STOR - STORE Capital: Farewell And Our Checklist Manifesto

Summary

• First of all, let me confess that the title is partially stolen from a book entitled “The Checklist Manifesto” by Atul Gawande.
• The book analyzed why checklists are vitally important in professions where people resist checklists the most, such as investing and surgery.
• After writing several bullish analyses on STORE Capital and seeing it to be acquired at a 20%+ premium, this is my last article on this stock.
• And I want to use this opportunity to say farewell and also to share a few things on my investing checklist.
• Do not bet against Buffett. Always interpret valuation under the context of risk-free interest rates. Do not mistake diversification for diworsification.

Thesis

In a book entitled "The Checklist Manifesto - How to Get Things Right?", the author Atul Gawande made a convincing and insightful argument about the need for checklists, especially in professions where checklists are particularly frowned upon. The Author, being a general surgeon (and also a professor at Harvard Medical School), analyzed the root reasons. People in professions like investing and surgery, typically highly intelligent and highly trained, tend to believe their success depends not on dumb checklists but on improvision and intuition - even against mounting evidence.

Being disciplined investors ourselves, we have been developing our own checklist over the years. This checklist has helped us avoid major mistakes and also identify successful opportunities such as the main topic for today: STORE Capital ( STOR ).

STOR showed on our radar in August 2021 and we started covering it. We have turned bullish since early 2022 as the valuation becomes compressed as seen in the chart below. Our view was that the market overacted to the perceived effects of interest rate hikes. We recommended "buy" when prices dipped below $30. STOR recently announced a definitive agreement to be acquired by Oak Street at $32.25 per share in an all-cash transaction. The acquisition price tag represented a premium of about 20% to its closing stock price as of September 14, 2022 (the day before the agreement was announced). Combined with its dividend yield, on average about 5% in the past years, shareholders who bought in under $30 are rewarded handsomely, especially if you consider the fact that the overall market suffered a double-digit correction during the same period.

Given the pending acquisition, this article is very likely our last article on STOR. And as such, I want to use this opportunity to say farewell and wish the business the best in the new Oak Street family. At the same time, I wanted to share a few items on my checklist that helped us identify it in the first place. And hope this simple checklist will help other investors with other investment opportunities as well. These simple check boxes are listed below, and the remainder of the article will go over them in more detail one by one:

• Do not bet against Buffett.
• Always interpret valuation under the context of risk-free interest rates.
• Do not mistake diversification with diworsification.

Do not bet against Buffett

If you are reading this, you must know that Warren Buffett has accumulated a sizable position in STOR since Q2 2017. As you can see from the chart below, he started buying in Q2 2017 and gradually increased his position to 24.4 million shares in Q3 2020. At its peak, this STOR position's market value was over $0.8 billion (somewhere around the second half of 2021). Of course, it is not the biggest position in his humongous portfolio, but 24.4 million shares did translate into about 10% of total outstanding STOR shares - a strong endorsement of STOR in my view.

Our experiences have taught us to not bet against Buffett. Furthermore, our experiences have also taught us that if we can buy stocks at prices below the "Buffett price", our odds improve dramatically, as detailed next.

The Buffett price and the role of risk-free interest rates

My earlier article back in Feb 2022 detailed the "Buffett price" or more precisely, the Buffett valuation at which he accumulate the bulk of his shares. As detailed in that article:

Buffett bought his shares near 13.2x FFO in 2017 and 2020 respectively at prices near $22 to $23 as you can see from the following chart. The share price rallied to almost $37 in late 2021. And the recent price correction brought the valuation to about 15.2x FW FFO in early Feb 2022, which is still about 15% above the valuation Buffett paid for his shares.

However, we need to remind ourselves that valuation needs to be always interpreted under the context of risk-free interest rates.

We have to understand that the interest rates in 2022 are dramatically different from those in 2017 when Buffett first started to buy the shares. Since interest rates act as the gravity on all assets valuation, the FFO multiples can be misleading and need to be adjusted by the interest rate changes. In terms of FFO multiples, the stocks were above the Buffett valuation by about 15%, but its valuation was actually more than on the surface when its yield is adjusted relative to the risk-free rates. Its valuation then was a lot closer to the "Buffett price" as shown in the chart below. As detailed in the same article:

The chart below shows the yield spread between STOR and the 10-year treasury. As can be seen, the spread is bounded and tractable. The spread has been in the range between about 1.25% and 3.0% the majority of the time, which makes sense for a stable and mature business like STOR. Suggesting that when the spread is near or above 3%, STOR is significantly undervalued relative to 10-year treasury bond (i.e., I would sell treasury bond and buy STOR).

Now, the pink squares denote when Buffett bought the bulk of his shares. As seen, he started buying shares in 2017 precisely when the yield spread approached 3%. And he added another 31% to his position during the first half of 2020 when the yield spread surged to a ridiculous level of 5% due to a combination of dirt-cheap valuation and near-zero risk-free rates. And you can also see that we turned to be bullish on the stock when the yield spread began to approach 3% in early 2020.

In contrast, the yield spread shrank to only ~1.1% as of this writing (about 5.2% TTM dividend yield minus 4.1% of 10-year treasury rates), near the thinnest level since its IPO. At its acquisition price of $32.25 per share, the yield spread would be even thinner. So I would say the STOR shareholders got a very good deal from Oat Street.

Do not mistake diversification with diworsification

Finally, do not mistake diversification for diworsification. Holding more stocks may help you to feel better diversified and hence safer. However, experiences have taught us the opposite. Holding a few well-understood stocks is far superior to holding a large number of poorly understood holdings both in terms of safety and performance.

And nothing illustrates this point better than the following comparison between STOR and the overall REIT sector (represented by VNQ). The details are provided in an earlier article we published back in April 2022. And a few highlights are quoted here:

• STOR provides superior profitability, consistency, and also valuation over VNQ. Its price-to-cash flow ratio is at a 30% discount to the sector average.
• Particularly, if we use dividends as an approximation for owners' earning yield, STOR currently provides a yield about 2.4% above VNQ (5.1% vs 2.7% and more on this later).
• Due to its superior profitability, it comes as no surprise that STOR also provided superior performance than VNQ.

Risks and final thoughts

Although note that you do need to be able to stomach STOR's higher price volatility than the sector fund, which brings us to the final checkbox on our list. If you do not feel comfortable with the business fundamentals or are concerned with day-to-day price fluctuations, stay within your circle of competence and do not buy the stock in the first place.

To conclude, this article is very likely our last article on STOR. Big congratulations to STOR shareholders for receiving an excellent acquisition deal. And our best wishes for the STOR business the best in the new Oak Street family. And finally, we urge all investors to develop a checklist to guard against their own investing weaknesses and blind spots - everyone has them. And if you believe you can rely on your intelligence or willpower to overcome them, chances are that you will only repeat them. You need a MECHANISM more than anything else, and a good checklist is the simplest and most effective mechanism in our experience.

Hope our following checklist helps you to identify other opportunities like STOR!

• Do not bet against Buffett.
• Our odds improve dramatically if we can below the "Buffett price"
• The Buffett price always needs to be interpreted under the context of risk-free interest rates.
• Do not mistake diversification for diworsification.

For further details see: