Category Archives: 2017

Q2’17 Investment Commentary

The technology sector come into focus in the second quarter of 2017. At the same time, the end of the “Trump Trade” we spoke about in our first quarter commentary continued, with cyclicals lagging the rest of the market. As investors aggressively shifted portfolios towards technology, they also moved money away from anything remotely related to the mall-based retail economy at an accelerating pace.

In January 2016 we highlighted the shift in our portfolio towards technology-based platforms that were solving old problems in new ways, with the following common traits:[1]

  • Two-sided networks—these companies all unite sellers of goods or services with consumers, at a scale that is on the one hand, large and defensible, and on the other, very lucrative.
  • Capital lean—these networks require very little incremental capital investment. There is little CAPEX needed for either maintenance or growth. Most of the actual investment flows through the operating line (R&D in some cases, marketing in others), thus actually suppressing what we believe to be the true long-term earnings power of each of these businesses.
  • High margin businesses—despite investment flowing through the operating line, these companies generate substantial operating profit margins and/or have the capacity to ramp these margins as the businesses further scales top line growth. Further, each incremental customer who buys or a good or is serviced on these platforms has very little incremental cost to the platform itself. As such, revenue growth has two effects: 1) the ramp of growth itself; and, 2) an upward pull on margins.

We listed the companies and summed up the opportunity as follows: “Collectively, we think of them as dominant business and commerce platforms for the future, with proven business models, robust cash flows and large growth runways.” Since that time, we have only added more exposure to this uniquely modern style of company. These positions have paid off nicely and due to the large growth runways, have ample opportunity to continue to do so.

While growth in intrinsic value has been an important driver for return in these stocks, most of the return has come from multiple appreciation. In other words, Mr. Market has warmed to these kinds of stocks and is willing to pay more for the same amount of earnings as he did just a mere year and a half ago. At the same time, Mr. Market has been punishing anything with even a passing connection to retail. While retail earnings have hardly been robust, and pockets of retail have been downright terrible, they have not been uniformly bad. The vast majority of the punishment in retail has been the flip-side of the technology sector: while earnings deterioration has hurt, Mr. Market is viewing the sector with increased concern. This is evidenced in the proliferation of references to “change at an accelerating rate” in retail, while in actuality the rates themselves have been fairly constant:

snip

[2]

Instead of an accelerating rate, what we are witnessing is the compounding effect of a consistent rate of change ultimately leading to increasingly large dollar volumes at stake in the shift in value from traditional retail to “technology.” Investors are realizing that companies either use technology to their advantage or risk obsolescence; however, they are not scrutinizing whether certain retailers are constructively deploying technology to that end. The natural endpoint is where people stop thinking of companies as “technology” or “retail” and think about how a particular company is developing technology to entrench their business in the new commercial landscape.  We have pursued a deep dive into the retail sector and its related companies. We entered this study with a few biases:

  • No company can rest on its laurels of having a “strong brand.”
  • Companies that are natively vertical, with a differentiated, high-quality product have an inherent advantage.
  • The world where big box stores could compete on a combination of location, well-curated products and generally (though not universally) low prices is entirely over.
  • Distribution and convenience are important challenges online, but can be overcome with some combination of low prices, premium quality and exceptional service.

It would be appropriate and well suited at this time to thank our terrific 2017 Summer Analysts, Ryan King, Joshua Herman, and Robert Palmer for their intellectual curiosity and diligent analysis. Each contributed tremendous value to our research efforts. Because of them, we can enter the second half of the year with a deep understanding of retail replete with an extensive watchlist of promising investment opportunities.

Not a Fully Furnished Yet, but Getting Started in Retail:

We have yet to get aggressive in the affected areas of retail, but we did commence our positioning in the space. Valuations are cheap, but the risk of being wrong (or early) is perilous.  Moreover, since nearly all these companies are priced quantitatively at valuations predictive of outsized gains, ultimately being right on investments in this space comes down to qualitatively determining the companies best positioned to succeed. As Buffett apparently said, “my greatest investments weren’t mathematical, they were unique qualitative insights.”[3] We are quite confident that will hold especially true here.

