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Summary

  • EZCorp has lost -42% at a time when the S&P gained almost +19% without even considering dividends.
  • I closed my position since I don't trust the company's management and I don't like its corporate structure, since one person, Phillip E. Cohen controls all the votes.
  • Management have made many mistakes investing the company's profits and what seemed like a great return on retained earnings is likely to be proven merely as an illusory return.

A little over a year after having published my thesis in favor of investing in EZCorp (NASDAQ:EZPW), I have now decided to publish my decision to close my position at a loss.

Before I begin, I want to be blunt with myself and my readers, on April 9th, 2013, S&P closed at a level of 1,568.61 and on Friday April 25th, 2014 (date when I closed my position) at 1,863.4, which equals a positive +18.79% yield without even considering dividends. During the same period, EZCorp reported a negative -42% yield level (yes that's right, minus forty-two percent).

(click to enlarge)

But I did not decide to close my position because of such drop or the even bigger drop of recent days. I closed it because I am rereading the full compendium of letters to shareholders from Warren Buffett and I remembered important and unbreakable principles that I have breached in several of my recent positions, including EZPW.

That is why, regardless of the issuer's downturn and the fact that it may possibly, even probably stand extremely above its current level in years to come, I have decided to close any position I have that does not meet the four basic rules for a good investment.

And what are these four rules? Buffett's principles for a superior investment are:

  1. Favorable long-term economic characteristics.
  2. Competent and honest management.
  3. Purchase price attractive when measured against the yardstick of value to a private owner.
  4. An industry with which we are familiar and whose long-term business characteristics we feel competent to judge.

It's questionable if EZPW meets rule number 1, but it certainly fails on number 2 because of Phillip E. Cohen, the company's largest shareholder and main advisor.

Mr. Cohen's shares have voting rights but other outstanding shares that are available for people like me have none, thus this person controls the direction taken by the company without anybody having a say in it. Besides, he charges fees that are out of proportion for his services, which are mainly related in investing the company's profits for future growth.

Therefore, regardless of the fact that I believe the company seems attractive at this price (much more than it already seemed to at $19 one year back), that I fully understand the industry and that it seems to be solid and with a positive outlook, I will be cautious and not invest in companies in which shareholders or directors are not fair and/or honest.

For those who are invested in EZPW I say that I am closing my position with no regrets of what may happen in the future, my advice to you is the following (and careful! because since advice is free sometimes does not add value, just the opposite):

  • If you stay, know that your business partners are not fair since they take advantage for themselves and only for themselves.
  • If you leave, know that it is possible, even probable to see the company trading at higher levels in years to come.

I'm not yet sure if my original thesis was correct or incorrect, but I'm now sure I made several mistakes in my risk assessment. Having said that, let's review the company's upturns and downturns during the last year and see how many hypotheses that were raised at that time turned out to be true or false:

  • Investing in Albemarle & Bond Holdings turned out to be a bad investment and the company had to discount the total value of such asset from its balance sheet along with the resulting economic loss of the original investment, approximately 26 million dollars (13 million in 1998 and 13 million in 2007), which at current value, considering a 3% inflation would represent more than 38 million dollars.
  • The fact that Cohen bills the company for his consultancy services raises a red flag that calls into question his ability to produce value for the company beyond generating expenses for his services and recommendations.
  • And although the company received dividends throughout the years for such investment, they were not enough to recover even the current value of invested resources, not to mention the opportunity cost of having distributed such resources among shareholders as dividends.
  • In my original article I indicated to be a red flag or risk the fact that Cohen may make wrong decisions for the company's shareholders and that most of EZCorp's net worth increase was in intangibles "Goodwill," entailing the evident risk of having impairments should the value of such assets result to be different than what the company had paid for, fact which starts to ring true after seeing what happened with the Albemarle & Bond investment.
  • Return on retained earnings, which during the last seven years stood above 25% (such estimate is supported over intangibles "Goodwill" and is likely to be proven merely as an illusory return over time) fell to a sad 4% during a year in which the main indexes offered returns close to 30%.
  • Therefore, far from adding value, Cohen and the company's management team managed to destroy it. Even worse for shareholders, Cohen collects fees that make up for this type of loss on his side of the coin and senior managers are paid very attractive salaries and options that detract any kind of corporate fairness; consequently, their incentives are very different from those of the rest of shareholders.
  • In reference to Cohen, I would like to add that he was once considered one of the most important representatives from the mergers and acquisitions industry and it has even been said that he once got an offer by Michael Milken (yes, the same Milken who was imprisoned) to manage 1 billion dollars (dollars in the 80's). Cohen rejected such offer.
  • Recent investment in Mexican companies by EZCorp don't seem to be going so well either, as only after a couple of years the company is already restructuring the operation and closing down dozens of points of sale. Certainly there are many explanations and plans to that regard, but as Buffett himself rightly says: "Any manager who consistently says "except for" and then reports on the lessons he learned from his mistakes may be missing the only important lesson-namely, that the real mistake is not the act, but the actor."

The future of the industry does not seem bleak, although it presents clear signs of risks as far as legislation is concerned. It is my view that this is an industry that must exist because it covers a real necessity that may not be covered by other businesses, but without a doubt, it may drastically take a turn for the worse if lawmakers so decide.

Pawning and high interest loans to those who need them the most will never be a popular business and they are an ideal target for any politician who seeks to draw attention from voters, therefore, whatever the result may be from current political attacks, it will not be the last time this industry takes a hit of this kind.

Conclusion:

  1. If the shareholding structure were different and Cohen did not control all shares with voting rights and;
  2. If the salary model for Cohen and senior managers was aligned with the return obtained for each dollar withheld by the company and not with the amount of business volume achieved or how many mergers and acquisitions are carried out;
  3. Then I would not have closed my position, what's more, I would have increased it because the company is a very attractive proposal at its current market price.
  4. However, the mere fact that my majority partner and controller has incentives that are so different from my own, concerns me and makes me rethink any interest I may have in the company.

Finally, I would like to add that there are many companies with these characteristics and many investors who just like me with EZCorp, don't value the importance of the second rule proposed by Buffett in order to make an intelligent investment.

To this regard and to wrap up I would like to make reference to an analogy that I have previously used. It is preferable for no country to have an atomic bomb, but if such preference is not available at least I would want to choose which country can have it and which country can't; without a doubt, I would choose the United States over Iran, Iraq, Russia, China or an endless list of countries that I wouldn't trust with such a huge responsibility on their hands, the same way I don't trust Phillip E. Cohen with the responsibility to decide on my behalf and on the future of the company.

Source: EZCorp: No Longer Among My Holdings

Additional disclosure: I have recently closed my position.