I recently wrote about the WuFlu that was coming to a neighborhood near you. It was meant as a warning that you should look through your book and see if you owned companies that were exposed to the virus. I bring this up because two weeks later, many companies in the hospitality sector have simply collapsed. My hunch is that it gets worse—much worse. You see, when you have high fixed costs and lots of financial leverage, small changes in revenue go a VERY long way. What happens if revenue simply evaporates? Well, we’d need to go way back, almost to the start of my investing career for a lesson on that one.
Following the disastrous attacks of September 11th, no one wanted to travel to “at risk” target cities. Remember how we all sat at home terrified, while watching the news? No one traveled in case there was another attack. I was young back then and didn’t really know much about investing, but I knew enough to know that this would all be a short-term thing. Travelling is part of being human; it’s vital to commerce and it’s something that the terrorists would never take from us. I was absolutely sure that travel would return to normal before too long—the only question was if it was going to be too long for my positions.
Long-time readers of this site know that I’m the sort of investor who’s drawn to panic and chaos—It’s just how I’m made. I don’t buy the hot story stocks; I seek out the thing that has collapsed and try to figure out if sellers have it all wrong.
With that in mind, let me tell you a story; it was roughly November of 2001 and this small hotel chain with substantial Washington, D.C. exposure had simply been obliterated. I don’t remember the exact details, but it had traded for something like $40 before the attacks and now traded for $10. A quick review of the financials showed a rather steady $5 a share in annual AFFO with an attractive dividend payout ratio. Why did it now trade for $10? Well, that was obvious, they owned 7 boutique historic hotels, all in Washington and literally no one was going to their properties. Occupancy was in the single digits and they were bleeding to death. I remember buying a few at $10 and within a week, they had eliminated the quarterly dividend of roughly $1 per share and were using scary words like “going concern.”
The stock immediately collapsed to $7, but I intuitively “knew” it was worth at least a few times that if it could get through this crisis—I had been to most of the hotels and knew the current valuation was wrong. I therefore did what I usually do when I’m stubborn—I bought more, a lot more. A few weeks later, they reported earnings and WOW, it was a debacle; Q4 guidance was negative $5 a share in AFFO; additionally, there were big impairments and covenant violations. It was my first of many lessons in how operating leverage can be vicious when it goes the wrong way. However, I did the only logical thing I could think of, I bought a whole lot more at $6.
You see, I had interned for a congressman two summers before (which mostly involved making coffee for smarmy guys in suits, shaking hands and writing letters to constituents about issues the congressman didn’t care at all about). I may have been 18, but I met the swamp-creatures of Washington. Like flies attracted to poo, I knew they’d eventually have to return to the capital. They’d risk their lives in order to loot our country—that’s just who they were. They all needed hotels and conference venues. They could stay away for a bit, but they’d return and they’d stay at the classy places where they could be discreet. My hotel chain just needed to outlast its creditors.
In any case, as I had suddenly lost like a quarter of my net worth, I did the only thing I could think to do—I learned everything I could about the DC hotel market. Since I had no idea what I was doing, I just bluffed my way through it and called the 7 hotels themselves.
Me: Hey there. It’s Mr. Kuppy. I’m looking to get married this spring and I need to hold a room block of 50 rooms. Do you have any weekends with 50 available rooms?
Receptionist: You’re kidding right? We have like 5 rooms booked for the whole spring. Every weekend works.
Me: Don’t you only have 57 rooms at your hotel?
Receptionist: Yea, 50 are available every weekend. Just choose a week.
Me: How about the 2nd week in April?
Receptionist: There’s literally no one booked the whole month of April.
Me: What about the 3rd week in March?
Receptionist: We have 2 rooms booked in all of March.
Me: Hmm… Can you email me how many nights are booked each day from December first until July? My fiancé and I will discuss and get back to you.
Surprisingly, all of them sent me their bookings list. It was brutal—they were screwed far worse than I thought was possible. Remember, this was before the days of last-minute online travel bookings. You would book hotel rooms weeks or even months in advance—especially for weddings and conferences—the mainstay of these historic hotels. These hotels had lost all of their bookings as no one wanted to be anywhere near Washington DC. They were simply drowning. No wonder the stock was cratering.
As November 2001, turned to December, the stock continued to leak lower and I kept buying. I had no thesis except the hotels were worth a whole lot more than the share price. By that point, a pretty large percentage of my account was invested in this boutique hotel stock. I kept making my calls and occupancy slowly started getting less awful (the front desks would just periodically send me the weekly occupancy email without wasting time on small talk). My rudimentary model said that at 40% occupancy, the hotels would be able to break even and with extinction off the table, the stock would trade back to fair value. Fortunately, we were now pushing teens occupancy, then twenties, but the stock kept fading lower. Remember the anthrax letters and other scares? They weren’t helping bring back Washington DC visitors or shareholders.
It was now February; year-end earnings were going to be a bloodbath and were due any day. However, occupancy was creeping up and I knew that outside of another attack, these guys would survive. That’s when the ratings agencies struck. The final bottom was when the ratings agencies downgraded the hotel to their equivalent of imminent default. (I have zero respect for ratings agencies—they tend to do zero work, get surprised by obvious news and then downgrade the corpse after the fact. However, in this case, the corpse had something of a pulse).
The stock was sitting there a few cents over $5 and I simply went all in. I knew the ratings agencies were wrong. My most recent round of weekly phone calls told me that these guys would now certainly make it. I used up every dollar that my broker would lend me. I was red-lined on margin and terrified that if the stock went under $5, the stock would be un-marginable and my broker would liquidate me. Then again, I was 20 and I knew nothing about position sizing or diversification (those were painful lessons that I was yet to learn in my career). I just knew that the business was turning and the ratings agencies were wrong. Fortunately, it worked spectacularly; or I’d be in some other career today.
After a few sleepless nights, the company announced the mother of all big-bath quarters and guided Q1 to another huge loss, but they also said the sorts of optimistic things that were obvious if you had been calling receptionists daily and sending them the occasional box of chocolates. The stock didn’t look back. It was $7 by end of day and teens a month later. For the better part of the spring of 2002, I’d wake up at noon, check the quotes and go back to bed. There was nothing to do—my entire account was invested in one hotel chain. The stock simply ground higher. I eventually sold most of mine in the mid-twenties and it was acquired a few years later in the $40s. It was one of the greatest investments of my career despite barely being able to read a balance sheet at the time. To be honest; I literally had no idea what I was doing—except I had a conviction that the assets were horribly mispriced and that my dysfunctional channel checks were accurately showing that occupancy was recovering.
Why have I bothered to tell you this? After making a few hundred percent in roughly six months, I forever have a sweet spot for the hospitality sector during a crisis. I also know that wading in too early can be deathly. While the share prices of hospitality companies have been brutalized in the past few days, they do not even begin to price in just how bad this could get. I’m not saying the shares go lower, but I am absolutely sure that negative operating leverage will surprise everyone. Be patient and wait for the turn. I suspect that there will be some great opportunities in hospitality once again this cycle—however there’s no hurry to buy the dip—that will come later. Remember, when the virus hits, you cancel your cruise for next week and also for next year. The backlog is still collapsing.
I’m very much about teaching a man to fish, rather than fishing for him and the first step is to know where to fish. Part of fishing is to also be prepared. If you think the bottom is in a few months, you really ought to start learning the companies now. I remember how vicious the rally in my DC hotel chain was once the “all-clear” was sounded. You don’t want to be chasing, you want to be buying the turn—right before everyone else realizes the turn is in. There are hundreds of these hospitality stocks globally that have been obliterated. Time to get to work…
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