1 Past performance is not indicative of future results. All returns are presented net of all fees that would be paid by any Owls Nest Partners Concentrated Long Only SMA client, and are preliminary, unaudited, figures that are subject to change. Actual client returns may be different from returns presented herein
Quarterly Attribution:
We had nine stocks that were gainers in the quarter. Gainers, in order of largest impact to smallest, were Floor & Decor (FND), Avalara (AVLR), Goosehead Insurance (GSHD), Allegiant Travel (ALGT), Affiliated Managers Group (AMG), Progyny (PGNY), Ensign Group (ENSG), Grand Canyon Education (LOPE), and Five Below (FIVE). Our only decliner was the newly initiated position, Interactive Brokers (IBKR). In general, those companies who could still grow through the pandemic performed extraordinarily well, while others generally had rebounds of various degrees off the very depressed levels where they closed the first quarter but still remain well below the highs they established pre-pandemic.
Portfolio Adjustments:
We had, by our standards, an active quarter as we took advantage of volatility to move dollars to where we think they could garner the greatest value and firepower to drive performance for the next couple years. We established a new position in Interactive Brokers Group, Inc., discussed below, and we added meaningfully to our recently established position in Progyny, Inc., also discussed below. We also added to our positions in Ensign Group, Goosehead Insurance, and Allegiant Travel.
Ensign Group, Allegiant Travel and Floor and Decor share a common Owls Nest trait in that they operate with a radically different and superior business model than the rest of their peers in their industry. As such, we are periodically given great moments to invest when their industries are out of favor for whatever reason. The paradox, however, is that whatever is hurting that industry almost by definition disproportionately hurts the weaker players with the weaker business models and hence leads to significant share gains and long-term opportunity for the stronger and differentiated company. And while this is playing out, the stock is available at very depressed prices because the vast universe of “investors” who manage money based on short-term visibility and with only superficial knowledge of their hundreds of holdings, elect to stay away from the entire industry. Admittedly, the timing of when the airline operator Allegiant can take full advantage of the vast retrenchment of its competitors remains very uncertain. But every day we have to wait means more pain and retreat for the weak and more long-term upside for Allegiant. The situation is very different for Ensign Group whose incredible operating momentum has garnered little attention from an investing community that has no appreciation of Ensign’s uniqueness, and has little desire to be invested in any operator of skilled nursing facilities until the pandemic dust settles. COVID, however, will prove to be a great catalyst for Ensign’s long-term growth as the regulatory and financial burden coming will put a crushing blow on the smaller operators who still make up the vast majority of this incredibly fragmented industry. In the same vein, Floor & Decor’s ability to accelerate share gains due to COVID is almost unfair. Local flooring retailers in small stores in strip malls still constitute 60% of the flooring industry. These “mom & pop” retailers are unable to compete with Floor & Decor’s ability to offer a full online shopping experience, virtual in-house design consultations, operate out of 80,000 sq. ft. stores which make social distancing easy, offer store pick-up where the contractor can just stay in the truck, keep their supply chain working and to remain fully inventoried, and so on.
We were clearly excited by the opportunities we seized in Q2. To fund those investments, we lightened up on Avalara and sold our position in Five Below. We remain extremely enthusiastic owners of Avalara who is a great beneficiary of the COVID-based acceleration of e-commerce. Furthermore, the company is making the investments needed to greatly expand their long-term market opportunity beyond the automation of sales tax calculation, remittance, and compliance in the United States. We expect to own Avalara for a long time but thought the portfolio would have better balance and value by shifting a few dollars to the names above. Five Below remains a very special business with a lot for runway for growth. It is very possible that we might own it again. However, we felt that we had our full budget of COVID-related risk elsewhere and opted to take advantage of the “re-opening rally” to sell our position and reduce that risk.
Progyny, Inc.:
The best and most rewarding way for us to accomplish our primary goal of making our clients money is to own companies that solve big intractable problems and have a great impact on many peoples’ lives. Perhaps we can debate just how profound the societal benefit is of, say, giving consumers the ability to save 30% on their flooring while also providing better service and product. Few, however, can challenge the societal benefit of Progyny’s service offering, and anyone who digs deep will also appreciate the magnitude of their financial opportunity.
