Beating the Street (27 page)

In December 1991, I got my hair cut at Supercuts, which had recently come public and goes by the symbol CUTS. If a prospectus for this haircutting venture hadn't found its way to the top of a pile on my desk, I would never have cheated on my regular barber, Vinnie DiVincenzo, who offers a $10 haircut with pleasant conversation thrown in as a bonus at his place of business in Marblehead, Massachusetts.

We talk about the kids and whether my rusty old ‘77 AMC Concord might qualify as an “antique” or a “classic.” I hope that Vinnie, who's not yet gone public, will excuse this one absence for the sake of my research.

The Supercuts I visited was located at 829 Boylston Street, Boston, on the second floor of a brownstone. Downstairs, a stand-alone placard advertised the prices, which I dutifully recorded on another indispensable investment tool, the yellow legal pad. The regular Supercut was $8.95; a Supercut with shampoo, $12; a shampoo by itself, $4.

These prices were in line with what Vinnie would have charged, and substantially less than the going rate at the beauty salons and unisex outlets where my wife and my daughters get their trims and where you might as well take out a bank loan to finance a henna treatment or a permanent wave.

As I walked into Supercuts and was greeted by the maître d', three
customers were getting haircuts, while four others were waiting in the anteroom. They were all male. Eventually, some women showed up, although in later conversations with the company I learned that men make up more than 80 percent of the clientele, while 95 percent of the stylists (they no longer call these people barbers, it seems) are female. I put my name on the waiting list and made a mental note: a lot of people must think a Supercuts haircut is worth waiting for.

I sat down and began to study the prospectus and the brochure that I'd brought along from my office. There's no more useful way to spend an afternoon than researching a company in its own habitat.

In October 1991, Supercuts made its stock-market debut at an initial offering price of $11 a share. It was a franchise operation, the McTrim of barbershops, with more than 650 stores already established. The founders had been bought out and the new management had embarked on a vigorous expansion campaign. They'd coaxed Ed Faber, the former head of Computerland, out of retirement to oversee the project.

I remembered that Faber was an ex-marine who'd done wonders for Computerland in its most prosperous fast-growth phase, before Computerland fell apart. He left, the company foundered, and then he came back. It was a surprise to find an ex-marine involved in hairstyling, but it didn't really matter what the company did. Faber's expertise was in “rolling out” a franchise operation from its original few locations into a nationwide network.

The theory behind Supercuts is that hair care is a $15-$40 billion industry dominated by independent barbers like Vinnie and locally owned unisex hair salons. Barbers are a vanishing breed (in New York State, for example, the number of licensed haircutters dropped in half in the last decade). Hair grows half an inch a month, and with the Vinnies of the world disappearing, somebody was going to have to cut it. This was a perfect opportunity for a well-managed, efficient nationwide franchise to come in and capture the market.

This was the same sort of situation I encountered years earlier when Service Corporation International began to take over the mom-and-pop mortuaries. People were dying at a regular rate, somebody was going to have to bury them, and the industry was made up of hundreds of inefficient small operators whose children wanted to go to law school.

According to the Supercuts brochure, each stylist is trained to perform quick and efficient snipping with no dawdling or nonsense, which fits nicely into the no-dawdling, no-nonsense ethic of the 1990s. Armed with small scissors and a “revolutionary comb,” the Supercuts stylist can snip through an average of 2.8 heads per hour, and the cut you get in Albuquerque should be the same as the cut you get in Miami.

There's always something new to learn on these forays—did you know that haircutters have to be licensed? I didn't, but they do, and that's more than you can say for fund managers. There are no requirements for managing billions of dollars, but before somebody can trim your sideburns, he or she has to pass some sort of a test. Given the record of the average fund manager over the last decade, maybe it should be the other way around.

A Supercuts stylist is paid $5-$7 an hour, which isn't much of a salary, but it's augmented with medical benefits, and at 2.8 heads per hour, she (I say “she” because of the preponderance of females who work there) can double her wages with tips.

Meanwhile, each stylist is bringing in $30 an hour in revenues for the franchise, which is why it's been so profitable to own a Supercuts. This isn't like the aluminum industry, in which half the earnings are eaten up in improvements to the plant and equipment. Other than the rent for the retail space, the biggest ongoing expenditures in a hair salon are for scissors and combs.

As I also read in the prospectus, the average owner of a Supercuts franchise invests $100,000 at the outset—this money pays for the franchise fee, the sinks, the barber chairs, the decorations, the shampoo, etc. In merely two years of operation, that store is expected to generate a 50 percent pretax return on equity, which beats almost any return any of us could get elsewhere and explains why the company has an easy time recruiting future franchisees.

What's good for the owner is also good for the shareholders—this is the part where I got interested. The company receives 5 percent of the gross revenues and 4 percent of the sales of the Nexxus products displayed in each franchise. (I could see these on shelves against the far wall.) The administrative costs are minimal. The biggest expense is in training the stylists. Supercuts hires a new trainer (at $40,000 a year) for each 10 new shops, but then these 10 new shops should contribute $300,000 a year to the annual revenues.

One of the first things you need to know about a retail operation, as mentioned earlier, is whether it can afford to expand. A glance at this balance sheet showed me that debt was 31 percent of total capital, a disturbing number that required further explanation. I made a note of it.

