Around a year back, Carrier (CARR) was spun off from UTX (now Raytheon Technologies). The event coincided with one of the craziest markets of all time. And so happened to be the opportunity. Stuck in the stay-at-home orders, I, too, took the plunge to start public writing. Honestly, writing was never my forte. But someday, you’ve got to begin. Anyways, the primary goal remains improving my investment process and get feedback from the smart people around me.
Finally, I sold off my entire position in CARR on Friday, garnering a decent 3.5x return in a year. I wanted to have cash for upcoming situations, and my portfolio’s exposure to the HVAC sector was becoming progressively higher because of my holdings in Honeywell and Johnson Controls.
Frankly, I didn’t expect this return in a large-cap stock in such a short time. While I always prioritize the process over the outcome, it’s a great feeling when you get a great outcome following your investment philosophy. I’m a big Joel Greenblatt fan. I might have read about his investment in Host Marriott spin-off (having similar parallels to CARR) in his classic book numerous times that I could speak about it even in my sleep now. Last month, I was amazed to read exquisite details about that investment along with excellent insights on Greenblatt’s investing principles in a fascinating book – Richer, Wiser, Happier. The author, William Green, brings never-before known investing principles from one of the world’s best super investors in this highly recommended book!
Hence, after selling my position, it was a good opportunity to document my learnings and what I could have done better by drawing parallels with the Host Marriott spin-off. I conclude by highlighting my notes on the HVAC industry.
Lesson 1: Vantage Point – keeping an eye on the debt market
With UTX squeezing out ~$ 11 bn of cash from CARR at the time of spin, the biggest fear was that a highly levered CARR with 3.6x net debt/EBITDA will breach its covenant terms by exceeding the 4x threshold. Imagine an already orphaned equity also losing its investment-grade (IG) status. It would have been catastrophic. But could a 100+ years old household brand name that is still the market leader in a high-entry barriers business, generating positive free cash flows of $1.5 bn- 2 bn in average years default? Market perception of it being a pure cyclical stock despite 75% revenues coming from the replacement market didn’t spare it either. With a market cap, that time, of $11 bn, implying an FCF yield of 16% was undoubtedly ringing bells for value investors.
“Marriott had two businesses: a beautiful swan and an ugly duckling. The beautiful swan (Marriott International) would be free to swim off into the sunset, leaving the ugly duckling (Host Marriott) to drown. Host Marriott was a highly levered stock that no one wanted to own. In the case of Host, though, I noticed a different kind of opportunity: tremendous leverage. Though the market may value the equity in one of these spin-offs at $1 per every $5, $6, or even $10 of corporate debt in the newly created spin-off, $1 is also the amount of your maximum loss.”
– Joel Greenblatt (extracts from Richer, Wiser, Happier & You could be a stock market genius)
As an equity investor, it sometimes pays to take signals given by the debt market. Bond yields after spiking >5% started to normalize. Debt holders realized that things were not that bad with no payment due until 2023 and a stable cash balance with an unused revolving credit facility of $2 bn available. This was my moment to strike after doing my due diligence.
Outcome: The rejuvenated management fresh out of the clutches of legacy workstyle ensured the deleveraging from 3.6x to 2.6x. Moreover, they have guided to take it down below 2x. CARR started with ~$10 bn of net debt and ended the year with $7.6 bn. Apart from free cash flows, let’s see more below on how it was able to successfuly deleveraging.
Lesson 2: Vantage Point – Hidden Assets
“The way you’re going to find bargains,” he says, is by searching for hidden value in assets “that other people don’t want.”
– From Richer, Wiser, Happier
Sometimes you don’t need an external activist when management itself speaks of becoming one. As part of the simplification process, I highlighted the CEO’s intention to dispose of anything that is not core. A good starting point for me to dig these non-core holdings (I call them hidden assets) was to look out at the footnotes for equity method investments. This led me to a stark realization that the company was saddled with 60 JVs with minority stakes of less than 50%. Do they make sense or move the needle?
The majority didn’t. But where could the money come from? Most of the valuable JV’s were with Watsco, Midea and Toshiba. Moreover, these were private and illiquid. But one of the JV was a publicly traded company – Beijer, an HVAC distributor in Europe with market cap of ~$2.5 bn. CARR’s ~37% stake in Beijer could have quickly filled ~$1 bn in its coffers when needed. Investing is not a stand-alone factual process. Joining the dots was equally important. This was a critical margin of safety to consider (Greenblatt style 😊).
Outcome: As of Q1 2021, CARR has exited 20 JV’s and plans to bring it down to 32 short-term. Most notable was the stake sale in Beijer for $1.4 bn (pre-tax gain of $1.1 bn), just as the equity markets stabilized.
