employ or the markets or instruments in which it may invest. Over time, markets change and the Adviser will seek to capitalize on attractive opportunities wherever they might be. Depending on conditions and trends in securities markets and the economy generally, the Adviser may pursue other objectives or employ other techniques it considers appropriate and in the best interest of the Fund. No representation or warranty is made as to the efficacy of any particular strategy or actual returns that may be achieved.
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PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS
Disclosures