We did take a starter position during the second quarter that has subsequently been increased to a more substantial size in one retailer whose characteristics embody what we are looking for: Williams-Sonoma (NYSE: WSM). Williams-Sonoma is unquestionably cheap, trading at a mere 5.5x 2018 consensus enterprise value to EBITDA. In the depths of the crisis, the company traded at 4x forward EBITDA, but outside of the November 2008-January 2009 period, the company has traded in a range between 5.5x and 11x EBITDA. While many associate the company with its namesake brand, William-Sonoma’s largest driver of earnings is Pottery Barn. As of next year, Williams-Sonoma the store will be the third largest source of revenues behind Pottery Barn and the fledgling West Elm brand. As evidenced by the valuation, investors right now are lumping this company in with “mall-based retailers” considering all its closest comparables are just that.

Upon closer inspection, it becomes apparent that Williams-Sonoma is a different company than meets the eye. While the brand is often associated with its mall-based footprint, nearly 52% of its revenues are generated online, with over 72% of its operating income earned via the web despite furniture’s status as an especially under-penetrated area online (only 10% of US furniture sales happen through the online channel). We suspect this is so because many people still like shopping for furniture in a way such that they can see and feel the quality and comfort of what they are buying. Stores thus provide a natural showroom. Moreover, William-Sonoma’s furniture brands use stores as a springboard for a high-touch retail offering that other natively online retailers (like Wayfair) cannot compete with. Specifically, the stores create a national footprint of designers who are positioned to help customers plan their layout and present and future purchases to furnish their homes.

Clearly Williams-Sonoma is doing something different here with the extent of their online success. We think the in-store designers help by tying people into the aesthete and driving future sales that may not be captured at the store level. Many strong brands making high quality goods, but formerly sold through the standard retail channel can enhance their business by expanding their “Direct-to-consumer” (DTC) offering. But, (we learned this the hard way in Under Armour) DTC comes with several problems that are short-run operational problems and long-term valuation ones. Here are a few of issues with DTC:

  • Lower margins
  • Requires greater working capital, specifically inventory to handle high rates of return
  • Ramped capital investment to handle new distribution and foster greater convenience for customers.

The company’s history in the mail-order catalogue business is an advantage in how it afforded management the opportunity to leverage the catalogue’s lessons learned and distribution footprint immediately into a distribution advantage online. This is as much related to the company’s physical capability to handle a large volume of online orders as it is about the company’s culture being geared towards driving sales irrespective of channel, with processes in place to fulfill customer needs and orders. Beyond that, management has proved adept in understanding changing tastes and trends, having built West Elm from scratch starting in 2003 to a $1b run-rate brand, all amidst the backdrop of this larger shift from retail to technology that we prefaced this company feature with. West Elm benefits greatly from leveraging Pottery Barn’s existing distribution infrastructure and lessons learned in capturing customer mindshare online.

All of the unique brands at Williams-Sonoma the company offer high quality products that the brand stands behind. Pottery Barn and West Elm in particular are natively vertical, with differentiated aesthetes in furniture. We think this is important, because people who buy into a particular aesthete, expectant of a certain level of quality and comfort, will be increasingly likely to make additional purchases from the same brand.

What do we own:

The Leaders:

Trupanion, Inc. (NASDAQ: TRUP) +57.38%

IAC/InterActiveCorp (NASDAQ: IAC) +40.04%

GrubHub, Inc. (NASDAQ: GRUB) +32.56%

The Laggards:

Cisco Systems, Inc. (NASDAQ: CSCO) -6.60%

Walgreens Boots Alliance (NASDAQ: WBA) -5.30%

Markel Corporation (NYSE: MKL) 0.00%

For those of you who have enjoyed reviewing our investment presentations in the past, we have a special treat for you. Elliot Turner was again honored to present at the 2017 Value Conferences Wide Moat Investing Summit. He presented IMAX at the inaugural event four years ago followed by eBay/PayPal in 2015, and Envestnet in 2016.  At the Wide Moat Investing Summit, recognized value-investors presented some of their best investment ideas. Elliot presented on Twitter and his slides can be accessed here[4].

