Interview with Joe Koster

This summer (summer of '06) I interned for a value fund in Charlotte, North Carolina. The fund is Chanticleer. I was introduced to the fund, which is intertwined with Coastal Carolina , by Joe Koster who went to Coastal and currently works for Chanticleer as an analyst. Joe e-mailed with help on analyzying insurance companies, and I offered to intern for the fund.

I eventually met Joe in person at Mohnish Pabrai's annual meeting - which we both had the extreme fortune of attending.

More recently Joe agreed to do an e-mail interview:

Right Price Investing: Are their any industries you tend to specialize in, what are the boundaries of your circle of competence?

Joe Koster: There are really no industries I specialize in, but there are plenty of boundaries to my circle of competence. My basic approach is to run screens and find things that look like they could be cheap. I then dive into the SEC filings and know pretty quickly whether or not it is within my circle.

There are certainly areas, like pharmaceutical companies or high-tech companies that I know are well outside of my circle and will always avoid. I think making sure a company is within your circle of competence is the most important thing for a young analyst.

RPI: What do you look for first in SEC filings? Do you have a '5-minute test' a company must pass first?

JK: The first thing I do is read the business summary to see if it is a model that I could potentially understand. Then, I go straight to the balance sheet to make sure the company has a manageable debt load.

I then take a look and see how revenues and cash flow has been trending over the past few years and also calculate the return on capital. If nothing scares me away, I dig in to the latest annual report and proxy and go from there.

RPI: At what point do you first try to calculate the value of the company? Like some value investors do you not look at the stock price until you value the company to stop yourself from any potential bias?

JK: I don’t try to put a value on the company until I have read everything I can about the company. This way I can have a conservative idea of what the company might look like a few years out.

I may look at the stock price ahead of time, but I won’t put in the shares outstanding figure into my model until I have already made my conservative projections going forward. This way I can try and avoid that bias that comes with hoping there is a valid discrepancy between price and value.

RPI: Like Great Value investors Charlie Munger, Eddie Lampert and Joel Greenblatt, Chanticleer holds a very concentrated portfolio. How do you mitigate risk with little diversification, especially with small, micro-cap stocks?

JK: MARGIN OF SAFETY. We read and get to know everything we can about a company before investing and then wait (and in most cases, are still waiting) until we get a significant margin of safety before investing. Eventually, our portfolio will likely hold 10-15 names but being a young firm, we just haven’t found enough ideas that provide us with that required margin of safety to fill out the portfolio.

RPI: Chanticleer also owns many names that are private. Have you had trouble in the past in buying shares of private companies and getting financial info from them? Also do you feel it is advantageous to buy a private company versus a public one?

JK: Our President at Chanticleer, Mike Pruitt, has a great network of people he knows that allows us to get information about many potential private deals. The process we take in analyzing private deals is the same as when we analyze equities. We make sure the business is one in which we can thoroughly understand how the cash comes in and how it goes out. We then will only take a stake if we can buy in at a significant discount to what we estimate is the intrinsic value.

Normally the asking price is already on the table, but if it is not and we have to make an offer, we will make sure our offer provides us with that all important margin of safety. I think there are two main advantages in looking at private companies. The first is that you often have a motivated seller, which leads to a higher probability you will get the price you want. Second, there are usually fewer potential buyers (less competition) in the private deals that we pursue.

Of course, we would never buy a private company or invest in one that is inherently illiquid unless we feel there is top quality management to run the business.

RPI: Tandy Leather Factory is one company you own, what's the business story here?

JK: Tandy sells leather, tools, kits and other accessories to leather crafters. They have a strong brand name and a business that has historically thrown off lots of cash. The business had a couple of hundred retail stores when the previous owners and operators decided that the internet was the best way to sell their product, so they subsequently shut down all their retail stores. This didn’t go over well because leather crafters like to feel and look at leather before they make a big purchase and the Internet didn’t allow that (at least not yet anyway!).

The business went into a tailspin and the current operators, Wray Thompson and Ron Morgan, who had been with the company for a long time, were able to take control and put the focus back on making customers happy and growing free cash flow. The company is now back expanding its higher margin retail operation, but is doing it very carefully so that they can make sure they don’t saturate their markets.

They have about 60 retail locations open now with plans to open about 12 a year until they get to about 100-120 in total. The stores are not capital intensive and are free cash flow positive about 90 days after opening. The management is great, both at the top and at the store level. The business has good returns on capital, with a great balance sheet, and little to no competition. What’s not to like?

RPI: Where do you put the value of Tandy? And how do you find it?

JK: We think TLF is worth about $8.50-9.00. That is based on a discounted cash flow analysis. It also has an earnings yield of about 9% pre-tax and a free cash flow yield a bit above the risk-free rate, which isn’t bad for a company with extra cash on the balance sheet, returns on invested capital around 35%, no competition, and steady growth over the next few years. As you can see, the margin of safety has closed a bit so we’re not adding to our position yet, but we’re certainly keeping a watchful eye.

RPI: One private holding of Chanticleer is Hooters, what niche do they have to keep them from the fragmented restaurant industry?

JK: The Hooters brand name is what we think is their biggest competitive advantage. The Hooters Girls, of which there are now over 15,000, are probably the biggest contributor to that brand name. Mr. Bob Brooks, who unfortunately passed away last year, did an absolutely incredible job of taking a concept from a couple of stores in Florida into one of the world’s biggest and most recognizable restaurant chains. We are excited to be involved with a business that has the great worldwide recognition of Hooters, and look forward to being involved for a long time to come

RPI: Scuttlebutt, which got its name form Phil Fisher's famous Common Stocks and Uncommon Profits, is the type of analysis where you interview management, customers, suppliers, ex-employees and everyone else you can find that know something, anything, about the company. Basically an extreme hands-on approach. What kind of scuttlebutt do you do and do you feel it has helped in deciding whether or not to invest in companies before?

JK: We try to talk to as many people as we can about the company until we think we thoroughly have a complete understanding of the business model.

For example, when we were going through the due diligence process on TLF, we talked to the top management first over the phone and then got permission from them to call all of the store managers around the country. We also visited one of their stores here in Charlotte and then another analyst at Chanticleer, Matt Miller, went out to visit the company in Forth Worth, Texas. He got to meet the executives in person and also all of the other key people at the company, of which every single one was terrific.

He also got to see the depth of management at Tandy and even took a leatherworking class. We knew the financials looked great, but the scuttlebutt gave us a detailed picture of day-to-day operations, extreme confidence in management’s ability to perform over the long run and the confidence to average down after we took our initial position.