Aryeh Capital Management
Jeremy Weisstub is the Portfolio Manager & Managing Partner at the soon-to-launch, Toronto- based Aryeh Capital Management. Prior to founding Aryeh, Mr. Weisstub was an Analyst at Greenlight Capital, a Principal at Redwood Capital and an Analyst at Perry Capital. He began his career in the private equity group at Oak Hill Capital and in M&A at The Blackstone Group. Mr. Weisstub holds an M.B.A. (Arjay Miller Scholar) from Stanford Graduate School of Business and a Bachelor of Arts in Economics (summa cum laude with Distinction) from Yale University.
Damian Creber is the Head of Research & Co- Managing Partner at Aryeh Capital Management. Mr. Creber was most recently a Senior Analyst at Owl Creek Asset Management. Prior to that, he was in the private equity group at Onex Partners and in the Leveraged Finance Group at RBC Capital Markets. Mr. Creber holds an MBA (Dean’s Honors and Distinction) from Columbia Business School, a Bachelor of Commerce from the University of Toronto, and is a CFA Charterholder.
Graham & Doddsville (G&D): Can you tell us how you got to this point in your careers, and what inspired you to launch Aryeh Capital?
Jeremy Weisstub (JW): Above all, Damian and I are at this point because we had the good fortune of having great mentors. We apprenticed under extraordinary talents at our previous firms and we absorbed what made them successful investors and leaders. My background is Canadian — I was born and raised in Toronto. My interest in the markets and in economics came early, inspired by my grandfather who was with the Bank of Canada. I decided to work for a stock brokerage for a year between high school and college to test my interest, and it stuck. I studied economics at Yale and then joined Blackstone in 1998, when it was still a boutique firm. Blackstone exuded a culture of excellence that was unmatched, and I learned a tremendous amount about professionalism and preparation. I took that to my next role in private equity at Oak Hill Capital, where I learned about depth of diligence.
My public-markets career began in 2005 when I joined Perry Capital after earning my MBA at Stanford. At Perry, I learned about probabilistic thinking as well as how to be opportunistic across the capital structure. When I moved to Redwood Capital, I was able to augment my experience in distressed investing by training under one of the great distressed investors, Jonathan Kolatch, who instilled in me the confidence to know how to take advantage of large market dislocations. At Redwood, I was also given a platform to develop and fundraise for a targeted fund, the Redwood Loan Opportunity Fund. My most recent experience was with Greenlight Capital, where I worked with David Einhorn for over six years. Learning from David pushed my knowledge of the equities business to the next level, and we had a great run together, with particular success in out- of-favor situations such as CIT Group, Delphi, General Motors, and Sprint.
Damian Creber (DC): Like Jeremy, I was born and raised in Canada. I studied business at the University of Toronto and then started my career in investment banking at RBC Capital Markets, where I focused mainly on the credit business, before moving to Onex to work in private equity. Columbia Business School and its renowned Value Investing Program brought me to New York, where I was fortunate to connect with and work for Jeffrey Altman at Owl Creek. Similar to Jeremy, each stop in my career has been a formidable learning experience. Onex taught me the importance of a world-class investment process and the power of strong culture and retaining good talent. At Owl Creek, I observed Jeff‘s remarkable ability to get to the heart of an idea, pull out the relevant information, and understand the path forward, regardless of whether that idea is in equity or credit, long or short. Jeff has a tremendous track record and I believe he is unique in the way that he has trafficked across the capital structure with great success over a long period of time.
JW: Aryeh Capital was inspired by a long-standing dream to build an investment firm of my own in Toronto. With all the experience I had picked up, it was time, and when I met Damian, I knew I had found a partner who shared my vision. As we got to know each other, it became clear to me that Damian was a truly special talent, and was someone I wanted to build my business alongside.
G&D: How exactly did you two meet?
JW: There aren‘t many Canadians in the New York hedge fund community, so we all tend to know each other. I had a sense that Damian was someone who could be a real partner, a sounding board for all investments, and provide incredible leverage to the investment process. Damian is truly all of that and much more.
