Market Reflections
If the story of 2023 was the “Magnificent 7” then there is a strong argument to be made that the most important story of 2024 is the “Magnificent 1”. Consider that Nvidia, by itself, has added nearly 5% to the S&P 500 overall return this year. In fact, Nvidia is now valued higher than Meta Platforms, Tesla, Netflix, Advanced Micro Devices, Intel, and IBM combined. It is even valued higher than the entire Canadian stock market!
We bring this up today because an ongoing story in the stock market over the past few years has been the ever-increasing dominance of just a handful of massive technology companies on market level returns. For example, market level returns are currently masking a lot of underlying weakness in the broader equity market:
Charlie Munger, the famous investor and long-time business partner of Warren Buffett, who sadly passed away earlier this year, had a great saying, “there is no better teacher than history in determining the future.” If we look to history, we will find that over longer periods of time the largest names in the index tend to underperform, not outperform. This is nothing other than math – the larger a business is, the harder it is to move the needle on growth.
For further evidence from history, consider the start of the 1980s when it seemed like IBM would be the clear winner going forward, or the start of the 1990s when it was clear that investing in Japan was right choice, or the beginning of the 2000s when Microsoft and Intel’s PC monopoly dominated the market, or the beginning of the 2010s when the so called “BRICs” – short for Brazil, Russia, India, and China – were thought to be the best choice for investment dollars. In each decade, the only certainty was that whatever the current investment fad was it would fall way to a new one in a few years’ time – often with a lot of pain for investors that bought into the hype at the top.
What is the current fad that is being predicted to dominate the future? Artificial Intelligence (AI). You will likely have read about or tried out the new ChatGPT product from OpenAI. The importance of ChatGPT’s launch was not so much in the technology itself (Large Language Models have been around for a while albeit not publicly) but in how it was packaged in a way that made the technology actionable and relatable to almost everyone – artists, students, business executives, etc. ChatGPT was the first product that gave us a glimpse of the utility we might gain as a society as this technology is refined and perfected.
However, as has been true with each paradigm-shifting technology that came before – the personal computer, the internet, smartphones, social media, etc. – markets tend to get ahead of themselves in bidding up every possible winner, despite history showing time and again that early winners in these revolutions (Macintosh PC, Yahoo, Blackberry, MySpace, etc.) are rarely the same winners a decade later (Windows PC, Google, iPhone, Facebook, etc.) not to mention the disruption to older industries that are displaced by these new technologies entirely.
The most important thing to remember regarding these “revolutionary technology” narratives we hear about in the media is that you can accurately predict that a technology will be revolutionary and still lose a lot of money betting on it as an investor – just look to the history of the automotive or airline industries. The better strategy is to continue looking at businesses on a case-by-case basis, focusing investment dollars solely where there is high confidence in what earnings power will be a decade from now regardless of whatever happens with this AI revolution.
And while this may be one of the strangest bubble-like market concentrations we have experienced in our careers, it is not all bad. When we do the fundamental work of looking under the hood, we are finding that many businesses that have not been caught up in this AI hype cycle are actually trading at very attractive valuations. When investment dollars are flowing to the largest businesses with no regard for valuation, those flows can create many great opportunities elsewhere.
In other words, we believe the future looks very bright for active stock picking.
Brasada Investing Philosophy
As long-time Brasada clients will know, we offer multiple strategies to better serve the unique needs of every individual. This makes it difficult to write a “one-size-fits-all” quarterly letter. However, no matter what strategy one may be invested in at Brasada, there are some things that will remain constant throughout – namely, our adherence to an overarching Investment Philosophy.
As a starting point, we would like to make a very clear distinction between speculating and investing. Two words which are often used interchangeably in the investment industry, but which to us represent fundamentally different pursuits.
Speculation involves buying an asset in the hope that someone else will pay more for that same asset in the future – your return is solely from price appreciation and is therefore reliant on one’s ability to forecast the actions of other participants. In contrast when you invest, you allocate capital in specific assets to generate a positive return in and of themselves. We participate exclusively in the second of those two disciplines.
There are many strategies that occasionally deliver high returns (usually with hidden risks) running strategies that are more akin to speculating, but almost like clockwork, when the tide goes out, these strategies are often left suffering significant losses.