Even its defenders must acknowledge that the U.S. healthcare system is occasionally very irrational. The current treatment of infertility and the state of fertility benefits coverage is a prime example.
Infertility is stated as “a disease of the reproductive system defined by the failure to achieve a clinical pregnancy after 12 months or more of regular unprotected sexual intercourse.” Infertility is included in the International Classification of Diseases, just like cancer or diabetes. And for those who suffer from this disease, they know that without treatment they may live another fifty or sixty years in perfect health otherwise but never be able to accomplish perhaps their single most important life goal.
You would think something this important and this enormous would receive robust public discussion and support. But infertility has grown in the shadows. Unlike cancer or diabetes, our society as well as societies going back to the beginning of time have long had a stigma associated with infertility. Cancer was bad luck, but infertility was a sign of inferiority or even punishment from some higher being. Fully insured health care plans and corporate self-insured plans provided little or no coverage, and the fertility industry has necessarily grown up as a private pay market, which has led to monstrous issues related to expense and access.
As the world has slightly awoken, states have begun mandating some coverage for infertility be included in insurance plans. Employers, perhaps out of guilt or fear of lawsuits, have responded by including some sort of benefit, typically a fixed amount lifetime benefit of somewhere between $10,000 and $25,000. A fixed lifetime benefit effectively communicates “Look, you’re on your own. Good luck. Submit receipts to us and we’ll reimburse you up to $10,000. We know that’s a drop in the bucket compared to your costs which will likely be multiples of that, but hey it’s a tough world out there and we can’t do everything. And, hey, dealing with infertility strikes us as a nice to have, not a real disease.” As a result, most people dealing with this disease go through it with no guidance and having to pay for most if not all the treatment out of their own pocket. Imagine the stress if you had to deal with the most important issue of your life with such little support.
And then there is the practical, financial view. Anyone who might think “that’s sad, but it can’t be unicorns and rainbows for all” needs to appreciate the following: If there is one product or service that proves the admonition against being “penny wise and pound foolish”, treatment of infertility is it. Follow me through a typical scenario: A woman tries to conceive naturally for 12 months, or 6 months if she is 35 or older before being declared medically infertile. Her employer provides her with a $25,000 capped fertility benefit. Her company’s insurance carrier (true to its ethos of restricting access and engendering stress) requires her to go through two cycles of intrauterine insemination (“IUI”) and fail before she could be authorized for in vitro fertilization (“IVF”). She already cannot work with her doctor-of-choice because many of the top performing clinics don’t accept managed care insurance (30% of providers in Progyny’s network do not take carrier coverage) as they have thriving cash pay practices and do not want to deal with the hassle of working with the carriers. So, to simply start the process she needs to choose a sub-optimal clinic who has a track-record of worse outcomes. And most likely, this doctor does not believe IUI will be effective because, with an average success rate of 5% to 15%, it usually is not. The mandated step therapy of IUI wastes 2 months and burns through $8,000 of her $25,000 coverage. Once IUI fails, she now has the carrier’s authorization to pursue IVF, but IVF on average costs $25,000. So, she works with the finance department at the clinic (yes, fertility clinics have finance departments on-site like a car dealership because this is such a problem) to secure a loan to pay for the rest of the treatment. Since this is already expensive and the carrier does not cover it, she decides to skip genetic testing of her embryos. This results in a failed pregnancy, she is now out of $8,000 of her own money, has gone through a traumatic emotional and physical experience without any emotional support or guidance, and now needs to borrow more to go through a second IVF cycle to get pregnant, now with no help from her employer or insurance.
With her second loan secured, she wants to ensure she gets pregnant this time because she can’t afford to take on any more debt before taking on the costs of a new child. So, she again makes the trade-off of care for cost, and instructs her doctor to transfer multiple embryos. This time she was successful and was able to give birth! But, to preemie twins… And this is incredibly common as IVF is the number one cause of multiples, and multiples are the number one cause of preterm births. This results in neonatal intensive care unit (“NICU”) stays for the baby, an extended time off for the mother, and poor productivity if and when she gets back to work.