Thank you for your trust and confidence, and for selecting us to be your advisor of choice.  Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have.  You can reach Jason or Elliot directly at 516-665-1945.  Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

[1] http://www.rgaia.com/robust-networks-for-the-long-term/

[2] http://dashofinsight.com/weighing-the-week-ahead-is-a-market-friendly-policy-agenda-in-peril/

[3] https://twitter.com/ElliotTurn/status/664475437679190016

[4] http://www.rgaia.com/twitter-presentation/

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed.

Twitter Slides from the Wide Moat Investing Summit

Elliot Turner was honored to present at the 2017 Value Conferences Wide Moat Investing Summit. He presented IMAX at the inaugural event four years ago followed by eBay/PayPal in 2015, and Envestnet in 2016.  At the Wide Moat Investing Summit, recognized value-investors presented some of their best investment ideas. Elliot presented on Twitter.  We are excited to share his slides here:

Q1’17 Investment Commentary

Many of the themes from the end of 2016 persisted into the early first quarter of 2017. Around the second week of February, the so-called “Trump Trade” reached its crescendo with many of the politically driven ascents fully faded into the end of the quarter. The market’s overall levels largely held up with a shift in strength towards technology and some of the other “high quality” laggards of late last year at the expense of cyclicals.

Underlying economic strength continued into the quarter and helped push the acceleration of expectations for the first Federal Reserve rate hike of 2017. Coming into the year, markets expected less than a 50/50 chance of a March hike, but during a spate of voting member talks in the month of February, these expectations shifted to near certainty. This coincided with the Trump trade’s inflection point.

We took advantage of the strength in cyclicals to shed some positions where we felt the pendulum swing in sentiment did not correspond to a shift in fundamentals—we sold both our auto manufacturer and car dealer (while maintaining our entire exposure to the financial sector). Below, we expand on two other notable portfolio changes during the quarter.

In which we realized our mistake quickly, though not soon enough:

In our 2016 year-end commentary we shared our thesis on Under Armour (NYSE: UA). [1] Shortly after publishing our thoughts, the company issued a trifecta of bad news when their earnings missed the mark, they abandoned what had been issued as longer-term guidance only three months prior, and their CFO resigned. Any one of these may have been indicative of a short-term problem, but together they compounded the woes. While our quick about-face may appear surprising, we think it is essential to remain flexible in our views despite our long-term bias and believe it is important to learn the right lessons from our mistakes. One of the foremost mistakes with UA was our under-appreciation for how much this company on the apparel side resembles a “fashion” company more so than a pure sports play. These quotes from their Q4 2016 conference call make this point stark:

  • “We need to become more fashionable with the products that we have out there. And one of the things we found is that some of the core basics were some of the challenges that we saw, is that we are counting on core basics as we have in years past to do more work for us. But the consumer today frankly has more options, and frankly most of those options are from good brands that we compete with, that are heavily discounting as well.” – Kevin Plank[2]
  • “So what you’ll see is that I don’t think it’s one shift of abandoning one for the other. Obviously, with things like the investment we’re making in UAS (31:30) in sport lifestyle in general, but we need to become more fashion. The consumer wants it all. They want product that looks great, that wears great, that you can wear at night with a pair of jeans, but that also does perform for them. But the performance has just become a bit of a given information. And so I think you’ll see us continue to react to that, and hopefully I think you’ll see us continue to lead in that.”[3]

We cannot help but ask, what is the company’s edge if “performance just become a bit of a given.”

Further, was growth demand-pull or supply-push? That is, did the company grow because consumers kept buying more and more, or because UA kept putting out more and more product. Obviously to some extent there is a symbiotic relationship between the two, but in hindsight it appears certain that the growth emphasis from leadership despite the reset in expectations during the Fall was a sign that the growth had inflected from a balance between the two to a more dominant supply-push. Supply-push is far less certain because it comes with increasing the capital base of the business ahead of the top line and requires growing inventory to the point where if something goes wrong, it will go very wrong. This is evident in the gross margin miss and the inventory build.

