Tuesday, July 17, 2018

Investment Climate July 2018: The Nonsensical Capital Gains Tax


Investors in Taylor Frigon Capital Management’s growth investment strategies enjoyed the best quarterly performance they have had in the last few years.  All portfolios ended the quarter with YTD performance that was well in excess of the general market, and the performance was broad-based, across a number of industries and sectors.  In our last quarterly commentary, we outlined a major change that is brewing in computer architecture for which we are positioning our portfolios. Some of those themes have already started to produce. And even some of our “older theme” positions have taken off, as well. It is particularly notable that we believe we are seeing the beginning and by no means the end of certain trends.  Thus, there is no one aspect of our portfolio management process to which we can attribute the performance.

We also noted last quarter that we transitioned out of a number of very long-term holdings that resulted in significant realized gains.  This transition has evolved over the last couple of years and we are pleased that we are much closer to completing that process than beginning it.  Needless to say, this results in the realization of long term capital gains and, therefore, the payment of capital gains taxes.  We will do everything we can to mitigate the impact of capital gains in our strategies, and considering we generally hold positions in our portfolio for many years exemplifies that approach, in contrast to management styles with higher turnover.  However, there comes a time when we have to realize our gains and reposition our capital in places we think can provide better returns in the future.

This necessity provides an excellent opportunity to reflect on tax policy and its impact on business and investment.

Anybody who is facing the hard, cold facts of paying taxes on capital gains understands how annoying, and even painful they can be.  In high-tax states like California and New York it is simply excruciating!  This allows those payers to understand that taxation affects behavior.  It often affects actions so much that people will make very bad investment decisions just to avoid taxation.  One example happens when investors blindly look to realize losses in companies that may be very solid long-term investments just so they can offset capital gains.  In other words, incentives matter, and tax incentives can lead to self-damaging decisions.

We struggle with the fact that tax law is inept, demonstrated by the fact that long term investors in real estate are given a favorable way to avoid capital gains taxes (1031 tax free exchanges, or “Starker Exchanges”) for “exchanging” (another word for “trading”) from one “like-kind” property to another, if done using a proper intermediary.  However, if one were to “exchange” (or trade) shares of Home Depot common stock for the shares of Lowes common stock (a like-kind exchange if there ever was one!) and did so by selling the Home Depot shares at a higher price than they had originally paid for them, he or she would have to pay a capital gains tax on the profit.  This creates a disincentive to making the trade, and a disincentive to investing in stocks altogether.  It favors investment in real estate over investment in the equity of a corporation.  It also incentivizes the real estate investor to over-pay for property just to avoid the tax (under 1031 exchange rules, the investor must identify a new property within 180 days) thereby driving the prices of properties higher than they would have been if the playing field were level.

None of this activity is grounded in sound economics.  It ultimately results in distortions and misallocation of capital, all of which hurts the economy, and ultimately costs us all in the form of lost jobs and even failed business.  With all the talk about taxes in the last year (and we would add that we believe there were some very positive aspects of the new tax law), we would’ve hoped the “un-economic” aspects of taxation would be addressed.  But they were not.  In many cases, taxes just got more complex, or at least were not made any simpler.

When we address this topic, we are often asked about a solution.  We have long stressed the solution is in true simplicity and a broadening of the tax base.  Here, we would argue for the lowest, flattest tax rate applied across all forms of income such that the incentives are all equally aligned to foster economic activity, favoring no one group or industry, and giving everyone a stake in the system.

Does that sound simple enough?

It is.

Do we think it will happen?

No.

Why?

Because politicians make the rules.

Meanwhile, we will continue seeking out companies that make it possible to, as Dick Taylor would say, “get by in spite, ”  and preferably “THRIVE” in spite!
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Disclosures: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Taylor Frigon Capital Management LLC (“Taylor Frigon”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Taylor Frigon. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Taylor Frigon is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Taylor Frigon’s current written disclosure Brochure discussing our advisory services and fees is available upon request. If you are a Taylor Frigon client, please remember to contact Taylor Frigon, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.