Rather, we do the fundamental work of evaluating businesses as long-term owners would, where we establish an underlying intrinsic value for the business itself, based on our expectations of its long-term ability to generate cash flow. As such, our returns as investors will track the performance of the businesses themselves.
Stock Selection
Thinking like a business owner means being interested in owning only what we believe to be truly wonderful businesses; the sort of companies that sit within attractive markets, with secular growth drivers, that are steered by excellent and correctly incentivized management teams, and which possess a significant and enduring competitive advantage – so there can be confidence in consistent and growing cashflows well into the future. All these (and many more) factors go into determining both the quality and the value of any business.
One implication of this approach is that when applying such a threshold to business quality, the investable universe shrinks markedly. We believe that most businesses listed on the stock market simply do not meet the necessary requirements to be investable. For example, in our view there are many industries so heavily regulated that individual companies have little control over returns, and many whose returns are determined by unpredictable commodity prices; there are others operating in declining industries, and many in markets so competitive that returns are miniscule. Instead, we focus on finding and understanding truly great businesses and seeking to own them at attractive prices.
Another implication of this approach is that it leads to a natural understanding that underlying business value can be very different from a business’s stock price. In our view, real business value (whether private or public) is derived from the future cash flows that can be produced for its owners over the long run. It is something that while subjective, can be estimated within a reasonable range and changes little over days, months, or even quarters.
On the other hand, stock prices can be volatile with fluctuations of as much as 30% in a quarter for no apparent reason. Why the disparity? Because stock prices are driven by many factors that are short term in nature, impossible to predict, and often irrelevant to actual underlying business value. Think of things like sentiment, asset flows, index inclusions, ‘style’ popularity, algorithmic trading, etc. In other words, there are hundreds of factors that drive stock prices up and down every day, but which have no impact on the value of the underlying business.
For us, we view this disparity between business value and stock price as a significant opportunity that can be exploited through a long-term mindset. The reason for this confidence is that if short-term factors are depressing the price of a stock, but the underlying business is grinding out consistent earnings growth, then eventually it is likely that either the market will come to appreciate that underlying business value growth in the stock price, or someone would just step in and buy the whole business at a premium.
As Ben Graham says, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
Portfolio Management
Another common attribute of all our strategies is how we view risk and diversification at the portfolio level. While we are cognizant to maintain exposure to different end markets, we do still concentrate our capital in only what we think are the most attractive opportunities available to us. In other words, we firmly believe it is better to own 20 to 30 names that we know inside and out than it is to own 500 names that we know nothing about. This approach differs significantly from the rest of our industry.
For example, the prevailing view within the investment industry around risk and diversification is that risk equals volatility and that in order to reduce volatility one should own many, many different stocks. In our opinion, the industry uses volatility as a proxy for risk because it is easy to calculate and can be integrated into sophisticated modeling, which has the ability to provide a false sense of security.
However, we do not think that price volatility is the same thing as risk. Volatility is backwards looking, it assumes a normal distribution, and leads investors to make the wrong decisions at the wrong time (selling into a panic). For example, if a stock price suddenly dropped very sharply compared to the market, that stock would now be deemed as “riskier” at its new lower price than it was at its higher price. We are hard pressed to see the rationality of thinking paying more for something is less risky.
More fundamentally, the problem with viewing volatility as risk is that volatility is solely focused on stock prices, not business value. We take the view that the real risk investors face is the risk of permanent business value impairment. Avoiding this kind of investment risk requires thinking deeply about the long-term economic characteristics of a business – factors such as management, competition, pricing pressure, regulation, industry shifts, consumer demands, etc.
Once the focus shifts from volatility to underlying business risk, it allows us to make calm and calculated long-term decisions even when the rest of the market is panicking over increased volatility. And for us, that is the true value of fundamental active management, arbitraging the difference between short-term sentiment shifts and long-term business fundamentals.
Investment Highlight: CCC Intelligent Solutions
In order to give clients a more concrete example of our philosophy in action, we thought it would be helpful to start highlighting investments from our different strategies in these quarterly updates. Today, we would like to highlight CCC Intelligent Solutions (CCCS), a recent addition to our Friedberg Focused Equity and GCI Select Equity strategies.