While Plank deserves admiration and is a worthy subject to study for how successfully he built UA, there was a warning sign that we did not consider until after-the-fact. Plank had been touting UA’s “26 straight quarters of 20% or more YoY top line growth.” This is a great accomplishment, but it is also an overt risk. When a streak becomes too important a corporate imperative, the incentive to continue the streak can outweigh the incentive to do the right thing because no one wants to be responsible for it ending.

UA’s goal in hindsight seems like it was kept up with pulling growth forward (creating way too much product and discounting heavily. Further, Q3 guidance for 2017 was shaped far too much by attempting to maintain the “above 20%” as an important threshold, instead of being realistic about what already was acknowledge as slowing but robust growth. Accounts receivable was a tell we should have noticed. Whereas inventory only grew 11.9% vs sales growth of 22.1% year-over-year in Q3 of 2017, receivables grew 29.5%. This inventory was sold through the channel to wholesalers who had not paid for the product. This helped boost sales and reach growth targets, when in fact it should have been a big red flag.

  • “a larger increase in accounts receivable of $53.7 million in the current period compared to the prior period, due to the timing of shipments driven by current period sales being more heavily weighted to the end of the period.”[4]

Perhaps the key takeaway here is as simple as the “capital cycle.” We were first introduced to this idea in “Capital Account: A Fund Manager Reports on a Turbulent Decade.”[5] The book featured the letters of Marathon Asset Management and its focus on the capital investment cycle at both the micro and macro levels and the impact it would have on valuations. We no longer own any other investments in companies which are simultaneously sacrificing margin & investing in capex at such a voluminous rate. We do have some investments in which out-year margins will be greater due to the investment that flows through; however, these businesses are very capital light and the investment through margin should be long-lived. UA is basically the reverse.

It’s very hard not to write off the big investments of the past year given how badly the company missed on both top line and margins, and what the outlook into next year is like for both as well as free cash flow. On the plus side, the company is lowering CAPEX spend, but this seems more out of necessity and leads us to wonder why it didn’t happen sooner. This does not strike us as a “capacity to suffer” (Tom Russo’s definition) problem right now.[6] This more realistically strikes us as a company struggling to find its identity in crossing the chasm from a passionate, profitable niche (performance gear for the active athlete) into mass market appeal. In the process, the UA is wavering between “performance” and “fashion” and “growth” and “operations” with none really emerging a clear-cut winner for the brand’s identity. Plank talks a lot about the identity, but if “performance is taken as a given” then we wonder what that identity looks like at the end of the day.

High quality at a depressed price:

During the quarter we commenced a position in Arcadis (AMS: ARCAD). Arcadis is a global design and consultancy firm with specialties in infrastructure, water, environmental remediation and architecture. They work on vital pieces of infrastructure that touch our lives daily: levees, tunneling for subways and water pipes, dams, desalination plants, help municipalities manage flood plains and construct plans, etc. The company’s 20,000 plus employees work on 30,000 projects annually around the globe.

The unique specialty and capabilities in water put this on our radar. If you casually followed some of the post-Sandy reconstruction in New York and the discussion of broader coastal protection, it is likely you have come across this name.[7] As we often do, we noted Arcadis’ contribution to the reconstruction efforts and put them on a long-term watch list. Over the past year, between a spate of poorly timed (and executed) emerging market acquisitions, an investigation by Brazilian authorities of corruption in the procurement of construction contracts (notably Arcadis is a design, not construction firm) and evolving needs of the formerly very profitable US environmental remediation business, the stock took a beating. Nonetheless, free cash flow remained high. Heading into the new year, the company “parted ways” (aka fired) its CEO Neil McArthur and hinted at a renewed emphasis on operations over growth. To that end, Arcadis hired Peter Oosterveer, the long-time COO of Fluor Corp (NYSE: FLR) who has the right experience and exposure to help streamline operations and restore profitability accordingly.[8]