And here is the rub. Who pays for those bad outcomes – the days or months in the NICU, the chronic issues associated with underweight, preterm babies, high risk pregnancies, et al., when an employee of a self-insured company goes through this process? The employer pays. Restricting access on the front end saved some money, but those savings are swamped by the costs on the back end. And this is to say nothing of the non-financial costs.
Enter Progyny. Progyny was created to solve one problem: better fertility experience and outcomes for patients. It is a seemingly Sisyphean task to attempt to change the healthcare system, but Progyny realized they could by first approaching the self-insured employers who bore the cost on the back end, especially those who were competing for talent. Studies show that to a woman in her early thirties, fertility benefits can often rank above salary, title, location or any other aspect of benefit coverage.
Progyny created a benefit plan design that is entirely focused on best outcomes and removes the perverse incentives in the existing system. Each plan is customized to each patient and follows rigorous best practices including genetic testing up front. Progyny assigns each patient a patient care advocate (“PCA”) who guides the patient through the process. On average, a patient speaks with her PCA 15 times during a treatment cycle, and that comfort helps drive a Net Promoter Score in the 70s whereas healthcare insurers typically are close to zero. Progyny partners with its network of IVF clinics regarding best practices and data sharing. This network loves receiving Progyny clients because there are no restrictive protocols, and there are no marketing costs, collections costs, or risk. Hence, they eagerly pass on the discount to private pay rates which forms the basis of how Progyny gets compensated and contributes to their ability to save the system so much money. Progyny’s powerful early clients like Google applied the pressure necessary to get carriers such as United Health to integrate systems with Progyny, enabling this carveout to be part of the broader health plan and ensuring that the benefit could be funded with pre-tax dollars. In 2018, Progyny added a pharma benefit to coordinate the administration of fertility drugs which greatly reduces waste and over-prescription and saves employers typically 25%+ on these costs, while assuring proper usage and timely delivery of necessary drugs.
The results of the Progyny program are staggering and easily verified and quantified because the Center for Disease Control (CDC) collects all results and data from all clinics in the nation. Outcomes for greater pregnancy success include 14% better pregnancy rate per IVF transfer, 30% reduction in the miscarriage rate, 23% better live birth rate, and 88% single embryo transfer rate compared to 58% average nationally. The result is a much lower multiple birth rate at 2.4% compared to 12.2%. The data makes it easy to show to customers that they are going to spend less on money on higher risk preterm births. And because Progyny is the only company who manages this process throughout the full episode, they are the only ones with such data. Competition, be it from the carrier directly or some concierge added on to the carrier’s plan because of patient dissatisfaction with carriers and at additional expense to the employer, loses track of the patient once the patient exits the insurance program and starts paying privately. Hence, they can never produce the outcomes data that Progyny has. Further they don’t have the network quality or collaboration. And when it comes to something like this, why would you ever hire anyone who doesn’t have the experience, the data, the network, the reputation for quality, once you have “seen the light” of managing the treatment of infertility. And with the nation spending more than $33B on the direct costs of high-risk pregnancies, very low birth weight newborns representing less than 1% of all births but accounting for 36% of total newborn hospital payments, and preterm deliveries and indirect costs of ~$6B due to lost productivity, more and more employers will see that bright light. And this does not even include the real but slightly less tangible benefits for employers in terms of ability to recruit talent and improved morale. We had one long time HR executive tell us that in his 35 years of overseeing plans for large employers, no new benefit ever got anywhere near the enthusiastic and emotional positive response from his employee base as when he announced the addition of Progyny to the benefits package.