DC: For me, the desire to build my own firm was equally strong and meeting Jeremy confirmed that. His experience is a true complement to mine and we are able to play off each other‘s strengths well.
G&D: Why Toronto? What about establishing your firm there differentiates you?
JW: The first advantage is reflected in our capital base. We have deep roots in Canada and with that has come a circle of business people who have known us, and grown to trust us, over many years. Our anchor investor is a well- respected Canadian businessman who has committed $75 million for seven years. We built upon that and have secured sponsorship from over 30 investment professionals in both Canada and the New York hedge fund community. Currently, we have raised over $125 million — with an average duration of over five years — before beginning a formal marketing process. This is a huge vote of confidence for us as we launch Aryeh. The second advantage is that Toronto is removed from the noise. The geographic distance supports our ability to build an independent mindset, which is critical to investing. The third is value for money. In Toronto, we are able to operate a firm with top-tier talent and infrastructure for half the cost of doing so in New York. This cost advantage, combined with the capital base we have already raised, means the business is fully funded for the next seven years without the need to raise any additional capital. That stability out of the gate allows us to invest all capital as if it‘s our own. We can capitalize on volatility in ways that few others can.
DC: The other thing I would add, as it relates to being based in Toronto, is that Canada gives us enormous recruiting advantages. We are able to attract both world-class professionals in Canada who are interested in moving to the public markets, for whom the options are otherwise limited, as well as expatriates in New York or elsewhere who want to come home but have few choices.
G&D: What else differentiates you?
JW: We have spent a tremendous amount of time thinking through this, and feel very strongly that our competitive advantage is not one single thing but rather a unique combination of things. In addition to the advantages related to Canada, there are five other elements that we feel set Aryeh apart. First, our judgment and experience — investment success comes with sound judgment, and I’m certainly proud of my record as an investor. At the same time, there have been plenty of mistakes that I‘ve learned from and those have also made me better and stronger over time. Second, we believe the duration of our capital will allow us to exploit time arbitrage in a way that few investment firms can. Third, we have specific expertise in distressed debt stemming from having worked with some of the greatest distressed investors. While we think that the current credit opportunity set is not particularly robust, when the opportunity arrives in the credit cycle, we expect to act on it aggressively. We are prepared, and will not be capturing that opportunity set reactively but rather with our best foot forward. Fourth, concentration — we will only invest when we have high conviction, and our portfolio will consist of 15 core longs. We strongly believe that concentration delivers outstanding performance over time. Lastly, our capped fund size puts us in a position to be nimbler as it relates to both equities and credit.
G&D: It‘s rare in this environment for startup funds to get as much capital as you have, for the length of time that you have, on Day 1. What about your philosophy or strategy stood out to your investors?
JW: I think, first and foremost, it was about trust. Our anchor investor is a long-standing relationship — somebody who has enormous comfort with both my character and my ability as an investor. For other folks who have committed before our formal marketing effort has begun, I think it is a function of longstanding relationships as well as an appreciation for the drive and set-up of our team. We are positioned to take advantage of opportunities across the market cycle given our experience in both equities and distressed credit.
G&D: Do you plan to focus your portfolio on Canadian ideas?
JW: No. Our portfolio will be concentrated and comprised of primarily U.S. securities. To take that up to a higher level, the ideas that make it into our portfolio boil down to two questions: Is a situation dislocated or misunderstood? And is it analyzable? Fundamentally, we‘re looking for good businesses that have been discarded or are misunderstood for one reason or another. Within credit, we‘re much more focused on dislocation — situations in which we think there‘s technical pressure temporarily mispricing something in the market. That said, our industry backgrounds and experiences are critical to understanding an investment scenario, and if we can‘t analyze it, then we won‘t invest in it. We just will not be able to develop a highly differentiated view in some sectors, such as biotech or a specialty technology business, even after months of diligence. Those go in the ―too hard bucket and we move on.
G&D: What about the short side?
