<August 27, 2024>
One Up on Wall Street was published in 1989. Co-authored by Peter Lynch, the book is filled with common sense wisdom from an accomplished fund manager. It’s been over thirty years since I read it, but I still remember one of the key takeaways—buy what you know. For instance, if you love taking your kids to Disney World, Disney’s stock might be worth considering. Simple enough!
Early in my career as a small cap analyst, I attempted to buy what I knew. Unfortunately, the companies I was researching didn’t provide products or services I was familiar with. For example, I recommended Gorman-Rupp, which manufactured construction and sewage pumps. Matthew International made memorial bronze plates for cemeteries. And then there was Tennant Corporation, the market leading provider of floor cleaning equipment. These were wonderful little companies, but not exactly products I used on a daily basis.
Eventually, as Peter Lynch advised, I recommended a company with a product I knew and enjoyed. The company was Papa John’s (symbol: PZZA). This was an excellent investment not just due to its attractive valuation and strong balance sheet, but because I love pizza!
At the time of purchase, Jayme and I worked at the same firm. To support our new holding, we made “pizza bets” throughout the week. The loser would owe the winner one large Papa John’s pizza (maximum two toppings). Unfortunately, I was usually on the losing end of these wagers as Jayme would only accept bets with favorable odds (to him!). For example, I’d bet the Federal Reserve was going to raise rates during its next meeting. Knowing the Fed loves easy money, Jayme would take the other side and win. After selling Papa John’s stock, the pizza bets ended, and I owed Jayme over 20 pizzas! Regardless of who won or lost, it was a fun way to help Papa John’s sales and closely follow our investment.
I was reminded of our pizza bets last week while researching Papa John’s. Considering its stock has been roughed up (down 37% YTD), I thought it was a good time to get back up to speed. The first thing I noticed was how much weaker its balance sheet had become over the past decade. When we owned the stock previously, Papa John’s was practically debt free. As of June 30, 2024, the company had over $700 million in debt!
Like many small cap companies we follow, Papa John’s used debt to fund a portion of its stock buyback program. As we discussed in The Buyback Wall of Shame, once a company leverages up its balance sheet, buybacks often slow or end. And once buybacks end, so does a very dependable bid!
After years of aggressive buybacks and debt accumulation, we believe Papa John’s has reached the point of redirecting capital from stock buybacks to debt reduction. In fact, during the first six months of 2024, Papa John’s didn’t buy any stock versus repurchasing $210 million during the first six months of 2023. The reduction in buybacks has occurred even as Papa John’s stock is trading at much lower prices. As companies with leveraged balance sheets often discover, opportunistic buyback programs can only be opportunistic if liquidity allows.
Interestingly, Domino’s Pizza finds itself in a similar position. After years of aggressive buybacks and debt accumulation, Domino’s has also reduced stock repurchases even as its stock price has declined (down 18% since 6/30/24). On Domino’s Q2 conference call, management noted, “…we did not repurchase any shares in the second quarter. We continue to maintain flexibility due to the volatility of the interest rate environment as we evaluate our upcoming debt maturity in October of 2025.” In effect, Domino’s is refocusing its attention from buybacks to debt reduction, especially as debt maturities approach.
After years of buybacks and debt accumulation, the once-dependable buyback bid for many small cap stocks is disappearing. This is especially important for small caps as they do not benefit nearly as much as large caps from the other price insensitive buyer—passive flows. Without buybacks and passive flows, a company must rely on fundamentals and investor scrutiny to determine its stock price (Heaven forbid!). Based on our observations, once a small cap company stops buying back stock and price discovery returns, its stock often underperforms. In effect, buybacks can work wonders for small cap stocks on the upside, but once the buyback bid disappears, beware of the downside.
As investors rotate into small cap stocks, we believe Peter Lynch’s advice of buying what you know is being ignored. Based on our bottom-up research and fair value estimates, we question if investors truly understand what they’re buying. While we appreciate the desire to reduce exposure to overvalued large cap stocks, we do not believe blindly rotating into less liquid, and often financially constrained, small cap stocks is the answer. In fact, with valuations still expensive, debt maturities approaching, and buyback bids disappearing, we believe investors currently piling into small cap stocks will ultimately be disappointed. Want to bet a pizza?
Eric Cinnamond
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Definitions:
Russell 2000: a small cap index that measures the performance of the small cap segment of the US equity universe.