Arcadis’ main input cost is labor capital. The company is not necessarily unique in this respect; however, they are unique in their ownership structure. The single largest owner of shares is an aggregated pool of employee holdings—representing 17.2% of the outstanding shares. There is very little physical capital deployed in the company. As such, capital expenditures are very low and most investment flows through in the form of labor expenses. The company has a shared common knowledge base that is “housed” in its DNA that gets deployed to each project along the way. This knowledge and expertise is something that other companies would have difficulty to replicate both in its scale, its vintage, and its specialty.

Returns on capital are very high at Arcadis (30% ROIC ex-goodwill and acquired intangibles). With goodwill and intangibles the numbers are inferior now—hovering around 8%, due to the sluggish performance of some of the more recent, larger transactions and the downturn in the Emerging Markets business.ROIC ex-goodwill is the best way to judge this company, because when you include goodwill, you are making a judgment on management in addition to the actual business. Looking exclusive of goodwill gives a clearer picture on the cash generation capacity of the business as it stands today. This is particularly relevant here as the company transitions from an acquisitive to an operations-focused CEO. Oosterveer comes in with a clean slate and will be unencumbered by the returns generated on goodwill (ie by the strategic decisions of previous management). Cash generation is very lush, and supports both the interest expense in its presently over-levered state, as well as a dividend payout of 30-40% of net income. CAPEX has been, and will continue to be low. Since there is little physical capital deployed in the business, fixed costs in the long run are very low; however, they are high in the short run due to certain institutional imperatives and the uncertainty with respect to how quickly cyclical forces will resolve themselves. When the company has clarity (as it does in Brazil) that the problems run deeper than merely cyclical ones, they can right-size the cost base and restore margins fairly quickly. This helps make cyclical margin problems shorter-term in nature, even if revenues don’t come back quickly enough. While the company is a cyclical, the infrastructure needs they service are secular. To that end, it is the funding cycles, not necessarily end demand which are cyclical. Working capital does eat up some capital, though that is proportionate to the revenue base at any given time. There are nearer-term problems right now as some oil and gas companies and countries exposed to oil and gas pricing have stalled on payments. These problems will be watched closely, though we believe they should be resolved in the not-too-distant future.

As a company that deploys labor, it’s important to mention that most of the projects are staffed locally—projects are staffed with people who are located in the same country as the project itself. The Hyder division brought in global outsourcing centers in India and the Philippines that are used for some elements of design and architecture, though this is mainly for UK-based projects. Only 3% of US-based projects are staffed with outsourced talent. This was particularly helpful in thinking about what may happen to the company were the US to adopt a border adjustment tax.

Further adding to our intrigue in Arcadis is the contribution the company can have to the portfolio’s correlations–in particular, flooding events are bad for the economy and especially so for insurance/reinsurance, to which we have exposure by way of Markel (NYSE: MKL) and Exor N.V (MILEXO.MI). If a flood event hurt the reinsurance sector, it is likely that Arcadis would move strongly in the opposite direction (for context, Arcadis rose 5.6% the day Sandy made landfall and enjoyed an especially strong year). At the time of our purchase, we picked up shares for just north of a 10% cash flow yield based on our 2017 estimate. Should multiples remain constant, then we would expect to earn this double-digit cash flow yield over time. This estimate assumes no margin improvement. If margins improve in 2018 (and the company has taken action to effect that outcome), alongside any basic recovery in cyclically weak areas of infrastructure demand, there is the potential for powerfully strong performance. One thing is clear with Arcadis: there will continue to be immense need for the crucial services they provide in making our world more livable, especially in the face of climate change.

What do we own?

