Quality Investing Outside the Blue Chips

Hello and happy holidays! I hope you have enjoyed a little rest and merriment this month. As the year winds down, I thought I would share a few final thoughts that have been percolating in my brain this season.

If I were to organize a popularity contest amongst all the various investing styles, “quality investing” would be the runaway winner. It’s easy to understand why. Who doesn’t want to own companies with predictable and growing revenue, strong margins, high returns on capital, good management alignment, and expanding end markets? What’s more, the recent returns accruing to companies like these have been extraordinary, leaving more pedestrian companies in the dust. And of course, “quality investing” has the stamp of approval of Mr. Buffett himself, who constantly exhorts us to “buy wonderful companies at a fair price.”

I do think many high-quality companies were under-appreciated by investors until recently. Truly superior companies deserve lofty valuations. A lot of money has been made by investors who identified a high-quality company, bought it at an “average company” price, and held on as the combination of earnings growth and multiple expansion yielded annual returns of 20-30% or more. However, I will sound a cautionary note. There is a limit to how high multiples can go before they become irrational, and today’s high-quality companies are not always tomorrow’s. Possibly the worst thing a “quality investor” can do is to pay a very high multiple of earnings exactly as a company’s financial and operational virtues are at their zenith. Once investors broadly recognize an enterprise as a “wonderful business!” the best of shareholder returns are often behind it. But not always! For instance, Visa Inc. has been considered extraordinary for the duration of its existence as a public company, but it has earned investors 18% annually over the last decade. In Visa’s case, the company was actually wonderfuler than most investors realized.

Even with those caveats, “quality investing” is a valid strategy. I think investors will continue to do well paying high but not stratospheric prices for the world’s truly exceptional businesses. While many of these businesses are household names with widely-held shares, there are numerous lesser-known enterprises that are no less commendable. Allow me to present a few.

Rand Worldwide trades over the counter with the ticker RWWI. The company has a market capitalization of $544 million and an enterprise value of $565 million. I have held shares of Rand Worldwide for several years. My only regret is not owning more of them. Rand Worldwide is a software reseller, mainly vending Autodesk products and providing training, integration, and support to its customers. Autodesk software is the gold standard in many industries. I often describe Rand Worldwide as a “Autodesk revenue royalty” because it’s true. As such, Rand Worldwide enjoys phenomenal returns on capital and cash conversion.

From the fiscal year ended June 30, 2018 to the fiscal year ended June 30, 2023, Rand grew its revenue by 163% from $116 million to $306 million. Its EBITDA grew 790% from $5.6 million to $50 million. Great results, but the growth alone is not the most impressive part. Incredibly, Rand Worldwide actually employs less total capital and less equity now than it did 5 years ago! Back in 2018, Rand had total assets of $53 million and equity capital of $25 million. At fiscal year end, Rand now employs $95 million in total assets and just $19 million in equity. How many businesses manage to nearly triple revenue while employing less capital?

Rand’s business requires essentially zero reinvestment, allowing it to distribute virtually all its earnings without hindering its growth. Over the time period in question, Rand declared a total of $4.25 per share in dividends, equal to 26% of today’s market price. Rand’s share price followed suit, rising from $3 in 2018 to over $24 earlier this year. Happy shareholders! However, the last few months have been less sanguine. From their summer peak, Rand shares have fallen by a third to $16. The reason is silly, but it still seems to have taken investors by surprise. From December 2018 through March 2023, Autodesk offered incentives for customers who bought 3-year subscriptions instead of annual software licenses. This was a major windfall for Rand, which was able to book the entire sales commission as revenue at the time of purchase. With this promotion over, Rand’s customers have returned to purchasing only annual subscriptions. Furthermore, many of Rand’s customers are working through their existing subscription terms and will not need to purchase licenses again until expiry. This created a revenue and earnings “air pocket” that Rand will need to work through over several quarters until their customers’ purchasing habits return to normal. The end of the Autodesk promotion was disclosed and discussed in every Rand Worldwide earnings report in recent years, but investors are still treating the reduced sales and profits of Q4 fiscal 2023 and Q1 fiscal 2024 as a permanent reduction in earnings power. For my part, I have zero doubt that Rand Worldwide’s operating results will resume their upward trajectory in due course.

At $16, Rand Worldwide trades at 11.9x trailing EBITDA and 11.1x annualized Q1 2024 EBITDA. (I am well aware of the pitfalls of substituting EBITDA for actual earnings, but in Rand’s case, EBITDA is almost exactly equal to operating income because of its minuscule capex needs.) The company continued to grow its revenue year-over-year, excluding 3-year subscription income. Q1 run-rate cash earnings per share are just over $1, a figure that is borne out by Rand’s recent special dividend of $0.25 per share.

All signs point to Rand continuing to distribute all its earnings. At $16, Rand shares yield 6.3% and have a P/E ratio of just under 16. Again, this is a for a business with zero investment needs, high single-digit organic growth through the cycle, and an industry-standard mission critical product offering. I happen to think a large premium to the market average valuation is warranted. Keep in mind my potential bias as a long-time and very satisfied Rand Worldwide shareholder, but I think Rand is one of the cheapest, highest quality opportunities in the market today.

I should note that Rand Worldwide is a controlled company, with notable investor Peter Kamin, his affiliates, and company employees owning a majority of the shares. Kamin’s usual modus operandi with his controlled companies is to manage them for long-term success and pay generous special dividends from excess cash flow. Betting on Kamin’s stewardship has worked out well for long-term investors in Rand Worldwide and other companies, but investors wary of investing in a controlled company should look elsewhere.

