The world according to GARP: CarMax KMX

I'm not talking about the Robin Williams film from the early 80's, I'm talking about Buffet's type of GARP: Growth at a Reasonable Price. Sometimes you'll see companies that trade at a premium P/E ratio and P/B ratio to its competitors, yet value investors like WB are buying the stock hand over fist. Why? Usually because:

1. The company has a wide economic moat that gives it a durable competitive advantage over its peers and an intimidating (or down right boring!) barrier to entry for future potential competitors. Brand recognition, scale, regulatory hurdles achieved etc etc contribute to the moat Example: Costco COST
2. The company has stellar management with its interest squarely in line with the shareholders. High insider ownership (not options), compensation that is performance based and reasonable corporate governance structure are check boxes here. Integrity of the CEO/CFO are key. Example: American Express AXP. NOTE: As a free market capitalist, I certainly have NO problem with senior executives getting rich as long as they create equivalent shareholder value along the way. Read more about the AMEX example here.
3. The company has a track record of increasing ROIC (Return on invested capital), ROE (Return on Equity) and returning wealth to the shareholders in the form of dividends and share buybacks if it cannot increase these metrics (mostly because it's too big). Example: HOG

Carmax KMX is a rapidly growing, mid cap ($ 4 B) used car dealership chain spun out of Circuit City in 2002. It has 90 stores and has been increasing new store openings at 20% yoy, targeting medium sized urban communities and 10% market share in those areas.

What distinguishes KMX from its many competitors is its business plan that has been very difficult for its peers to reproduce so far:

• customer experience oriented sales: no haggle pricing, flat commission for salespeople who are purposely chosen from fields outside of the auto industry, one person deals with customer from introduction to finish, including financing
• scale of company and innovative IT network allows customers access to larger choice of colours and styles of vehicles than the vast majority of competitors as well as rapid delivery from other stores to the client
• Increasing gross and operating margins despite the recent economic headwind
  

This strategy has paid off as the company keeps winning award after award for consumer and employee satisfaction. It has the highest market share for used car sales in the US at 2% and it only has stores in 40% of the US regionally. The majority of the stores are less than 5 years old and repeat customers usually return on average every 5 years.

Fundamentals and Balance sheet review:

• P/E 20 both 20-30% above comps.
• P/B 2.8
• Debt/Equity 0.2 low v.s. comps
• Current ratio > 2
• revenue growth 16% average 5 year compounded increase. Projected to maintain this by CEO and Morningstar (5 star rating)
• ROE 18%
• Insider buying last 3 months
• Gurus with major stakes: Warren Buffet (21 M shares acquired Sept and Dec 07 at $21), Dodge and Cox, Chris Davis, Chuck Akre and more

I have little doubt that Car Max will experience short term pain with US unemployment rising and a reverse "wealth effect" active as consumers see their house values continue to crumble. I see an opportunity to buy long term growth in a well managed company that can easily weather a downturn. Morningstar research suggests that used car sales don't change much in economic downturns-- new car sales do.

What would attract me even more to this stock: a dividend (even a small one). I understand that the company is focusing on growth right now but I like the fact that dividend payments motivate executives to have fiscal discipline.

I've purchased a small amount at $19 for my RRSP and am hoping for more downside in the share price.

I expect to hold this from 18 months to 5 years and possibly beyond. Once store saturation occurs, the company's strategy needs to be examined again.

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