Manager’s Quarterly Commentary – Felix Narhi – Q1 2016

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The first quarter was volatile and strange. It was a wild, roller coaster-like experience. There have been very few periods over the last three decades which have seen a larger number of three standard deviation moves across different asset classes. Yet, similar to the bewildered riders getting on and off a roller coaster, the large cap S&P500 index ended up largely where it left off at the end of 2015 (although we suspect roller coaster enthusiasts would have had more fun on their trip). When investing, it is important to remember that just about everything is cyclical to some degree and nothing goes in one direction forever. Looking beyond stock market volatility, there are three main themes that matter from our point of view.

1.       Building Enduring Business Value

Our first and most important concern remains the ongoing progress of building business value, especially for our “compounder” holdings. The gradual build-up of business value continues over most periods, regardless of stock market fluctuations. Ideally, we want to see value creation manifest itself through revenue growth, earnings momentum and smart capital allocation decisions. However, reported results do not always show up in a smooth upward progression because of business cycles, market conditions and other factors. At a minimum, we want to see solid headway relative to peers. Great companies tend to take market share from their rivals over time and frequently make their biggest gains during times of industry turmoil. Top performing managers are constantly digging a deeper “moat” (competitive advantages) around their business and seeking new opportunities for growth. These moat-digging exercises ultimately show up in greater earnings power and higher stock prices, but require a long-term orientation. Virtually all great businesses engage in “pain now, gain tomorrow” activities. Not surprisingly, over time those companies tend to outperform peers that are managed to optimize short-term results (i.e. make their quarterly numbers), which often involves the opposite behaviour – “gain now, pain tomorrow”.

Some examples of “pain now, gain tomorrow” activities within portfolio companies include:

  • Panera Bread and its heavy upfront “2.0” investments to embrace technology and increase customer convenience;
  • Syntel’s transformation as it makes far-sighted digitization and IT automation investments to better serve its clients;
  • Platform Specialty Products with its front-end loaded expenses to build out critical infrastructure as it prepares to become a much larger enterprise in the future;
  • Wynn Resorts and the willingness to constantly elevate and redefine the best-in-class luxury resort guest experience with its ambitious multi-year developments.

All four companies are led by leadership groups that have made similar “pain now, gain tomorrow” decisions in the past, and which paid off handsomely for patient investors. With much of the “pain” now behind us (we hope!), our belief is that these companies are nearing an inflection point for the “gain” period of accelerating revenue and earnings momentum. Although each company is at a different stage of their journey, we anticipate the majority of our compounder holdings will be worth substantially more over the next three to five years.

It is important to remember that total returns for equities are generally driven by three factors: Earnings growth, the dividend yield and valuation changes. The current earnings season is one of the weakest since 2009, yet stocks have remained relatively resilient. The stocks of large American corporations continue to outperform their underlying businesses. At the end of the first quarter 2016, the operating earnings of the S&P500 on a trailing twelve month basis were down about 9% from two years ago, yet the stock market, excluding dividends, was up 10% over the same period. A rising P/E ratio accounts for almost all of the gains over the last few years.

This cannot continue indefinitely as the P/E ratio is already nearing decade highs. As economist Herbert Stein observed long ago, “If something cannot go on forever, it will stop”. All things being equal, earnings growth will be required to drive returns higher. However, things are rarely equal.

2.       Ultra-Low Interest Rates – The Gravitational Pull for all Asset Prices is in Uncharted Territory

Although aggregate valuations do not look particularly attractive from a historical perspective, we are living through an unusual period of extremely low interest rates, where there are few useful benchmarks. Almost no one predicted interest rates would go this low and stay so subdued for this long (we certainly didn’t). This has had a huge impact on asset prices. Assets are clearly worth more when interest rates are near 0% than if they were 6% or 7%.  If interest rates stay at current levels (or go even lower), the S&P500 can remain at seemingly elevated valuations, even during periods of anemic growth. Long-term, no one knows the consequences of such an environment in part because there has been no real historical precedent. 

Whether the S&P500 is expensive, based on its historical track record, or fairly valued because interest rates are at ultra-low levels, we will continue to be occasionally opportunistic with individual stocks we believe are mispriced and patient with holdings that we believe are growing enduring business value at a decent clip. Even when aggregate valuations appear high, there are always stocks in the market that are mispriced for one reason or another.  We will always remain value focused because market history has shown that low valuations tend to be the starting point of superior long-term returns. Value investing as a strategy has an enviable long-term record. However, “value” investing is currently going through one of the longest anti-value periods in 50 years. In many cases cheap stocks have gotten even cheaper and the expensive have become dearer. We have no plans to abandon the value approach we know and understand and have practiced to date. Like a coiled spring, we believe downside risk is modest and there is plenty of pent up potential after the cycle eventually turns.  If you are seeking success over time, one needs to know the long-term odds and stick with them.

3.       Technological Disruption – Don’t Get Steamrolled

We are increasingly vigilant about the disruptive forces from technological innovation on business models. There are a number of businesses that will not face significant disruption by technology, such as those selling household products like soap and food products (Unilever), iconic time-tested brands (Diageo) and insurance (Markel). At the other end of the spectrum is the set of companies that are leading the disruption, like Alphabet (Google), Uber, Amazon, Tesla and Netflix. Some of these companies operate in markets with winner-takes-all-or-most characteristics. Whether they succeed or not, it is probably not a good idea to get in their way!

In between these extreme groups there is a large number of companies which are facing threats from these disruptive changes to varying degrees. Historically, it is not uncommon to find incumbent enterprises that enjoyed highly profitable businesses driven by past economic and competitive realities fade relatively quickly after the paradigm has shifted. We believe this risk has only increased. Warren Buffett is famous for saying that he wanted to own a company so great and enduring that even a “ham sandwich” could run it. However, those days are increasingly numbered in our opinion. We believe companies that are likely to do well increasingly require superior management teams that are likely to stay superior for a long time, embrace technology for both offensive and defensive strategies and are capable of adapting to dynamic change.  When weighing decisions about how to deal with disruptive technologies, we believe investing alongside management teams with a “pain now, gain tomorrow” mindset is more critical than ever. Previously successful business models are changing rapidly. The more quickly companies can adapt to the new realities, the greater the likelihood that they will survive and thrive.

Please do not hesitate to contact me, should you have questions or comments you wish to share with us.

Felix Narhi, CFA
May 15, 2016