Monday, July 2, 2018

Have you heard of this company? Carvana (CVNA)

























image: Carvana website (link).

From time to time, we highlight specific companies which we believe fit the profile of a classic Taylor Frigon growth company. These are companies which meet specific criteria which indicate that they are well-run businesses operating in fertile fields for future growth, as discussed in previous posts  (such as this one) describing our investment philosophy.

Fertile fields for future growth often involve a paradigm shift in a business or industry -- and while companies involved in the technology industry may be the first that come to mind for many investors looking for paradigm shifts, transformative paradigm shifts are taking place in other industries all the time. Sometimes these shifts involve the application of new technologies to industries that might seem to have little to do with traditional "tech names" at all. Investors looking for growing businesses should be alert for such opportunities.

One industry that might seem to be far removed from the transformative power of technology is the used-car business. Over a trillion dollars a year are spent in the US alone for the purchase of used automobiles, but it is an enormously fragmented market, with many of those transactions taking place between private individuals or at small used-car dealerships, and some of them at new-car dealerships. The market is so fragmented that the largest used-car seller in the country, CarMax, makes up less than 2% market share.* An even more revealing statistic pointing to the extreme fragmentation of the market is that the top 100 players account for less than 10% total market share.

Into this trillion-plus-dollar marketplace, Carvana brings an entirely different approach, with the goal of transforming the car-buying experience using technology and a scalable logistics operation which enables them to cut costs, lower prices, and (perhaps most importantly) eliminate some of the biggest pain points in the used-car buying experience for their customers.* 

Carvana's approach is to use technology to eliminate the physical dealership and the used-car salesman altogether, enabling the buyer to shop for and purchase the vehicles entirely online, similar to any of the other e-commerce business models which have transformed retail. However, because an automobile purchase is so much larger than the typical e-commerce purchase, the auto-sales industry is not easily disrupted by the same forces that have so radically transformed (and continue to transform) other areas of retail. Among other reasons, auto purchases are very high-dollar (typically the second-most expensive purchase for any household), the sheer range of products is overwhelming (in terms of make, model, body style, year, mileage, special features, etc., about which different potential customers will have very different feelings, often strong feelings), the purchasing process itself is complex (and often involves the trade-in of another vehicle), and an automobile is obviously too large to send through the mail or leave on your doorstep in a cardboard box.

In order to create a buying experience which enables the purchase of something as complex, personal, and challenging as an automobile, Carvana has built a well-planned logistics infrastructure to enable them to acquire, stage, and deliver used cars to buyers all over the country. From the buyer's perspective, the process is extremely simple -- they can go online to Carvana's website, choose from an inventory of nearly 10,000 used cars and trucks, select the one they want, obtain financing if necessary, and buy the vehicle without ever setting foot in a dealership. The buyer schedules delivery, and Carvana then delivers the vehicle to the buyer's home or business, on a single-car carrier, as soon as the following day (depending upon the location of the vehicle they selected). Carvana also picks up the trade-in vehicle (if any), and takes it away to sell at wholesale auction (Carvana is not re-selling trade-in vehicles).

The purchased car comes with a warranty, and the buyer can return the vehicle to Carvana within seven days if they change their mind or find something about the car they didn't like.

The entire process is designed to be superior to other methods of buying a used-car by offering better selection (nearly 10,000 vehicles, with greater variety than can be found in a single local market or at a single physical dealership), better value (due to the elimination of traditional dealership costs, including the cost of real estate and the cost of paying a salesforce), and a better experience (making the purchase of a car as easy as other e-commerce purchases, and eliminating the pressure and haggling that is typically associated with buying a used car, whether from a dealership or from a private individual).

The entire online purchasing process takes about twenty minutes -- and some customers go through the process in as few as ten minutes. Additionally, by eliminating the costs associated with the traditional model, Carvana can save the buyer an average of about $1,400 versus the conventional used-car model. 

Carvana's logistical network consists of staging lots which do not have to be located in prime retail locations (they can be located "out in the woods" somewhere, in order to save on real estate costs, since customers do not come to these lots), as well as a fleet of multi-car carriers to move inventory between different staging areas around the country, and a fleet of single-car carriers to deliver vehicles within each selling region (each local market in which Carvana presently operates needing only two such single-car carriers, to take the purchased vehicles from the staging lot to the customer's home). 

