Manager’s Quarterly Commentary – Felix Narhi – Q3 2016

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 “Nothing is so painful to the human mind as a great and sudden change.” ― Mary Shelley Although we live in a world where change is constant, it seems to be getting increasingly unpredictable. In the first quarter, global markets simultaneously swooned on concerns of a big slowdown in China. Then during the second quarter, UK citizens surprised the world in a stunning rebuke to the status quo when they voted for Brexit. Not to be outdone, Americans soon embraced their own brand of populism by voting in Donald Trump as the 45th President of the United States. These events may be a harbinger of things to come with unforeseeable global implications. Citizens and investors alike are now trying to understand the implications of a President who thrives on unpredictability and is constantly shifting his positions. A Trump victory was widely expected to send the markets into a tailspin. But instead of plunging, US markets have remained remarkably resilient as investors shifted their bets on the potential winners and losers from “Trumponomics”.

The multi-year momentum of high quality stocks and other “bond proxy” stocks favoured for their high relative yield has reversed as investors have been rotating into sectors seen as benefiting from higher interest rates, less regulation and pro-growth policies. While unsettling, investors must best navigate this new reality. Politics aside, we believe this rotation is overdue from an investment perspective. We have been increasingly wary of the market’s growing enthusiasm for “safe yield” while ignoring longer-term risks (see Utilities – Reward-free risk). After an eight year bull market, investors should reflect on Sir John Templeton’s sage advice, “Always change a winning game.” No cycle lasts forever. Renowned global macro investor Ray Dalio recently quipped, “There is a good chance that we are at one of those major reversals that last a decade.” Post-election, the market’s narrative has noticeably shifted.

Where tomorrow’s fortunes might be found

While change is inevitable, there are some constants that have stood the test of time. Focusing on such constants can sow the seeds of future fortunes. For example, by concentrating on things that are stable rather than trying to predict the unpredictable, Amazon founder Jeff Bezos built one of the most impressive retail success stories of all time. How is this possible when Amazon itself has been one of the biggest disruptors and change agents within the retail and technology landscape? Bezos explains his counterintuitive logic:

I very frequently get the question: ‘What’s going to change in the next 10 years?’ And that is a very interesting question; it’s a very common one. I almost never get the question: ‘What’s not going to change in the next 10 years?’ And I submit to you that that second question is actually the more important of the two — because you can build a business strategy around the things that are stable in time.

Bezos’ strategy was built on the premise that retail customers will always want low prices, fast delivery and vast selection. Who would want the opposite – high prices, slower delivery and limited selection? Instead of focusing on what might change, he built his strategy arounds things that were almost certain not to change in 10 years. He kept his focus on the horizon and largely ignored short term investor pressures. (See how prescient Bezos’ original letter to Amazon shareholders in 1997 was, and how his long-term customer focus has stood the test of time.) Virtually all great businesses engage in “pain now, gain tomorrow” types of activities and Amazon is no exception. We own a disproportionate number of companies that are still managed by their founders, either as CEOs or active Chairmen, because we find they are more apt to make value-creating decisions than their professionally managed counterparts.

What will not change

We believe this mental model applies to investing as well. It is important to understand what will not change in 10 years when contemplating potential returns because investors should decide whether we are in the “pain now, gain tomorrow” or “gain now, pain tomorrow” part of the investment cycle. Let’s consider the relentless rules of humble arithmetic when it comes to investment returns. Long-term S&P500 returns are likely equal to earnings growth plus dividends and plus or minus any changes to the P/E valuation multiple. The same is true for most individual companies.

The first two components – earnings growth and cash dividends paid – are the fundamental long-term drivers of stock returns. Since 1957, when the S&P index expanded to its present day size of 500 stocks, the typical firm paid out roughly half of its earnings as dividends and retained the rest to reinvest back in the business. This invest-part-of-today’s-earnings-back-into-future-opportunities was the main reason why earnings per share increased more than 23 fold by the end of 2015, or about 6% on an annualized basis. The average dividend yield over the same period was slightly more than 3%*. Collectively, these two fundamental factors accounted for about 90% of the markets wealth creation power since 1957.

On the other hand, changes to the valuation multiple factor are primarily driven by investor psychology and interest rates. This can be a positive or negative factor in any given time frame, but this variable has been range bound and mean reverting over time. The P/E of the S&P500 rose from 13x in 1957 to 23x in 2015*. This was a huge jump. Yet, this change to the P/E multiple contributed less than a two-fold boost to returns, or about a 1% tailwind per annum (far less than the 23 fold contribution from fundamental earnings growth). Investor psychology is clearly the least important long-term driver of returns, accounting for about 10% of total returns. In the decades ahead it is likely that the earnings power of corporate America will be many times higher, but it is hard to imagine even much of tailwind from P/E expansion from today’s elevated levels. The P/E ratio can’t expand indefinitely. If anything, P/E is more likely to trend lower and detract from the S&P500’s medium-term returns.

Gain now… but then what?

Why does this matter? Over the last three years, the most transient contributor to stock returns – changes to the P/E multiple – has driven the vast majority of the S&P500’s returns. Earnings have been flat, but the index is up 29% as the trailing P/E has gone up from 16 to 21. This level of ongoing upside from P/E valuation changes is unsustainable in any sort of normalized environment (i.e. 9% per annum recently vs. 1% long-term). Below is a chart showing the relative importance of sentiment and fundamentals across different time horizons. This shows that while fundamentals invariably drive returns over the long-term, anything can happen in the short term.

What won’t change: Importance of fundamentals to stock returns increases over time

We have been increasingly cautious on quality stocks, utilities and “bond proxies” because they had become the most expensive and overcrowded trades in the market. Their impressive returns have lasted far longer than we anticipated, driven by the impact of declining interest rates and a feedback loop as inflows from valuation-agnostic index funds gathered momentum. Investors are invariably drawn to favourable price action. Many don’t care how the returns are generated. After all, a 10% return will buy the same goods and services regardless of how it was achieved. The lesson investors seem to have (over) learned this cycle is that valuations don’t matter. This could prove to be costly. As the old saying goes, “Games are won by players who focus on the field, not the ones looking at the scoreboard.”

When valuations are at high levels like today’s S&P500, investors are implicitly “borrowing” a portion of their future returns. After a long bull run like today, the index is likely in the late stages of the “gain now, pain later” phase of the investment cycle as P/E multiples contract. For stocks to go higher, at some point fundamental growth must kick in to drive returns. Unfortunately, the “bond proxies” that had been driving the market higher have limited growth prospects. They tend to be legacy incumbents operating near peak margins within mature slow-growing industries. Most have been paying more than 100% of their earnings back to shareholders in the form of dividends and share buybacks. Mathematically, it is difficult for the average company to grow if they don’t have much left over to reinvest for the future growth (e.g. the opposite of Amazon’s successful reinvest-almost-everything long-term approach). Furthermore, dividends are tax inefficient and corporate America’s track record at buying back stock has been terrible, with peak activity usually coinciding near bull market tops and bottoming near bear market troughs – this is the corporate version of buy high, sell low! This would be worrisome if the market was monolithic. Fortunately, it is not. In our view, the markets have become increasingly bifurcated. Popular index holdings paying out most of their earnings in dividends today have become expensive and crowded, while below-the-radar companies focused on building long-term value look cheap.

Investment vehicles of “Hall of Fame” operators on sale

We believe good recurring examples of long-term value creation through brilliant execution (through often misunderstood complexity) can be found amongst the Liberty Group of companies. These companies were founded and managed by John Malone, who is one of the greatest value creators in our generation. According to Fundstrat Global Advisors, an investment of $100 with Malone in 1973 would have been worth $315,337 (23% annualized) in 2015, compared to only $7,308 (11% annualized) for a similar investment in the S&P500 over the same period. Spanning over four decades and many business cycles, such stellar results are truly Hall of Fame-worthy (if there were such a thing!). As a practical matter, his core value creation tenets are worthy of special study to see if they are repeatable.