Progyny has an incredible amount of growth ahead of it. Just within the self-insured employer market, it has only 132 out the more than 8,000 sizeable plans and covers only 2.1M lives out of the nearly 70M covered by self-insured plans. Furthermore, it can expand horizontally into other areas related to pregnancy and childrearing that are poorly managed and can leverage their existing relationships, trust, and base of trained PCAs. Clients that we have spoken to have made it clear that they would be keen on having Progyny manage additional aspects of their employees’ family journey. And within fertility, with scale will come excellent opportunities for vertical integration of associated services such as testing which would increase profitability while improving product quality and outcomes through tighter integration. And fertility is a growth market anyway due to demographics and preferences for having children later.
We can’t believe our luck as to timing. In a stock market where visible growth might trade at prices never seen before, we believe COVID has created an opportunity to buy cheaply a company on the verge of more than a decade of visible, straightforward, even inexorable growth.
Part of the discussion of timing relates to the current headwind the company faces and which explains the stock being well below its pre-COVID prices. Fertility treatments got lumped in with elective surgeries, and many IVF clinics were forced to shut down or curtail activity which would lead to a proportional decline in revenue for Progyny. We aren’t terribly bothered by this because the company’s variable cost business model, low cost structure and balance sheet strength are such that Progyny had the flexibility to do the right thing and keep the team and PCAs intact once the pandemic hit and clinics shutdown. And while other things may be deferrable, the decision to have a child is very much time sensitive. Unlike the provider network for most medical procedures, the fertility network has plenty of excess capacity to absorb increased demand as things open. And going to a fertility clinic is obviously much less risky than going to a hospital. We have no doubt that current business will bounce back strongly. And this is a benefit, once offered, that will never be withdrawn.
But the impact of COVID on new sales cycles is much less clear, more nuanced, and much more interesting.
Based on where the stock is trading, the market believes understandably that Progyny will hear a lot of “Sorry. Unsure times. Can’t add any benefits.”. And we expect they will hear plenty of that, especially from CFO types who have never been exposed to Progyny or analyzed their healthcare expense data. But this gives no credit to Progyny for being able to lead more with cost savings and disregards the fact that there are plenty of companies who are killing it, especially in technology where Progyny enjoys great success and where the competition for talent is as extreme as ever. And with only ~2% penetration of their current target market we think they will sail through this, at least when viewed through the lens of our investment time horizon.
But the discussion above also ignores societal changes. We are approaching a watershed moment for this industry. The discussion of offering coverage for treatment of infertility is changing. The world is focusing more on discrimination and inclusion. #MeToo was part of our initial thesis, but Black Lives Matter may end up having a more dramatic effect. The conversation is changing from “wouldn’t you feel good doing the right thing for your people (and saving money and going up in the employer ratings surveys)?” to “Do you really want your benefits package to be patently discriminatory by not providing coverage for a disease that impacts one in eight people of child-rearing age and which is perhaps the most important benefit to women under 45 and to members of the LGBTQ community? And for a disease that affects African American women twice as often as non-hispanic white women?” The dam might break sooner or it might later. It might happen through the market or it might happen due to legislation. But the dam will break. And when this huge market needs management and coordination, Progyny will be uniquely positioned to profitably oversee billions of spending. We love the win/win/win Progyny provides their partner clinics, their employer clients and their employee patients. We look forward to a fourth win – our very substantial long-term profits.
Interactive Brokers Group, Inc.:
When we speak about the financial markets of today, we sound very much like William Wordsworth lamenting the onset of the industrial revolution: “The world is too much with us…” Intellectually, we are still romantic believers in the notion of well-informed, long-term investors meeting underneath the buttonwood tree for the occasional trade. But, instead the world has embraced an ever-accelerating explosion of financial “innovation” in which too often, in our view at least, trades aren’t even initiated by humans, knowledge of the underlying company is superficial at best, and “investment” time horizons are measured in nanoseconds. Rather than bemoan the state of affairs in iambic pentameter, we prefer to figure out a way to make a fat profit. Always struggled with poetry, anyway.
At a high level, our entire investment program is premised on taking advantage of traders less informed, less patient, and less tolerant of short-term volatility (which is only a problem for those who aren’t informed and who can’t be patient). But in buying Interactive Brokers Group (“Interactive”), we’ve gone one step further. We’ve invested in the premier arms dealer to those wishing to wage war against their fellow traders using derivatives, leverage, algorithmic trading, global arbitrage and the like.