DC: We view shorting as a core part of the portfolio. We think it should only be done in a situation where you‘re actually generating dollar returns for your partners, not as just a hedge on your long performance. Our short ideas typically fall into three different buckets: The first, structural shorts, as you would imagine, are your standard broken business models — we think there are segments of U.S. retail that are in this bucket today. Second, cyclical shorts, is where you see the market confuse a cyclical upswing for a secular change. And the third bucket is credit-driven shorts where we either feel the credit or equity market is missing some idiosyncrasy associated with the credit on a levered name. One example includes equity investors occasionally ignoring important information on balance sheets; another is shorting unsecured bonds trading at par for businesses that have real challenges.
JW: We anticipate putting on up to 20 shorts, although in smaller sizes than our longs. A large short for us would be 2% of the book, whereas a large long would be 10%. Taking all these together, we plan to construct our portfolio by taking a bottoms-up view of investments, calibrated to the opportunity set. And by that, I mean two things. First, we think about our net exposures over a market cycle and plan to position our portfolio accordingly in that context. Second, our exposure to equities and credit will range based on the opportunities we see. As an example, right now, our net exposures would be more conservative, and the portfolio would be more heavily weighted towards stocks; however, as the credit cycle turns, we would expect to be more heavily weighted towards distressed credit.
G&D: How are you building up the team?
JW: Two junior analysts, both Canadian, have already joined Aryeh. Our investment team of four is a good size for an organization with a portfolio of 15 core longs. We are modeling ourselves after a very select group of investment firms that have had long-term success with a high-caliber, but reasonably small, team. Similar to those organizations, we want to keep it simple. The team will likely grow modestly over time, but it will never be a large organization.
DC: We deliberated about the right people to fill these roles, and in particular needed to find investment analysts who understood that our process is modeled after private equity, which tends to be different from how most people approach public markets. Our process demands a significant amount of time to research ideas, and that depth of research we believe is unique. Having the right people for this kind of process, who also exhibit intellectual horsepower, work ethic, curiosity, passion, and judgment, was an important mixture for us. We feel very fortunate to have found that.
G&D: How will you divide responsibilities among the team?
JW: The team works very collaboratively; however, I am the sole Portfolio Manager of Aryeh. Damian is the Head of Research. All investments are going to be discussed as a group. And since we are a small team working in close touch day-to-day, it is a very cohesive process.
DC: The investment process is designed to achieve certain goals. The first is that we want to try to get to a ―kill decision very quickly. Second, if we do end up getting to a ―yes through the process, we should have enormous conviction in those ideas. And so, while the investment team consists of four people, we plan to work in pairs as we go through the research process on an individual idea. We divide the process into three phases that we reference as ―a day, ―a week, and ―a month internally. The first phase of looking at an idea involves ―a day of work, which is designed to ensure that we‘re spending time on the right ideas that could meet our two core questions of either being misunderstood or dislocated, and being analyzable. The second phase, which is about ―a week of work, is meant to deepen our conviction. This is where we dive deep into the business, the industry, the numbers, and where we‘re constantly asking ourselves the same questions, but with a more substantial degree of rigor. And the third phase, which can take up to ―a month of work, is where we do the largest portion of our primary research, which includes visiting the company and its facilities, calling customers, suppliers, attending industry conferences, and working with the management team to dive below the deepest layer of the financials. In each phase, we write a detailed memo that goes out to the entire team, which effectively gives the entire team all the relevant information to analyze the idea. Everybody is encouraged and expected to weigh in.
JW: We then sum all that work we‘ve done into quantitative criteria for our portfolio, which is how we determine sizing. Though I can‘t share those criteria here, because we view them as a core part of our intellectual property, it‘s safe to say that we think they reflect the most important characteristics of any investment. We layer these quantitatively onto our research process.
G&D: You mentioned the quantitative model you use for sizing. Have you used something like that in the past?
JW: Neither of us have used the exact model we are incorporating today at Aryeh — we blended our worlds in this sizing model. Some of the elements are ones that you would expect to see from any investment process. The core of our risk- management philosophy revolves around downside protection, and so as we think about how to size any investment, the first and foremost consideration for both of us is framing our downside. Our largest investments will always be our lowest-risk investments.
G&D: How do you generate ideas?