CCCS is a business that is central to the automotive insurance ecosystem. Its software systems connect autobody repair shops with parts suppliers and insurance carriers. There are multiple necessary points of contact between these three parties in the process of settling a claim, and CCCS helps streamline it all in a way that gets cars off the lot and back to owners more quickly and efficiently. That's of immense value to the insurer (rental days) as well as the repair shop (labor hour throughput).
CCCS has the dominant position in this market with an installed base that includes all but 3 of the top 30 insurance carriers in the U.S as well as somewhere around ~30k out of ~35k autobody repair shops. Consider that ~80%+ of all US Auto Claims are running on the CCCS platform – this looks like a winner takes all market, and CCCS is already the winner.
Source: CCCS Investor Presentation (May-June 2024)
CCCS also collects data on over $100 billion annual transactions in this space. Their vast and growing data set offers a unique position to leverage data analytics and ML to automate the insurance claims process. Their customers – those insurance carriers and repair shops – continue to face headwinds from inflation, including labor, parts, and more complex repairs, given greater advances in vehicle technology. This all creates the need for new solutions which CCCS is uniquely positioned to provide.
In terms of what attracts us here, CCCS is a SaaS business model that generates high returns on capital, has durable growth with a long reinvestment runway, is non-cyclical, has high customer retention, and has a longtime CEO (1990s-today) who has proven himself to be a good capital allocator – investing early in technology (cloud in 2003, AI in 2011) to keep CCCS ahead of the industry while consistently using its vast data set to create additional value for customers.
And that last point is key, we find that almost all the best companies have some sort of customer obsession. Whether it is Costco, Amazon, Copart, Chick-Fil-A, etc. the common factor is the core desire to delight customers and earn their loyalty and thus greater future business, which in turn allows them to avoid the growth fade that almost all other companies experience. CCCS is no different, and one of the few vertical SaaS plays where customers all seem to have nothing but nice things to say about them. As far as Net Promoter Scores, CCCS is in the top percentile as far as Software benchmarks.
Source: CCCS Investor Presentation (May-June 2024)
Now, the best place to be is probably a high NPS software product with low market awareness/ penetration, because then all you need to do is add some sales and marketing and you can jumpstart growth. The second-best place to be is probably a high NPS software product, with high market share, where winning new customers is hard, and market share shifts are non-existent. Let’s call this the Microsoft Office goldilocks zone where even if Excel’s yearly cost doubled overnight, it would probably still be a hugely positive ROI, considering how much of the world’s output depends on it.
CCCS is in that second bucket, which we think is a good place to be, but we also get the bear case – how do you grow a business that is already a near monopoly? But there is already evidence of that happening, growth has actually accelerated here over time through new products and expanding into adjacent segments like parts and casualty.
Source: CCCS Investor Presentation (May-June 2024)
What is the Competitive Advantage of CCCS?
Source: CCCS Investor Presentation (May-June 2024)
CCCS competes with a private equity owned company called Mitchell and to a lesser degree a company called Solera. Historically, the way the market has worked is that competitors would come up with single point solutions, which CCCS would then either copy or acquire, plugging into their established install base, and winning through a one-stop-shop solution. As such, overtime, the overlap between CCCS and their smaller competition has gotten less and less as the Mitchells of the world retreat to areas of the market CCCS isn’t big in like casualty.
My understanding is the only large insurer that uses Mitchell for estimation purposes is Progressive, so repair shops may maintain a Mitchell subscription just to get that Progressive business, but in almost every case they will have the CCCS subscription as well. Mitchell has basically bet its entire product roadmap on pleasing Progressive, and as such has lost business with everyone else. The way one customer puts it:
Every few years, we would look at them. And the only real competitor out there, honestly, was Mitchell. And Mitchell was, I would say, Mitchell was way behind for a very long period of time.
At the end of the day, there was nothing that compelled us to feel like we needed to make the change away from CCC. There was nothing that Mitchell was bringing to the table that we thought would benefit us from moving away from CCC. Solera is out there, but really Mitchell is the only other, I think, meaningful competitor realistically.
CCC’s technology is really good. They are very linked into the body shop network. But there are a couple of other things. First, CCC has really been, I think, on the cutting edge of expanding their capabilities in the auto space. So, they're owning more and more of the space. It's no longer just auto physical damage. They're into other areas as well. So, there's a whole suite of products right now that we were utilizing that go beyond offerings that Mitchell has. Now Mitchell has a bill review tool as well, but Mitchell isn't so much involved in the other spaces. So that's another thing.