To appreciate, Interactive’s future, one needs to understand its past. Its founder, Thomas Peterffy, arrived in this country essentially penniless as his family evaded communist takeover of Hungary. Peterffy taught himself how to program computers and built trading software for Wall Street firms. He used his savings to buy an exchange seat and developed innovation around trading, compliance, and risk management technology to the point that by 2000 his company had captured 20% share of the worldwide listed options market. As profitability in the options world began to decrease due to smaller spreads, Peterffy realized that his automated platform would be perfect as a low-cost brokerage platform for active traders, and Interactive Brokers was born.
While other brokerage platforms were busy collecting accounts through innovation-killing consolidation or by spending a fortune on brand building advertising, Peterffy followed the only playbook he knew: automate, automate, automate. This focus on productivity explains why the company’s revenue per employee is ~$1.3M compared to ~$0.5M for Charles Schwab, and it explains why 70%+ of the employees at Interactive are programmers as is the majority of senior management. The barrier to entry that comes with a multi-decade start on automation is hard to overestimate. Not only does this radically lower Interactive’s cost structure, but it drives consistent share gains through the ability to offer a superior product offering and tools for the customers that other brokers will never be able to offer. For example, their costs are so low and the pricing they offer so competitive (pricing in this case refers to interest charged on margin, interest paid on idle cash, amount shared from proceeds from security lending) that if other public brokers were to match Interactive’s pricing effectively all of their brokerage profitability would evaporate. Today, for example, on a $300K margin loan Interactive charges clients 1.21%, while TD Ameritrade charges 7.50%. But beyond being low cost, Interactive offers a superior platform given their integration to vastly more markets and products, and the ability to update leverage limits real time so as to allow clients to maximize leverage in a way that does not expose Interactive in its role as lender, to excessive risk.
Interactive is a great example of our desire to invest in businesses that profit because of innovation and vision as opposed to exploiting some profitable but perhaps sordid gap in the markets. Any discussion of this industry and any discussion of why we think Interactive will dramatically grow market share for decades to come must include a discussion of the practice of payment for order flow (“PFOF”), which accounts for a significant share of the profitability at most public brokerage firms. In PFOF, the broker doesn’t directly execute your trade at wherever he thinks you will get the best execution but instead sells your order to someone who reports back the price at which it got executed. Somehow, this brain child of Bernie Madoff is supposed to be good for brokerage clients even though the brokers profit mightily from this and the largest buyer of this order flow is Ken Griffin’s Citadel Securities, who is buying homes for $238M a pop, which I guess makes it fair to assume that buying order flow is also profitable for him. So, who is getting screwed here? As per usual, the brokerage client. The applicable proverb for any customers of Schwab, TD Ameritrade, E*TRADE et al., is “There ain’t no such thing as a free lunch.” For almost all of their accounts, Interactive charges a modest commission on trades, but in exchange bypasses the PFOF practice and uses the trade router they’ve developed over the years to find the client the best execution, which saves them much more than the commission. Additionally, we have always been repulsed by the brokerage community’s inclusion of small print in client agreements which forces clients to agree to allow the broker to lend the client’s securities but allows the broker to pocket all lending proceeds. Interactive splits any lending proceeds with the client. And they pay much higher rates on idle cash, and as already mentioned charge much lower margin rates.
With fewer than one million accounts globally including only ~280K accounts in the United States and only ~$200B of client equity, Interactive has enormous room to grow as they apply their low-cost advantage to a much larger portion of the overall market. New product innovations are coming and will increasingly include more consumer services such as banking. In fact, to us, discussing Interactive versus TD Ameritrade in the competition for active traders is akin to the 1997 discussion of Amazon and Borders competing over the book market. Some ice cubes melt faster than others, but there is no lack of ambition at Interactive and there is no lack of awareness of what can be done to leverage such a strong base. The company is already growing rapidly internationally and has growing businesses serving introducing brokers who white label Interactive’s platform, and along with financial advisors who value that Interactive is low-cost and is not in the business of competing with them in financial advisory, as Schwab and others are. With its high productivity and profitability, Interactive enjoys 60%+ pre-tax margins and management has made it clear they intend to invest in every adjacent market opportunity that they can, if they feel they can uniquely automate it and use that automation to drive competitive advantage and profitable growth.