DC: As mentioned, first and foremost we focus on securities that we understand to be dislocated or are ripe for potential misunderstanding. Drilling down from there, we naturally gravitate towards ideas that come from existing knowledge gleaned from prior investments or industries we know. For example, both Jeremy and I have spent many years trafficking across global industries, with Jeremy spending much of his career in industrials, real estate, and financials, while I spent chunks in each of industrials, consumer, and healthcare. So, we have good familiarity with businesses in those industries, and when a stock is down 20% on one day, we know if that can be interesting to us. We also do quantitative screening that can surface some interesting situations, particularly smaller-cap names that we haven‘t looked at before. Historically, we have both worked at larger firms with greater liquidity constraints.
JW: On the credit side, it‘s important to be ready when dislocations present themselves so we are on the lookout for situations that have the potential to be future large restructurings. Often, there are companies that you know run the risk of getting into trouble in the coming weeks or months. In those instances, the securities that are relevant to potential investment may not look cheap yet — they may still be closer to par than 50 cents on the dollar — but you want to be ready to buy on the way down. You want to be ready to step in when there are a lot of folks looking for liquidity. Once the wave of selling is absorbed, it‘s typically much less liquid on the way back up. In building a position, you often want to be there on the way down.
G&D: Given the small, cohesive team, do you have any tactics to avoid groupthink once you‘re involved in an idea?
DC: Yes, we have designed precautions into the investment process to address exactly this. The pair that is not the lead on a specific investment will be involved during the memo process and they are encouraged and expected to have real push- back. We incorporate check- ins with the pair that is not going deep into the research on a specific idea in order to keep us on track as a team. We‘ve further enhanced this concept by compensating the team on firm-wide performance and asking every member of the team to invest their own capital into the fund. We are entirely aligned with our investors.
G&D: You mentioned you often pick stocks that are―misunderstood. Can you clarify? Isn‘t almost all investing capitalizing on someone else‘s misunderstanding of a story or situation?
JW: Yes, you could say that even a growth stock is a form of misunderstood security. But the way we mean it, and the way we‘ve succeeded with misunderstood securities,involves controversy over what the business really is and how the path forward looks for that business.
DC: Misunderstandings — or controversy — can evolve from many areas such as spinoffs or multi-segment businesses where people are overly focused on one segment and miss the forest for the trees. Complexity or news events or change, whether it‘s management change or capital allocation change, also tend to drive misunderstandings. The market, for the most part, thinks linearly in these instances but businesses tend to move nonlinearly, and that creates our hunting ground. We really like misunderstood situations where we‘re able to buy a quality asset at a discount, and where we have real comfort in the quality of the business. In these cases, we get two things: We get an immediate re-rating when the bear case or bull case falls away as the controversy is resolved. Second, the underlying value of the dollar that we bought at 50 cents is now growing, so the business is inherently getting cheaper every day on an intrinsic-value basis. The reason we‘re attracted to misunderstood or dislocated quality is that, if we‘re wrong in our analysis of the dollar, and it‘s only 80 cents, the 80 cents is growing. This is one of the biggest lessons I‘ve personally learned in terms of mitigating downside risk. That‘s why situations where the dollar has dislocated to 50 cents, but where the underlying business is still truly growing, are our Holy Grail.
G&D: What are some other investing lessons from your careers?
JW: One of the key lessons that I learned was from the financial crisis, through which I learned to appreciate the enormous opportunity cost of illiquidity during periods of market stress. One common way to reach for yield is to accept increased illiquidity for the sake of getting a little bit of incremental return. The issue is that illiquid credit can cost you enormous upside from an opportunity cost perspective — because it‘s critically important to be able to migrate to the best opportunities when markets are the cheapest. For the same reason, cash provides the ultimate form of optionality. Another lesson is that, when companies run into trouble, talking to management teams can hurt you. Typically, we are very fundamental, private- equity-style investors who like to speak to management teams. But in those circumstances when there‘s a lot of uncertainty around a business, speaking to a management team typically results in one of two things: Either they‘re going to tell you a story that is overly optimistic or they will have no answer. Neither scenario is helpful to our process.