And then the final thing that I would add is that CCC is really excellent in terms of client relations. They have individuals that are dedicated to each of their carriers. There's a regular dialogue that takes place between them and the carrier partners that they work with. They do a lot of one-off things, whether it's data requests or customization things that we want to do. And they also have what they call an advisory council. And that advisory council is made up of customers. And those advisory council meetings, they seek feedback on what's working, what's not working, what other things could we do that would be of value, et cetera, et cetera. So, I mean, they've just carved out huge aspects of this business in a way that there's a lot of stickiness.
One of the benefits of the CCC tool is we get a lot of data. And the data is helpful to us in terms of evaluating shops, in terms of developing performance scorecards for our staff and insights into the business around what's happening from a trending perspective.
Consider if a repair shop was to use Mitchell and a customer came in with insurance that didn’t use Mitchell, then there would just be no way to electronically submit that claim to the insurance company’s adjusters. It must be e-mailed, or faxed in. So, the options really are to use CCCS as a repair shop, or do things manually, and wait for a check in the mail that can take weeks.
Another thing to consider here is CCCS’s relationship with insurance core vendor Guidewire which is basically the lifeblood system for the work adjusters do. CCCS plugs into Guidewire through an API and as far as we can tell, there’s very little decision support tools and capabilities built within Guidewire itself, instead that is integrated through vendors like CCCS. Guidewire builds their system in a way that they can integrate easily with a lot of these data platforms. And so, it really is in synergy with one another as opposed to direct competition with one another.
As far as the competitive moat here, it is basically switching costs, the network effect, and the scale + data advantage. On the first and second point, CCCS has a Direct Repair Program (DRP). Basically, a DRP connects auto insurers and collision repair shops to facilitate standardized repairs. These DRP connections have created a strong network effect for CCCS’s platform, as insurers and repairers both benefit from a virtuous cycle in which more insurers on the platform drives more value for the repair shops on the platform, and vice versa.
On that last point, CCCS can spend more on R&D in absolute terms than their competitors, and the historic crash data that they have is an amazing asset – they have $1 trillion of crash data that they can train their models on. This data is very granular, consistent of hundreds of data elements per claim, and is updated in real time from the massive amount of data flowing through the system daily.
All of this lends itself to considerable pricing power – this is a chicken and egg thing where insurance can’t roll off CCCS because all the repair shops use them, and the repair shops can’t roll off because all the insurance companies use them. And yet, CCCS has never been that aggressive on price – they've been a pretty good partner. From a customer:
So, we always found them to be good partners, they’d come back every few years when the contract was renewed, they'd want more, and we pushed back a little bit at it. But I felt like it was a pretty good and healthy dialogue, and we never ended the contract negotiation with them in a place where there was any bitterness.
What is the Growth Runway for CCCS?
Source: CCCS Investor Presentation (May-June 2024)
To say the U.S. car market is large might be an understatement. There are ~285M registered vehicles and ~240M registered drivers. Americans purchased ~16M new cars in 2023 and the total miles traveled by all vehicles in 2023 was nearly 3.3T. Given these numbers, there will inevitably be accidents.
Processing the claim from a single accident can require hundreds of transactions involving consumers, lenders, collision repair facilities, automotive manufacturers, dealers, parts suppliers, medical providers, vehicle auctions, and others.
These transactions depend on extensive hyper-local decisions and data, creating a level of complexity that can increase processing costs as well as the potential for fraud and other forms of claim leakage. This complexity is only getting worse due to several converging factors:
For many years in a row now, combined loss ratios in the insurance industry have been over 100%. In other words, insurance companies take in $1 of premium and pay out more than $1 in claims and expenses. Inflation has caused huge issues with parts and labor costs while regulations make it difficult for insurance companies to raise prices fast enough to offset the impact.
