Friday, August 22, 2014

Bearish on Post Holdings, even after its decline

Eric Falkenstein has tried to explain market cycles by drawing an analogy with Batesian mimicry: he argues that investors look for shortcuts in assessing investment quality, and if securities with a certain feature have historically been safer or produced higher returns than other securities, investors will assume that feature is a marker of high quality. Entrepreneurs will then take advantage of this assumption by issuing securities that have the feature but differ in substance, i.e. securities that look high-quality but are really low-quality.

Post Holdings (POST), the cereal maker, is a great example of this dynamic. Cereal sales are declining, and POST is at a disadvantage to competitors like Kellogg and General Mills because it's much smaller and has historically underinvested in its business. POST has tried to escape its poor competitive position by buying faster-growing food companies, but it's paid very high EBITDA multiples for these acquisitions and financed them with junk bonds. Essentially, POST has overpaid for its acquisitions and bet that artificially low interest rates will make them economical.

Objectively POST is a pretty bad investment, but it trades at a rich valuation because it has two features that investors associate with high returns:
• Its CEO, Bill Stiritz, is an "outsider CEO" with a long record of success
• It's a spinoff, and Joel Greenblatt's popular book You Can Be a Stock Market Genius has glorified spinoffs

I think these things are a lot less meaningful than investors assume, both for POST and in general.


Outsider CEOs

One of Buffett's famous quotes is that "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact."

Buffett is correct, and CEOs who are skilled at capital allocation aren't exempt from this general rule. The soft positive of an outsider CEO is unlikely to overcome the hard negative of a structurally handicapped business or an enormous debt load. More generally, a CEO who's been successful in the past won't necessarily be successful in the future if the circumstances are different. And the circumstances are very different for POST compared to Stiritz's previous companies.

A comparison between POST and Agribrands, a company Stiritz ran in the late 1990s and early 2000s, illustrates this. Like POST, Agribrands was spun out of a larger company that Stiritz controlled, but the similarities end there. Agribrands had significant net cash, traded at single-digit P/E ratio, and disavowed acquisitions because it couldn't find any that met its return hurdle. POST has significant debt and deeply negative tangible equity, trades at a double-digit EBITDA multiple, and grows through high-priced acquisitions.


Spinoffs

Like outsider CEOs, spinoffs don't magically impart higher returns. Traditionally, spinoffs outperformed other stocks because they were neglected and under-owned. Many investors were effectively prohibited from owning spinoffs. E.g., a mutual fund that specialized in owning large-caps would have to sell any shares of a small-cap spinoff that it received.

The situation is radically different today. Everyone knows that spinoffs have historically outperformed the market, and buying them is a popular strategy among hedge funds. When I was active on SumZero a few years ago, it gave users the option of listing their favorite book in their profile. You Can Be a Stock Market Genius was by far the most popular choice. It's a mistake to expect spinoffs to outperform the way they traditionally have when the reason for their outperformance no longer exists.

1 comment:

  1. Cereal is actually a good business despite the secular decline. Food businesses in general are high quality. These businesses have pricing power and can innovate out of their current decline.

    But I agree the debt load is troublesome. If I were General Mills or Kellogg, I would be very promotional and make life a living hell for Post. and then hopefully picking up some assets on the cheap later.

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