G&D: What happens if you‘re a major holder of a company and that stock tanks because of some perceived trouble? If the management team proactively reached out to you and other investors, would you stick to your philosophy of not talking to them, regardless of what they had to say?
JW: In that scenario, when a business is in trouble, you have to recognize the likelihood of misinformation and approach management‘s ideas with caution.
G&D: What is an idea that you think embodies your type of investing?
DC: We are currently very excited by a business called ServiceMaster Global Holdings (SERV). It‘s a reasonably complex company, whose stock got dislocated in the middle of last year — and dislocations, as we talked about, pique our interest. ServiceMaster is a collection of three somewhat disparate businesses. The first is Terminix, a high-quality termite and pest-control company that is the market leader in the space, which represents 55% of EBITDA. The second is American Home Shield (AHS), the market leader in home warranties, which represents 35% of EBITDA. And the final bit, which is 10% of EBITDA, is a franchise business that does everything from residential and commercial cleaning, to natural disaster restoration, to home inspections and furniture repair.
JW: We generally like complexity because it often scares off other investors. When Damian introduced me to SERV, we were both attracted to three main factors — the complexity, the combination of very high- quality assets, and a stock price that had fallen from slightly over $40 to $32 in the span of a few months. All three of ServiceMaster‘s businesses have market-leading positions, high margins, and limited cyclicality, yet the market hadn‘t given these qualities much credit. It was also appealing because it had many of the elements of investments with which I have had success in the past — a dislocation, followed by a clear misunderstanding, all of which takes time to resolve itself in the marketplace.
DC: The dislocation occurred because Terminix had shown decelerating organic growth over a few quarters, and there were some very vocal bears suggesting the business had been broken by prior private- equity owners in a way that it could never recover. We came to the conclusion that not only did the Terminix bear case not have substantial merit, but also that all the bears were missing the truly amazing business that is American Home Shield. The research process involved spending countless hours speaking to former employees, competitors, suppliers, customers, and management. We concluded that Terminix had stubbed its toe around certain operational issues but that none of these were structural and all of them were in the process of being fixed. This is a business that is in a market that is growing 4–5% a year organically, and has the ability to tack on very accretive M&A. It just needed a little love to get back to this growth rate. More interesting, however, was AHS. AHS is a well- moated business. Its strong competitive advantage is its scale, allowing it to source effectively from its suppliers. It has grown revenue 10% a year, as home warranties have continued to penetrate the market of homeowners, and has very attractive incremental margins. All of these factors rolled up to where we could see ServiceMaster growing free cash flow per share by 15–20% per year for at least a handful of years, and at the time SERV was trading at a 7.5% FCF yield. We have a bias for attractive cash flow yields, and certainly attractive cash flow yields that grow each day. Almost a year later, the shares stand at about $47 — a nice run from $32 last summer. But we think there‘s substantially more left to this story, particularly as we‘ve seen Terminix organic growth re-accelerate and AHS growth hold. The most interesting piece of the story from here is that management has decided to separate AHS and Terminix by spinning off AHS in order to unlock value for shareholders. The spinoff is expected later in 2018 and we think that‘s the next catalyst for the business to continue to unlock value for shareholders. We think the stock is worth $60 today based on conservative sum-of-the-parts math.
G&D: Why exactly did Terminix decelerate and why was that a misunderstanding?
DC: Terminix had decelerated for two reasons. The first relates to the type of product that they were using to treat termite infestations. Historically, you‘ve treated for termites by walking around a home, digging a bunch of holes, and pouring in a liquid. The liquid is not toxic, but people have discomfort with it and there‘s no recourse if a customer cancels the ongoing maintenance fee — you can‘t take the liquid out of the ground. A few years ago, the market started to shift towards what people call termite ―bait.‖ This bait involves installing what looks like a sprinkler in your lawn, where you put poisoned termite food, which the termites eat and die. All the competitors had shifted to this product, but Terminix was not sure about its efficacy for some time, and so it continued to offer liquid instead of bait and this caused a slowdown in gross customer adds. The second reason was that the company had a technician retention challenge after changing the compensation plan, causing some customer satisfaction issues. It was clear from the research that these two reasons were being addressed and that Terminix wasn‘t permanently broken, but had just fallen down for a period.