Given its competitive strength and investment virtues, Interactive has been on our radar screen for a long time. In Q2 we finally got the entry point we’ve looked for following a fundamental headwind that coiled the economic drivers for future growth and depressed sentiment around the stock. With countless workers all over the world at home and figuring out how and where to trade, Interactive is a short and long-term beneficiary of COVID as evidenced by its remarkable acceleration in account growth. New account growth in May 2020, for example, was more than quadruple that of May 2019, and the overall number of accounts in June 2020 was more than 35% higher than where it stood a year earlier. However, the COVID-inspired slashing of interest rates has dramatically impacted Interactive’s current earnings given that approximately 30% of their net revenues comes from the yield on clients’ idle cash. They give a much better share of the interest earned on those funds to their clients than other brokers, but nonetheless they were still earning ~100 bps on those billions last year. It is impossible to earn that much with rates cut almost to zero. Additionally, in the downdraft clients reduced profitable margin balances significantly shrinking Interactive’s profits. The company has also gotten negatively caught up in the trade war with China, which represents a huge potential market for them, as over 8,000 new Chinese accounts are set up weekly. However, the Chinese government has severely curtailed the ability of its people to fund accounts with foreign brokers, so the 16% of accounts that are Chinese only account for a portion of their latent potential. Lastly, a bizarre, one-time event occurred in April that cost Interactive a lot of money, but in our mind just reinforces how difficult their business is to replicate and what a huge barrier to entry exists. Interactive’s systems contemplated the price of oil going to zero, but not actually negative (where the physical delivery price briefly traded). When this occurred, certain clients took losses that Interactive felt obliged to make whole. The process cost them a little over $100M and punished the stock to an even greater degree. This will only make Interactive stronger from a risk perspective going forward, and this event reinforces why two clever guys in a garage will never be able to create anything remotely competitive. As a result of all this, IBKR stock traded down 30% from its pre-COVID levels and at roughly half the levels it traded two years earlier, despite the rapid acceleration in account growth. We believe history will show that our patience and discipline were rewarded with a great entry on a great long-term grower.
So, while “financial innovation” may be a “sordid boon”, we expect the profit that comes from Interactive to be noble and unalloyed. And maybe somewhere Wordsworth is smirking because perhaps unbeknownst to everyone at the time, he was actually a worldly polymath and made a killing furtively reinvesting his poetry proceeds in canal stocks, the internet/SaaS stocks of early 19th century Britain.
The World Is Too Much With Us
BY WILLIAM WORDSWORTH
The world is too much with us; late and soon,
Getting and spending, we lay waste our powers;—
Little we see in Nature that is ours;
We have given our hearts away, a sordid boon!
This Sea that bares her bosom to the moon;
The winds that will be howling at all hours,
And are up-gathered now like sleeping flowers;
For this, for everything, we are out of tune;
It moves us not. Great God! I’d rather be
A Pagan suckled in a creed outworn;
So might I, standing on this pleasant lea,
Have glimpses that would make me less forlorn; Have sight of Proteus rising from the sea; Or hear old Triton blow his wreathèd horn.
Investment Program:
For the benefit of any first-time readers, 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 receive our requisite value if we accept that our companies will appear “catalyst-less” and uninteresting for some time. We believe we are wildly overcompensated for this modest level of patience, especially since it is in these moments that a company can invest in its own business with the highest returns. There is wonderful optionality associated with a well-run, shareholder friendly, cashladen 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) and our predisposition to avoid crowded trades and instead invest in temporarily out of favor areas.
Closing Thoughts:
We hope you and your family remain safe and well.
More than ever, we thank you for your support and for choosing to have your money working alongside ours.
Gratefully,
Philip & the Owls Nest Partners team
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PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS
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