Malone utilizes a proven playbook of value creation techniques more commonly associated with successful private equity firms than the typical publicly traded American firm. Specifically, Malone’s management principles include a preoccupation with improving tax efficiency, optimization of the capital structure, achieving leverage through scale, and a laser focus on cash flow generation. His pioneering use of spinoffs, tracking stocks and suitable management incentives are also part of his flywheel of techniques. The private equity approach is often a messy and noisy process which understandably does not appeal to many managers. It requires an uncommonly long view to not worry about the near-term impacts of sound decisions that should compound wealth over time. Such a view is more easily held when one controls the enterprise, either through outright voting control or through the moral authority that only accomplished founders can provide. On the other hand, most public companies are obsessed with appeasing short-term shareholder demands rather than focusing on long-term investments and value creation. Aesop’s classic “The Tortoise and The Hare” fable foreshadows how a long or short view can often decide who wins the race.  

Malone generated much of his exceptional record as one of the original pioneers that consolidated the fragmented US cable industry. He readily admits he performs best when he sticks to his knitting (e.g. cable is in the center of Malone’s circle of competence.) Today we hold stakes in three of his cable entities which operate on three continents – North America, Europe and Latin America/Caribbean. “Rollups” and growth-by-acquisition strategies have fallen out of favour recently thanks to well documented failures like Valeant Pharmaceuticals. However, an analysis of rollup failures clearly indicates that the problem is not the concept, but the execution. After all, some of the greatest business success stories of all time used rollup strategies as part of their value creation process (e.g. J.D. Rockefeller’s Standard Oil and Henry Singleton’s Teledyne). This has also been a common strategy for many successful private equity groups. Rollups look elegant and simple when plotted on spreadsheets during accommodative markets, but require an unusual degree of discipline, leadership and attention to detail to work. As Yogi Berra observed, “In theory there is no difference between theory and practice. In practice there is.” It makes sense to look for signs of a repeatable track record and to remain particularly skeptical of managers on their first roll up attempts. Acquisition-driven strategies are difficult and most managers fail on their first real world test, often imploding during their first down cycle. When betting on a jockey, investors should heed Henry Ford’s counsel, “You can’t build a reputation on what you are going to do.”

We own a number of companies run by accomplished owner-operators who are using private equity-like strategies. Besides John Malone’s cable entities, we have invested alongside other Hall of Fame owner-operators like Martin Franklin (Platform Specialty Products) and the Rales Brothers (Colfax). Their collective achievements have been impressive and we consider their strategies repeatable. Importantly, each underlying business enjoys strong competitive advantages as quasi-monopolies (Malone/cable), defendable niches (Franklin/specialty chemicals), and market leadership within fragmented industries (Rales/industrials). We believe these companies have the potential to be compounders, but are currently on sale as plain old cyclicals. Most of the underlying businesses are in the process of bottoming with reasonable upside as the next cycle builds momentum. However, these potential returns could be meaningfully enhanced if these operators can execute on their Hall of Fame-worthy value creation playbooks. As noted, these managers have faced cyclical challenges in the past and have proven to be resilient. Investments made on their entities in previous cycles have usually paid off handsomely. Although these businesses have faced a tough cycle, the set up for returns from recent prices appears very compelling. We consider such dynamic long-term driven companies as “private equity proxies”. In many respects, they are the opposite of conventional dividend paying “bond proxies”. Given the recent rotation in the market, we think that’s a good thing.

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

Felix Narhi, CFA
November 17, 2016
*Source for data points: S&P Dow Jones Indices, Robert Shiller data, PenderFund
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