G&D: What distinguishes Terminix from competitors?
DC: There are two large players in the market, Terminix and Rollins, that together account for approximately 60% of the termite control market and 35% of the pest control market. The remainder of the market includes small mom- and-pop operators. Rollins and Terminix have limited advantages against each other, but have massive moats compared to the mom-and- pops. The first moat is lower procurement costs on the termite and pest treatments. The second moat, and perhaps the most powerful advantage, is their network density, which matters because adding more customers to a driver‘s existing route results in additional revenue yet almost no incremental costs. The third moat is the ability to stand behind and guarantee the product — that if you were treated, but the termites still caused damage, you would be reimbursed for the repairs. Mom-and-pops cannot afford to take that risk.
G&D: What‘s the moat for AHS?
DC: AHS is 40% of the home insurance market, and it has effectively no competitors. The competitors that do exist are typically either very local, small guys, or subsidiaries of the title insurance companies. On AHS, the moat is distinctly its scale. Their size allows them to negotiate lower rates with contractors and pass that along to customers. Say you have a home warranty for which you pay a $575 fee per year, and then you pay a small deductible if you have a claim. AHS takes care of everything — it sends contractors to your house, if something has to be repaired they repair it, or if it needs to be replaced they replace it. AHS uses the scale to guarantee contractors a minimum amount of work, and that allows AHS to negotiate much lower rates from these contractors where no one else can compete effectively. AHS then shares these savings with the customer so the customer both saves from using this product and has the peace-of- mind knowing they are covered.
G&D: Why aren‘t the large financial institutions bigger in this business?
DC: This is a business that requires a reasonable amount of logistics to organize. You effectively have to have a network of many thousands of contractors, and many thousands of customers.We‘re now at a point where AHS has created the famous Bezos ―fly-wheel‖: the only reason you can offer the warranty at the price you do is that you‘ve negotiated much lower costs with the contractors by guaranteeing them work. If you don‘t have scale, you can‘t guarantee them work, you can‘t get lower costs, and you can‘t offer the price that you do.
G&D: How did these three businesses end up under the same roof at SERV?
DC: The original business was actually the franchise business going back to 1947 as a moth- proofing company founded by Marion Wade. Over time, ServiceMaster bought up a bunch of different businesses, including Terminix, some of which made sense together but mostly it was just a holding company for services businesses. Clayton, Dubilier & Rice (CD&R) took the whole company private in 2006, at which point the largest segment within ServiceMaster was TruGreen, a lawn care business. The TruGreen business was very cyclical — it was effectively a luxury to have someone come over and mow a lawn — so that unit got hit hard when the business cycle turned in 2009. CD&R then carved out TruGreen, and took the remaining business public, and that‘s how you ended up with the SERV portfolio that you‘ve got today.
G&D: Fast forward to today, are there advantages for SERV in owning all three of the businesses? Perhaps in the logistics needs for both Terminix and AHS?
DC: No. The businesses are run almost entirely distinctly. The contractors at AHS are not employees, they are independent contractors. AHS sends them to a job, but contractors are responsible for the actual logistics. At
Terminix, the people who
show up to fight termites are employees, and SERV handles the logistics. There is theoretically some cross-sell opportunity over time, but we haven‘t really seen that happen, and we think that‘s why management recently decided these businesses made more sense as separate entities.
G&D: Hurricanes have been particularly punishing in the U.S. this season. How would that affect SERV‘s franchise segments, including ServiceMaster‘s disaster restoration business? And how do you think the market thinks about such events for the overall business?
DC: That‘s a great question, and I think this relates to some of the misunderstanding with SERV. Every time you speak to an investor, they know about Terminix, sometimes they know about AHS, but rarely has anyone spent time on the franchise business. This is an extremely high-quality business, with recurring revenue and high margins, and impressive growth. Last year, the fires in western Canada were a big driver for this business, as the hurricanes will likely be this year. These aren‘t big dollars, but it is a very profitable segment that people just aren‘t focused on.
