Idea Brunch with Keith Smith of Bonhoeffer Fund

Keith Smith on consolidation, overseas investing, and his top ideas

Welcome to Sunday’s Idea Brunch, your weekly interview series with underfollowed investors and emerging managers. We are very excited to interview Keith Smith!

Keith is currently the portfolio manager of the Bonhoeffer Fund, a value-oriented investment partnership based in Webster, NY. Before launching Bonhoeffer, Keith was a managing director at Empire Valuation Consultants for eighteen years and served as a captain in the U.S. Air Force.

Keith, thanks for doing Sunday’s Idea Brunch! Can you please tell readers a little more about your background and why you decided to launch the Bonhoeffer Fund?

Thanks for inviting me. I have an electrical engineering background—having designed an integrated circuit while attending Union College—but have always been interested in the securities market. One summer during college, I worked at Cornell University and got a chance to read the classics (The Intelligent Investor and Security Analysis) and even put some of the ideas to work on information/data from our business school library. After college, I joined the Air Force and worked on a communications satellite called Milstar, a state-of-the-art satellite system designed to work through a nuclear war. Once the Cold War ended, I left the Air Force and worked as a cost estimating contractor while I got my MBA at UCLA. After receiving my MBA, I worked for PricewaterhouseCoopers as a business appraiser during the dot-com boom, which offered great firsthand experience. In 2000, I left Pricewaterhouse and joined an appraisal firm in Rochester, NY, called Empire Valuation Consultants. I worked as an appraiser for 18 years before leaving as a managing director. I launched Bonhoeffer Fund in June of 2017 with Willow Oak Asset Management and left Empire in 2018 to work full time on the fund.

Throughout my career, I have always been interested in investing and have invested my savings in individual stocks. The fund’s focus is a spin-off of that experience and invests in a portfolio of stocks that provide unique exposures to investors with the goal of providing above-average risk-adjusted returns. When I began the fund, the focus was on special situations and value situations around the world. Over time, I’ve expanded my circle of competence to include consolidating industries and situations where there is significant operational leverage.  Consolidation is interesting, as it can provide cash flow growth independent of industry growth.  Since growth around the world has slowed considerably, consolidation can provide growth in a lower-growth world. In addition, most analysts do not include growth from consolidation in their forecasts or underestimate the effects consolidation can have on margins through operational leverage and cost synergies.  

Another theme I have recently been examining is industries/firms in transition. The internet has caused disruption in many industries and generated fragmentation that can then be subsequently consolidated. Consolidation can be especially effective if there are common infrastructures or costs that can be used to reach and support customers. An example of this is in retail operations. Many online-only retail firms have emerged as competitors to existing brick-and-mortar retailers. As a response, many legacy retailers have launched online channels of their own and have become omnichannel. The omnichannel approach can be a powerful way for customers to have it their way in terms of the retailing experience. Another observation is that the online approach appeals to a younger demographic; thus, legacy retailers can develop relationships with younger consumers online and wow them with customer service and experience in their brick-and-mortar locations. Increasingly, brick-and-mortar locations are becoming destinations the customers want to go to for more than buying merchandise. An example here in Rochester is Wegmans, which has been described as the Disneyland of food.

You heavily invest in small-cap companies overseas, especially in Italy, Korea, and South Africa. Why?

The reason is to have a larger opportunity set of companies to examine. The way we look at places in which we are willing to invest includes markets that have a history of shareholder capitalism over time—or are moving in that direction—and have good disclosures in English or can be easily translatable into English. Shareholder capitalism results in good disclosure of the value drivers and KPIs associated for most firms. Shareholder capitalism, as we know it in the US today, was first adopted on a large scale in the Netherlands in the 1600s, where strangers (non-family members) via the Dutch East India Company, could invest in businesses. The English made the Dutch ruler the King of England, and he brought the economic system with him to England. Then the system was expanded to English and Dutch colonies such as the United States, Canada, Australia, and South Africa through immigration. Over time, the system was adopted in much of Europe and in some places in Asia such as Singapore, Hong Kong, Taiwan, and South Korea. This disruption replaced the more traditional family-only capitalism that had been practiced for thousands of years. One risk we examine while looking at companies overseas is currency risk; you can be right on the industry, business, and management and still lose money in USD through currency depreciation. We examine a country’s currency going back to 2000 vs. the USD. If there has been currency depreciation, then we increase our return threshold for those businesses. The only country in this position today is South Africa.

I tend to focus on markets playing by similar enough rules to the United States for me to evaluate these firms. Outside of these regions, a different game is being played that I do not understand, so I stay away.

I’ve found holding companies to offer interesting upside to investors, and they are common in many foreign markets like South Korea. One of the challenges of holding companies is the catalysts to reduce the discounts at which they trade. The best way to unlock the Holdco discount, in my opinion, is via a spin-off or sale. I have found interesting special situations in South Korea in their holding company transactions. In these transactions, the interests in the operating companies are exchanged and combined into a holding company for the patriarch’s heirs to pay estate taxes without losing control of the operating subsidiaries. To do this, the government requires better corporate governance practices and disclosures. We have had positive experiences with these transactions in Korea—specifically in unlocking some of the holding company discount.

What are some of the common red flags or positive signs you look for in your research process?

In the industries I focus on (media/telecom, distributors, real estate, and consumer products), one of the red flags is high debt (low coverage ratios) in mature or declining cash flow situations. I have learned from personal experience with my own money in the 2000s that these can create losses if growth is not present. In addition, there are some aspects of disruption in many of these industries, so you have to evaluate whether the disruptor will destroy the economics of the subject company or whether the subject can adopt the innovation and compete with the disruptor. Typically, if the disruptor builds a new value chain that others can’t or won’t build, then the disruptor is successful. If incumbents can modify their value chains to meet customers’ needs, then they will be successful, since they have a pipeline of legacy customers. Another area that needs to be evaluated is capital allocation given that all of the firms we look at generate cash. Finally, the firms we like have high returns on equity, typically above 15%, which can lead to nice longer-term growth rates.

What are two or three interesting Ideas on your radar now?

I like the theme of industry consolidation and operational leverage. One idea that I find interesting is traditional auto dealers that are incorporating the disruption of the internet into their business. Dealers have been some of the best businesses in the US. Many of the owners of dealerships have become very wealthy in a generation or two, as the business requires little capital (most of it is financed by OEMs or third parties) and can realize local economies of scale via sales growth or consolidation. The car dealership business is very fragmented, with the largest dealers having about 2% market share nationwide. This allows for revenue growth of 20% per year via consolidation for at least the next 10 years for more than one firm, despite low single-digit comparable to GDP growth for the entire industry.

The specific dealer I like is Asbury Automotive Group (NYSE: ABG — $3.78 billion). Asbury is the best performing of the traditional dealers, with the highest return on equity, margins, and inventory turns despite not being the largest dealer; this is due in part to Asbury’s clustering strategy which takes advantage of local economies of scale.