At this point in my deliberations (the employees who saw me looking around and taking notes may have pegged me as a spy from the barbers' union) my name was called and I was ushered past the reclining chairs and into the room with the shampoo sinks. A comely young specialist washed my hair in short order and then directed me back to the cutting area, where she wrapped me in a sheet and proceeded to snip off everything, including my sideburns. This happened so quickly I had no time to object. I felt like the privet hedge in the movie
Edward Scissorhands.

Since in normal circumstances I'm never sure if I look good or bad, even when I saw myself in the Supercuts mirror I didn't protest, preferring to await the verdict that really counts—from my family. For all I knew, the shorn look was in.

When I got home and was greeted with a “What happened to you?” from Carolyn and my daughters, I realized that the shorn look was not in, at least not when applied to a 48-year-old with Warhol-like white hair. Several acquaintances said I looked “young,” but only, I sensed, because they were struggling to be positive without lying too much, and “young” was the best they could do. When people tell me I look young, I begin to realize they once must have thought I looked old and neglected to tell me.

Here is an exception to the rule that you have to like the store before you buy the stock. After being sheared at Supercuts, I found myself liking the stock (or at least its prospects on paper) far more than I liked the store. I promised myself never again to stray from Vinnie DiVincenzo and his regular $10 haircut.

The privet hedge problem I brought up with Supercuts' senior vice-president and chief financial officer, Steven J. Thompson, in a phone call to California. He commiserated with me for my lost sideburns and then said, “The good news is that hair grows back at the rate of a half inch per month.” I'd already taken hope from this fact when I read it in the brochure.

We discussed the idea that Supercuts stylists are all licensed professionals who have to take a refresher course every seven months, and that the medical benefits and the tips will attract good
people. What I worried about here was high turnover and poor hedgemanship among poorly qualified and/or disgruntled employees. I asked about the turnover rate, which Mr. Thompson said had been low so far.

Most of the news was positive. The debt level that I'd noted earlier as a potential problem turned out not to be as much of one as I thought. Supercuts had $5.4 million in annual free cash flow, and most of that, Mr. Thompson said, would be used to pay off debt. By 1993, the company expected to have no debt at all, and the interest expense of $2.1 million in 1991 would disappear.

Since this was a franchise operation, the money to set up the new Supercuts would come from the franchisees. This was another big plus: Supercuts could expand rapidly without using its own capital and without excessive borrowing.

The biggest plus of all was that 250 million Americans needed haircuts every month, and with the mom-and-pop haircutters closing their doors, no dominant chain store had emerged to fill the void. Supercuts' major competitors included Regis Corporation, which operates Mastercuts in malls, where the rents are much higher and the clientele is mostly women; Fantastic Sam's, which has twice as many locations as Supercuts but most are franchise operations that produce less than half the revenue of a Supercuts shop; and J. C. Penney, whose unisex salons are confined to J. C. Penney stores.

Supercuts had the additional advantage of being open on Sundays and in the evenings. The company was working on a national advertising campaign to give it a brand recognition that none of its competitors enjoyed. This was a 20 percent grower at the initial stages of its takeoff, selling for 16 times earnings at the time I recommended it.

In the end, the excellent numbers won out over the lost sideburns, and I touted Supercuts in
Barron's.
“I got a haircut there, I tried it out,” I told the rest of the panel. “Is this your current haircut?” asked Mario Gabelli, and I had to admit it was. “We won't advertise that,” said Abelson.

Great Companies in Lousy Industries

I'm always on the lookout for great companies in lousy industries. A great industry that's growing fast, such as computers or medical technology, attracts too much attention and too many competitors. As Yogi Berra once said about a famous Miami Beach restaurant, “It's so popular, nobody goes there anymore.” When an industry gets too popular, nobody makes money there anymore.

As a place to invest, I'll take a lousy industry over a great industry anytime. In a lousy industry, one that's growing slowly if at all, the weak drop out and the survivors get a bigger share of the market. A company that can capture an ever-increasing share of a stagnant market is a lot better off than one that has to struggle to protect a dwindling share of an exciting market. This leads us to Peter's Principle #16:

In business, competition is never as healthy as total domination.

The greatest companies in lousy industries share certain characteristics. They are low-cost operators, and penny-pinchers in the
executive suite. They avoid going into debt. They reject the corporate caste system that creates white-collar Brahmins and blue-collar untouchables. Their workers are well paid and have a stake in the companies' future. They find niches, parts of the market that bigger companies have overlooked. They grow fast—faster than many companies in the fashionable fast-growth industries.

Pompous boardrooms, overblown executive salaries, demoralized rank and file, excessive indebtedness, and mediocre performance go hand in hand. This also works in reverse. Modest boardrooms, reasonable executive salaries, a motivated rank and file, and small debts equals superior performance most of the time.

I called John Weiss, an analyst from Montgomery Securities in California who'd written reports on several discount appliance store chains. I wanted his opinion about the Good Guys, a stock I'd been following since 1991. Weiss said that competition from Circuit City was hurting the Good Guys' earnings. When I asked him what else he liked in this lousy industry, he mentioned Sun Television & Appliances.

Weiss's version of the Sun TV story was so compelling that as soon as I'd hung up with him I called corporate headquarters in Ohio to talk to the source.

When you can get the CEO on the line without delay and you've never met this person, you know the company doesn't suffer from excessive hierarchy. I was connected to Bob Oyster, an amiable chap. We rhapsodized on the merits of Ohio golf courses before we got around to the purpose of the call.