G&D: What‘s Terminix‘s pricing power like?
DC: These are recurring revenue businesses. For example, imagine turning off your pest control services as a restaurant in downtown Manhattan — it‘s just not an option. So the businesses have real pricing power. It is a relatively low-cost product but one with an extremely high cost of failure, and such businesses can exhibit pricing power. SERV has taken somewhere between low and mid-single digit percentage price increases per year for a very long time, but they‘ve been smart in that they‘ve never gouged their customers.
G&D: Are you concerned about the debt?
DC: Right now, SERV has ~4x leverage, which some people may balk at. But it‘s all long- term debt, as the company recently refinanced, shifting to 75% fixed rate and moving the maturities beyond 2022. This capital structure makes us feel comfortable, but we also think all debt/EBITDA metrics aren‘t created equal. ServiceMaster has monster cash conversion due to very limited capital requirements and a negative working capital model such that there are really no concerns for us about the company‘s ability to service debt.
JW: I would add that debt can really cause you pain in cyclical businesses but ServiceMaster has almost no cyclicality. Perhaps the best way to illustrate this is to tell you that both AHS and Terminix grew in 2009. Leverage is a real risk as it relates to businesses of cyclicality, especially if you have covenants, but ServiceMaster‘s portfolio doesn‘t exhibit those characteristics. We think the market misunderstands the risk from the company‘s optically high leverage and that‘s another reason we‘re attracted to the opportunity.
G&D: What could derail the story?
DC: One risk is that Terminix stubs its toe again around organic growth. People may then say that this business is perpetually stubbing its toe, and then it will always receive a discount to where it should theoretically trade.
JW: The second risk involves Terminix‘s M&A. This segment has so far allocated capital very attractively for ServiceMaster, as it bought out small players for under 5x pro-forma EBITDA. Today, however, a competitor in Europe has been more aggressive around M&A and is paying higher and higher prices for those businesses. We don‘t think that this will break the thesis, but it could certainly make the 15–17% FCF growth a little bit lower if it remains true for an extended period.
G&D: What are your holding periods in general for such investments, on both equities and credit?
JW: We expect our average period to be two to three years. In some cases it could be much longer — and there are some situations that may resolve much sooner — but we‘re certainly not aiming for high turnover. We‘re making investments with what we hope are good companies that we hope to be invested in for some time.Credit and equities can sometimes have similar features, in that there are various phases to the investment — and each has the potential to create real value. If you invest in a credit restructuring, the first phase has maximum uncertainty, when there‘s effectively a food fight as everyone figures out who‘s getting what. Just the clarity that comes with that resolution can be a catalyst. The second phase is the company issuing new securities — either plain equity or a combination of equity and debt — as those securities are distributed and valued separately in a market with often more liquidity, we see another leg of value creation. That takes some time as well. The last phase, which can take months or years, is that―seasoning that you see as the company comes out of reorganization. Sometimes it takes a while for a situation to properly re-rate as the enhanced business quality from a restructuring is underappreciated until a new set of buyers warms up to a story. Delphi came out of a bankruptcy at $20 a share in 2011; it‘s at nearly $100 today. If you look at how Delphi unfolded, there was value created for investors through every part of its restructuring and post-reorganization. With ServiceMaster, we see a similar pattern. This equity story started with a dislocated security that was out of favor and cheap. As we began to really understand the business, it has now migrated into what we might think of as a more event-driven opportunity, with the coming spinoff. That leg of our investment thesis hasn‘t yet played out.
G&D: What advice would you give MBA students interested in investment management?
DC: Though this sounds a little cliché, we both think it‘s very important to work for a firm and with someone with whom you truly click. This industry is one where you can be successful in many different ways, but success only comes from being in an environment that resonates with you. Find the type of investing you like to do, and work for someone who sees the world the same way you do.
JW: My best piece of advice is to think of CBS and the Value Investing Program as only the beginning of your investing education. The investment business is one of lifelong learning and requires passion, so it is important to figure out a way to get better every single day.
G&D: Thank you.