Moving on we have OTC Markets Group Inc., ticker OTCM. OTC Markets Group operates what else but the US OTC markets, my primary hunting ground for the last decade. Despite the over-the-counter markets’ reputation for being the home of pipe dream companies, stock promotes, and failures to launch, the owner of the market itself, OTC Markets Group, is the picture of financial health and success. OTC Markets’ 5-year compounded revenue growth is an impressive 14%, with EBITDA expanding at the same rate. EBIT margins have averaged north of 30% and the company’s return on equity is pushing toward 80% despite the presence of a large slug of excess cash. Much like Rand Worldwide, OTC Markets has very limited investment needs and chooses to share its earnings in the form of dividends.

OTC Markets Group’s successes have not escaped the notice of investors, who have bid shares to 23x trailing earnings. While this looks high to me coming from my world of all-but-forgotten companies, it is roughly a market multiple for a company that is significantly above average on every conceivable financial metric. OTC Markets continues its efforts to improve access to OTC-traded securities, creating market tiers with higher disclosure requirements and working to make it easier for non-listed companies to raise capital and attract investors. If the company meets with success, its P/E multiple will compress rapidly in coming years.

That said, I see a few suspicious clouds hovering on the horizon for OTC Markets Group. Despite the good efforts of the company, I expect the number of “investable” OTC-traded companies will continue to decline. By this I mean companies with well-established and profitable businesses that produce cash flow. There are far fewer now than in years past, the result of buyouts and mergers. As the Magnificent 7 and the almighty NASDAQ 100 continue to suck capital away from everywhere else, I don’t see the environment becoming easier for small public companies. Their cost of capital seems to move ever upward. I honestly don’t know why a small company would choose to go public any more, considering the cost of capital and the annoyances of reporting and compliance versus accessing private capital. I dearly hope I am wrong and that the US finds a way to make public existence more tenable for small-cap and micro-cap companies, ushering in a great small-cap value renaissance, but I doubt it.

If the number of small public companies continues to decline, that obviously has ramifications for OTC Markets Group’s terminal value. The higher a multiple of current earnings and cash flows an investor pays, the more that terminal value matters. I worry that investors could start to shift their view on OTC Markets if the vibrancy of the US small-cap and micro-cap ecosystem continues to decline. On the other hand, these issues are not new, and OTC Markets has grown its top line at mid-teens rates anyway. The balance sheet is robust as could be and they have a high degree of recurring revenue. An enviable position from which to address any challenges.

Finally, let’s jump across the Atlantic to some of my long-time favorite companies, the Swiss alpine railways! These are a different kind of quality. Rand Worldwide and OTCM Markets earn world-beating returns on capital offering specialized services. Very profitable but also completely intangible. The Swiss alpine railways are the total opposite. Their businesses are very capital intensive and they don’t earn very impressive returns on all that capital. On the other hand, their assets are unique to the extreme and totally immune from new competition. They have the moat to beat all moats: inimitable physical assets. It is simply impossible to build a new and competing system of railways and high altitude tourist attractions in the Swiss Alps. Just imagine the outcry over the disruption to such an ecologically sensitive area. At most, existing railways and facilities will be permitted to add capacity.

The biggest of these public companies are Jungfraubahn Holding AG and BVZ Holding AG. There are others, but I will leave the fun of finding them to you. Jungfraubahn has an enterprise value of right around CHF 1 billion, while BVZ is about half that size. Jungfraubahn employs little debt, while BVZ has taken advantage of some very low-cost debt offered by the Swiss government to finance its rolling stock. Jungfraubahn’s claim to fame is offering transit to the “Top of Europe.”

The website has a great overview of the various attractions and activities in the area. And guess what? You aren’t driving up the mountain or otherwise self-transporting. If you want what the mountaintops have to offer, you are taking a train or a cable car operated by Jungfraubahn or another company.

BVZ Holding AG has its own collection of railways. If you happen to sprechen Deutsch, their semi-annual magazine is worth checking out for the updates. If not, the pictures are still worth a look.

I have gone on long enough and there are Christmas cookies downstairs with my name on them, so I will spare you an in-depth examination of these companies’ finance. Suffice to say each is consistently profitable (outside of years affected by global pandemics) and each will likely be taking tourists to the various mountaintops for another 125 years. One of my central investing beliefs is that humans actually change very little over time. I consider it a near lock that in 2123, humans, or whatever cyborgian successors we may have, will still enjoy looking at pretty mountains and eating fondue.

This is a different kind of quality, but one I think is worth including in a portfolio. A company like Jungfraubahn is unlikely to be anyone’s top performer over long periods of time, but it is also highly unlikely to experience catastrophe due to technological obsolescence, changing consumer tastes, or mismanagement. (I’m not saying it’s impossible to lose money operating a world-class tourist attraction, but it’s difficult even for the dimmest.) In other words, companies like these may not be “get rich” investments but they are most definitely “stay rich” investments.

I don’t begrudge any investor who is satisfied to stick with the tried and true names of quality investing. The Costcos, Microsofts, and Visas of the world. But for anyone who wants to look further afield, there is no shortage of amazing little companies out there! Thanks for reading, and my best wishes for a happy, healthy, and prosperous New Year.

Alluvial Capital Management, LLC holds shares of Rand Worldwide Inc. and Jungfraubahn Holding AG for client accounts it manages. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.