Source: https://www.bloomberg.com/opinion/articles/2024-05-23/more-cars-are-being-totaled-as-repair-costs-used-car-prices-bite
The only way to effectively manage this increasing complexity and cost is through digitization. Back in the day, all this was a highly manual process. Very disjointed, lacking coordination. Everybody kind of did it differently. As we already talked about, along came CCCS saying, hey, we're going to try to standardize this process and automate it. If everyone in the ecosystem can operate on the same platform and they can all agree on some standardization around pricing for things like parts and labor, it makes it less arbitrary, it creates less friction, and it reduces cycle time. Hence why the ecosystem has come to not only rely on but embrace CCCS as a near monopoly solution.
Management has put out a 7-10% organic topline growth guide and internally it sounds like they target 15% topline growth. How are they going to hit these numbers?
Source: CCCS Investor Presentation (May-June 2024)
Let’s start with the automotive repair side. They have about 29,500 auto shops on their platform, and the total market is probably 40,000 repair shops, in which maybe 34,000 are doing real auto body work, and the rest are doing things like oil changes. That leaves maybe 4,500 new logos to go after, so not much growth runway there and that 4,500 is probably exclusively Progressive and Mitchell’s DRP anyway. The remaining growth here is going to largely be from upsell.
The entry level SKU for repair shops is just going to be Estimating, the next level up is going to be estimating plus DRP tools, and then the big package is going to be all of that plus workflow (ERP for the repair shop). Workflow customers are only about 30-40% penetrated and there does remain a long runway as mom-and-pop locations are consolidated and update their tech stacks.
The other opportunity here is in their diagnostics product (think car readouts). As the diagnostic scanning rate increases over time, the way CCCS monetizes that is they charge a toll for providers to be on their network. As usage increases, it’s basically a 100% EBITDA drop through because there's not really a cost associated with it. Maybe 15%-25% of all repair orders today have a diagnostic scan, but that is increasing quickly as repair shops need to make sure sensors, cameras, and ADAS systems are working before sending cars back on the road.
Management has talked about this being a north of $300M revenue opportunity (they only did $866M of revenue in 2023).
And then moving to the insurance side of things. Similarly, there isn’t much room for new logo growth, they already process something like 80%+ of all claims. Instead, the main growth engine here will be adoption of straight through processing (STP) over the next few years. STP is just a fancy way of saying fully automated claims processing from start to finish. It will take a few years to fully scale this product, starting with simplistic claims, like a small fender bender with one party, and then building off that with better models until 100% of all auto claims are completely touchless. They have had early success here with customer feedback being very positive.
The other driver on the insurance side is going to be on the casualty side, think bodily injury in car crashes. CCCS may have a monopoly in physical damage, but they haven’t even scratched the surface on the casualty side (Mitchell actually has more market share on the casualty side). If CCCS can get their casualty product up to par with point solutions in the market, and plug it into their full menu offering, then there is the opportunity for significant growth here.
The other nascent business with upside is their parts marketplace. Parts is tricky, up until a couple of years ago there were three main players, OPSTrax, OEConnection, and CCCS, and each of them had approximately 1/3 market share. But then OPSTrax and OEConnection merged with each other, giving them the best scale, which is important when you are a marketplace, offset by the fact that they aren’t integrated with the insurance estimating process.
Where CCCS could still win here is by winning on the STP front and having parts procurement just one more step on the fully automated process. In other words, taking the decision away from the body shop technicians who might not be shopping around for the best deal nor the best cycle time in the way an automated process could. According to a former employee:
I talked to the CEOs of a couple of MSOs when I was refreshing the parts strategy, and they both said this uniquely on their own and saying, "Hey, if you can like automate this, like I will drop the other providers, and I will exclusively go with you because this is like a huge deal. We're leaving lots of money, gross profit dollars, on the table because we're not able to automate the decisioning”.
Big picture, the way to think about CCCS is that the steady state business can do 5-10% organic growth purely from established pricing and upselling. Along with that, there are some upside options, if they nail STP, if they nail the parts marketplace, if they nail something entirely different that we aren’t even talking about today that will help the ecosystem, the growth rate can be closer to 13%-15%. If we can buy this underwriting 9% growth, then these upside options will give us a nice margin of safety.
We believe the economics here are pretty locked in for the next few years, and at today’s valuation we expect to earn double digit returns with very little risk of permanent business value impairment.
As always, please feel free to reach out to us if you would like to discuss anything in this letter in further detail.
Sincerely,
David Shahrestani, CFA
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