Lesson 3: Overcoming Anchoring Bias
Right at the height of the pandemic, it was natural for me to model the most pessimistic estimates. I assumed that sales won’t recover to 2019 levels, at least until 2023. I was dead wrong. Revenue declined by only 6% YoY for 2020 against my expectation of a 15% decline, and it is well on track to exceed 2019 levels in 2021 itself. Hence my blue-sky scenario of a $27 share price (100% upside) was hit just in a few months.
Lesson 4: Position Sizing
I exited half of my position right after 50% gains. Thankfully, I didn’t sell 100%. Having a selling discipline mattered. Else I would have regretted losing the significant upside. Could I have bought more? Was my position sizing sufficient to match my firm conviction? Unfortunately, no! Together JCI and CARR formed just ~15% of my portfolio after the rise till last week. This was despite closely tracking the HVAC sector and having a high conviction.
I had the historical precedent of Trane’s mammoth re-rating (a much better-positioned company) from a 12x PE to 30x PE after it spun off Ingersoll-Rand. I had seen the true economics of a mature pure-play residential HVAC player (Lennox) playing out with sustainable RoICs of the high 30s despite operating in a cyclical industry. It might be I underestimated the rapid flows from ESG and sustainability funds to HVAC players.
Twitter is a beautiful platform. It always delights you with timeless learning resources. Recently, there was an interesting thread on position sizing shared by Clark Square Cap and Read Capital. Here Greenblatt in conversation with Shane Parrish speaks about “Being too timid on a few good ideas that come your way is the biggest mistake people make…” This to me was worth documenting as I want to imbibe this in my mental model for such situations in the future to become a better investor.
Read Capital shared an interesting anecdote from Richer, Wiser, Happier that further reinforced my learning for the current post. Greenblatt had put 40% of his fund in one this one position! In an interview with William Green, Greenblatt says – “I don’t buy more of the ones I can make the most money on. I buy more of the ones that I can’t lose money on.”
Within four months, Greenblatt tripled his money as this ugly duckling defied its doubters and took flight. Greenblatt had never expected the wager to work out so quickly. “That was luck,” he says. “But we set ourselves up to get lucky.”
– From Richer, Wiser, Happier
Notes on CARR and HVAC industry
Market share Gains
Over the last year, both CARR and Trane have been able to garner market share. Probably because the competitors were having supply-chain problems. To add, CARR has added about 600 salespeople over the last 9 months. This year the Watsco and CARR JV acquired the largest Carrier distributor in the Midwest – TEC, a privately owned entity led by Skip Mungo, who’s regarded as the best-in-class in the Chicago region. CARR is serious about gaining market share as it has further aligned 40% of compensation incentives for its executives to sales.
CEO to build aftermarket similar to his Aerospace experience
While Carrier is #1 in the residential and light commercial HVAC markets, it is distant #3 in applied and lags in China. The company wants to become #1 in applied in the next 5 years. All good so far. But unlike in residential/light commercial, the sale of a chiller has lower margins in applied. Hence the margins are sacrificed to gain market share. I sense that David, CEO, who comes from the Aerospace background of UTX, wants to play the longer-term game of garnering a higher aftermarket share. The current aftermarket share for CARR is just 30%. Whereas in aerospace, you control the entire 100% aftermarket for your product. Hence, it will be interesting to observe the strategy.
Digital healthy buildings offering & School reopenings
With reopening around, how do you quench the anxiety of people willing to go back into crowded indoor spaces – be it a commercial office building or making a restaurant reservation? Enter the digital healthy building offerings, which ensures a safe indoor air quality (IAQ) by interacting smartly with various data points in the building. It promises to gather information on air quality levels (ventilation, Co2, particulate matter etc.) on a real-time basis, thereby adding to sustainability.
The leaders here are Siemens, Honeywell, Schneider and Johnson Controls, which can control the platform. Many of these companies have talked about $10-15 bn type opportunity. Through their SaaS-based, cloud platform they are equipped to carry a host of services connecting the lighting, elevators, energy efficiency etc., to make a building more sustainable. Carrier was late into this with its launch of Abound. Hence it will be focusing on an open architecture product that will remain platform agnostic.
Replacement cycle and SEER upgrade
A higher-priced SEER upgrade regulations (more energy efficient) will come into effect in 2023. Along with that, new refrigeration requirements will kick-off between 2023 – 2025. California is at the forefront in the reduction of HFC emissions in HVACs. Companies with better design preparedness will benefit. It will also ensure better pricing but could lead to a prebuy in 2022. This might also match with the end of the 18-year replacement cycle I wrote in my post. After all, all stocks are cyclical in nature. But I’m optimistic about the environmental impetus from the Biden administration to curb emissions. Around 15% of all greenhouse gas emissions come from HVAC systems, and 50% of the electricity generated in your home comes from HVAC.
The Investing Principle (TIP)
Position sizing matters – matching one’s position with conviction is crucial. Getting to know inside the minds of the greatest investors help to train one’s mind because market may unsettle you in the short-term.