Stock selection criteria

Dear Reader,


We have often mentioned in past articles on this site that our investments are primarily based on companies that are relatively easy to understand, with clear, basic and sustainable competitive strengths, favourable and stable market structures and a cheap price for the security of interest. We add to this criteria companies that have little debt relative to equity and generate a consistent positive free cash flow. In difficult times such companies are less likely to diseappear due to oweing more than they own, and less likely to find themselves in a desperate situation with limited liquidity; and therefore forced to borrow from banks or the capital markets at absurdly high rates . We truly live by our mantra: focus on the downside risk and the upside return will take care of itself. This approach allows us to try and reduce the number of assumptions we must make to decide on going ahead with an investment idea. The more assumptions we make, the higher the chance of error, and therefore a potential loss in invested capital.


We take this opportunity to summarise a recent position we have started to accumulate in our portfolios: Cintas (CTAS, NASDAQ).

Its primary business is designing, manufacturing and servicing employee uniforms. Over time it has expanded it´s product line to include linens, fire extinguishers and janitorial supplies. It also has a document-management business.

The key to Cintas’ business is the route density around centralized laundry and warehouse facilities. The more clients serviced within the radius of the facility, the higher the incremental margin earned on each additional client. Drivers are much more than just delivery people, they are customer-service contacts and are at least partly responsible for cross-selling additional services.

The Cintas growth story was built around successfully driving the consolidation of a very fragmented industry. As the market leader in a business with significant scale economies, they’ve been able to translate their size into higher margins than their competitors, and have also made it difficult to compete with them on price. This is the competitive edge of Cintas.

As the business matured, the City/Wall Street has consistently marked down Cintas’s valuation (low growth companies without large media attention are often punished by investment banks). The share-price damage only accelerated as the economy became worse in 2008/09. The company has responded by quickly reducing headcount and capital spending, but earnings have still been hit.

However, we are happy with the sustainability of the competitive edge of this company, which generates an earning power that can currently be bought for an attractive price.

We do not assume this company will grow more than in the mid to low single-digits on the top line. Yet, even with such an assumption, the valuation available in the market is likely to offer the possibility of generating a modest return over the next 5- 7 years (the next business cycle).

That may seem rather mundane, one does not look to double their money in the next year with this investment. Indeed, the reality is it is highly improbable in many investments. The search for quick money in stock markets often lead to quick losses. What is more probable with the average investment is potentially losing money, and this is what we feel we are not likely to incur with the purchase of the common stock of this company if bought at less than 25 USD/share. Yet, we will enjoy the benefit of:-

1. Growing with this company

2. Enjoying the market re valuation of its sustainable earning power


Over the next business cycle we feel we are likely to generate 50 – 80% return (including dividends) from this investment, with little possibility of making a permanent capital loss. This is likely to be substantially higher than the cumulative return on cash deposit rates during that period. We like to hold investments of these characteristics in our portfolio to help the portfolio generate consistent, low risk (risk as defined as the probability of permanent capital loss) returns.

However, we cannot leave this article with simply stating this is the perfect "no risk" stock. There are various business risks we are following that can either temporarily, or permenantly damage the valuation of the company (we are more concerned with the latter, and see opportunity with the former).

The health of the business is closely tied to employment, so continued rising unemployment would likely not be a positive for the share price. That could be partly offset – or exacerbated – by the direction of fuel prices, which are a big cost component. A more structural risk is that attempts to unionize the Cintas workforce gain steam with the advent of new labor laws and regulations proposed by the current administration. The company today has 34,000 employees, of which under 400 are unionized, so any significant shift toward a more unionized employee base could have a highly negative impact on margins. They’ve been successful in avoiding unionization so far, but it’s clearly an issue we have to continuously monitor. We like the approach management is tackling this issue as is displayed on its web site and corporate documentation.


Yours sincerely,

Alessandro Sajwani