The Passive Investor (PI) Ratio

I intended to complete my review of Q1 earnings reports and conference calls this week. Unfortunately, or fortunately, I was distracted by several stocks on my possible buy list that were in decline. Considering I’m eager to own equities again, I decided to postpone my maintenance research and work on possible buy candidates.

While several stocks on my possible buy list are down due to weak commodity prices, others declined as a result of disappointing operating results. Speedway Motorsports (TRK) is one of those stocks. Although Speedway’s operating results were in line with management’s expectations, revenues declined -3.5% during the quarter.  Management blamed weak revenue trends on the economy, underemployment, changing demographics, shifts in media entertainment consumption, and the absence of a stronger middle class recovery. While management maintained its earnings guidance for the year, its stock has fallen -12% since its earnings release.

Rarely do investors tout that they like slow growing businesses. Maybe you have, but I’ve never heard a portfolio manager on CNBC say, “We like boring companies with little if any growth.” It’s just not exciting television, nor is it good for sales! I don’t mind slow growing companies, especially if the business generates considerable free cash flow and has a well-defined capital allocation strategy. As long as the slow growth rate is properly considered in your equity valuation, I find nothing wrong with investing in a tortoise.

I expect Speedway Motorsports to remain a tortoise business as its struggle to generate organic growth continues. I believe attendance and event related revenue growth will remain particularly challenging. However, the stability and growth of its NASCAR broadcasting revenue should continue to help offset the softness in other areas of its business (at least until 2024). In fact, the growth and dependability of the broadcasting revenue has helped Speedway Motorsports generate consistent and meaningful free cash flow over the past several years.

Paying down debt is one of my favorite uses of free cash flow by a slow-growth business. There are several reasons why this makes sense. First, it’s tough to mess up debt reduction. There is an immediate and certain increase in the intrinsic value of the equity net of debt. Furthermore, declining debt reduces financial risk and improves operational and strategic flexibility. Greater flexibility and lower risk can also lead to a lower discount rate (higher multiple), increasing the value of the equity further.

Although Speedway Motorsports hasn’t grown noticeably over the past five years, its business generated $445 million in free cash flow (current market cap $715 million) since 2011. Speedway used its free cash flow for debt reduction, buybacks, and an above average dividend (current yield 3.4%). During a period when many slow-growth companies are eager to take on debt to make acquisitions, I’m impressed with management’s commitment to deleveraging its balance sheet. Speedway’s long-term debt has declined from $555 million in 2011 to $254 million in 2016 (debt to equity is down from 0.7x to 0.3x).

As I was getting caught up on Speedway’s fundamentals and putting together my valuation, I stumbled into a statistic related to its equity float that I found concerning. Specifically, I was surprised to see how much of the float was owned by index funds.

Speedway’s float is small considering insiders own 72% of shares outstanding. With 41 million shares outstanding, that only leaves 11.5 million shares for outsiders. Based on my classification and calculation, 50% of its float is owned by institutions that I consider passive investors (index funds and ETFs).

Many journalists and analysts have written about the shift from active to passive investing, but what about the impact this shift has on business valuation? Investors often apply a discount to companies that are illiquid, closely held, or have customer concentration. The large index fund ownership of Speedway’s float caused me to ask, should investors also apply a discount to equities with concentrated passive ownership?

Investors often look at an equity’s short interest ratio or institutional ownership, but what about passive investor ownership? I believe passive ownership as a % of float is an increasingly important ratio to monitor. I call it the PI ratio and will be monitoring it closely going forward.

As we know, passive investors are price insensitive. Do I want to own an equity with 50% of its float controlled by price-insensitive investors? In my opinion, the potential for a price-insensitive investor to cause a dislocation in the stock is a real risk. As the popularity of passive investing increases, price-insensitive risk grows, along with ownership concentration and PI ratios. And at this stage of the market cycle, I’m much more concerned about a price-insensitive seller than buyer (price dislocation risk to the downside).

From a valuation perspective, I find concentrated passive ownership to be a very interesting and important topic. Should active investors be compensated for assuming the risks of investing alongside price-insensitive investors? And if concentrated passive ownership is a risk, as I believe it is, what is the appropriate discount to apply to the equity? Is it 10%, 20%, or 30%?

To illustrate passive concentration risk, let’s assume equity valuations normalize and stocks decline 30-50%. How would flows into passive strategies respond? The rush into passive strategies could very well reverse, as investors frantically press their “next day same as cash” sell buttons in an attempt to reduce risk and raise liquidity.

If passive strategies that own Speedway Motorsports experienced a 10% outflow, it would require the funds to sell 575,000 shares, or two to three weeks of trading volume. If passive funds were able to participate in 50% of the stock’s average volume it would take approximately five weeks to reduce the position. Passive funds and ETFs are fully invested and do not hold meaningful cash balances; hence, they don’t have the flexibility to gradually sell assets to meet large outflows. Cash needed to fund outflows would need to be raised almost immediately. In such a scenario, the stock price would decline until a sufficient bid was found, which could ultimately lead to a large price dislocation.

There are many variables to consider when determining the impact passive investor concentration has on an equity’s value. In addition to determining the appropriate discount to apply, when should it be applied? What percentage of float ownership by passive investors is considered too high? These are good questions and considering passive investor concentration has never been higher, it’s difficult to come up with definitive answers.

Passive investor concentration risk and PI ratios are growing. I plan to pay close attention and will be reluctant to own equities with high passive ownership unless I’m being properly compensated. Assuming the equity of Speedway Motorsports continues to decline, I may become an interested buyer. That said, in order to assume the risk of investing alongside a concentrated group of price-insensitive investors, I will adjust my equity valuation accordingly and demand an appropriate margin of safety.