Because Carvana owns their own trucks, and knows how long it takes to get a vehicle from one part of the country to another on its trucks, it can confidently tell a buyer when that buyer's vehicle will be delivered to them, and control the process to ensure that the car is delivered on time.

Carvana acquires (or "sources") their inventory at auctions, using their own proprietary algorithms based on what characteristics and features they believe will be the most marketable, and what they learn from the data they accumulate from their own business records. Unlike other buyers at auction, Carvana saves money by not sending human reps to these auctions, but instead relies on their algorithm, and then sends the acquired vehicles to centers where they will be inspected and reconditioned before being put up for sale. 

At the heart of this logistics system are these inspection and reconditioning centers, or IRCs -- a concept pioneered by CarMax and adopted by Carvana as well. At the IRCs, the vehicles acquired at auction are prepared for sale, and they are photographed from all angles, inside and out, so that they can be displayed online. Any flaws or dings are noted and listed, so that potential customers have a level of confidence and transparency that rivals what they could see in person at a dealership. 

Carvana's logistical network constitutes a barrier to entry for competitors trying to duplicate their system -- particularly the large-scale inspection and reconditioning centers that create the capacity to power a national used-car brand. It is important to recognize that the used-car market has previously been a local market. By creating the logistical backbone necessary to sell cars online nationwide, Carvana has created a scalable business -- one in which the number of potential buyers for their entire 10,000-car inventory grows with each new local region that they enter. 

Because they do not have to purchase or rent expensive real estate or pay expensive salespeople the way a traditional dealership would, it is relatively inexpensive for Carvana to open up operations in a new region -- they just need a staging lot to receive vehicles, and two single-car carriers with local customer-service personnel to deliver vehicles to their customers.

Instead of having a vehicle delivered to their door, the Carvana customer can also opt to pick up their purchased vehicle at one of Carvana's signature "vending machines," which they have built in selected markets. These machines are fully-automated (see this video) and are stocked with vehicles that have already been purchased by customers who choose to pick them up there instead of having them delivered. The image at the top of this post shows Carvana's newest such machine, a nine-story platform in Phoenix, Arizona -- their largest yet, capable of holding up to thirty-four vehicles at a time.

If you want to buy a vehicle from Carvana but live in an area where they do not yet have local deliveries, you can fly to a city with a vending machine to pick up your car and drive it home -- and Carvana will pay $200 towards the cost of your airline ticket (as well as pick you up at the airport to take you to your car, where it will be waiting inside the machine).

The vending machines are largely a marketing tool -- but they are a cost-effective form of marketing, usually built in a high-visibility location, visible from major freeways, and they help build awareness among the car-buying public of the Carvana brand.

Of course, any company involved in the auto industry will be subject to changes in market sentiment surrounding the perceived outlook for auto sales. However, investors should realize that when prices go down, Carvana is able to acquire vehicles for lower cost as well (and the opposite holds true in an up market). As we have written in other previous posts about our investment philosophy, we believe in owning a business through the market cycles, if it is a well-run business which is positioned in front of fields for future growth.

We believe that customers are becoming more comfortable with making even major purchases online, and that Carvana has created a well-conceived model to enable the online purchase of used cars -- a model which could transform the way many people buy cars. For this reason, we believe it is the type of company that investors should be looking for, and that it fits the definition of a Taylor Frigon growth company -- which is why we own it for our investors, as part of a portfolio of other companies from many different industries and sectors, in our Core Growth Strategy.


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* At the time of publication, the principals of Taylor Frigon Capital Management owned shares of CarMax (KMX) and Carvana (CVNA).

Disclosures: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Taylor Frigon Capital Management LLC (“Taylor Frigon”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Taylor Frigon. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Taylor Frigon is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Taylor Frigon’s current written disclosure Brochure discussing our advisory services and fees is available upon request. If you are a Taylor Frigon client, please remember to contact Taylor Frigon, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services.