The Leaders:

The Priceline Group (NASDAQ: PCLN) +21.41%

Exor N.V. (MI: EXO) +20.00%

Arcadis N.V. (AMS: ARCAD) +15.86%

The Laggards:

Under Armour, Inc. (NYSE: UA) -24.95%

GrubHub Inc. (NASDAQ: GRUB) -12.57%

Envestnet, Inc. (NYSE: ENV) -8.37%

Thank you for your trust and confidence, and for selecting us to be your advisor of choice.  Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have.  You can reach Jason or Elliot directly at 516-665-1945.  Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards and all the best for a healthy, happy and prosperous 2017,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

[1] http://www.rgaia.com/2016-year-end/

[2] https://seekingalpha.com/article/4041127-armour-ua-q4-2016-results-earnings-call-transcript?part=single

[3] https://seekingalpha.com/article/4041127-armour-ua-q4-2016-results-earnings-call-transcript?part=single

[4] https://www.sec.gov/Archives/edgar/data/1336917/000133691716000113/ua-9302016x10q.htm

[5] https://www.amazon.com/Capital-Account-Manager-Turbulent-1993-2002/dp/1587991802

[7] http://www.pbs.org/newshour/rundown/engineers-draw-barriers-to-protect-new-york-from-another-sandy/

[8] http://www.enr.com/articles/41625-fluors-retired-coo-will-become-ceo-of-arcadis

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed.

2016 Year-end Investment Commentary

The calendar turning is an arbitrary metric-point from which to measure and assess the recent past and what it portends for the future. It is a moment when we can take a step back and think about our goals and specific paths to achieving them. At key moments during the year, we contemplate what our year-end commentary would look like were the year to end at that very moment. In 2016, there were four distinct periods in which the narrative forged a decisive break from what preceded it:

  1. The Meltdown: January ended with the S&P down 5%. It was down 10% about halfway through the month. The only worse Januaries were in 1990 and 2009. The infamous “January Barometer” which holds “as January goes, so does the market” had many investors trembling. During this time, markets were trading in lockstep with crude oil.[1]
  2. The Snapback: February was similarly volatile, with the S&P and Russell finishing within spitting distance of UNCH (unchanged), after a 6.52% and 9.05% respective drawdown. The 1st quarter finished up for the S&P after a strong March. Energy, mining and industrials led the way up.
  3. The slow grind: This act lasted from the beginning of April through the day before election day. For the first part, markets slowly churned with an upward bias, only to be interrupted by an interlude dubbed “Brexit.” The second half of this act saw the slow upward grind give way to a slow downward grind. While this downward phase will make history books as the “longest losing streak since 1980,” the market fell just shy of 5% altogether.[2]
  4. The Post-Election Frenzy-This was the outcome and reaction that no one predicted. Even the most enthusiastic Trump supporters did not expect a market rally upon a Trump victory. What overnight on Election Day seemed like a market catastrophe turned into a surge led by financial stocks, industrials and energy stocks. This strength persisted through year-end, with the tech sector the notable laggard.

While this summary focuses on equity markets, the action in bond markets was equally noteworthy. Coming into the year, consensus was that we were at the start of a rate hike cycle and that rates would rise as the curve steepened throughout the year. Instead, in the first half, rates collapsed and the yield curve flattened. We felt this was “flat wrong.”[3] By the end of the year, rates ended up higher, though the yield curve only steepened slightly. The path was volatile, to say the least.

1

Trading Politics

The year’s political developments deserve further discussion, as they greatly influenced market action throughout 2016. Brexit was the first political landmine for markets during the year. This landmine left little collateral damage on global markets, with the recovery in US indices taking nary more than a few days. It remains to be seen whether the United Kingdom will actually “leave” the European Union, as the political processes were not prepared in advance, and the outcome was hardly popular across all demographic profiles. Notably, the younger voters (under 24) voted in favor of “Remain” by a 75% to 25% margin. [4]

2

In a backwards-looking assessment of 2016, it is easy to forget that what looks like a strong year for equity markets, the pockmarks were severe, with serious questions raised at the time.  At the time, prominent news sites and analysts alike dubbed Brexist “a Lehman Moment” implying that the consequences would be as severe for markets and economies as was the failure of Lehman Brothers in September of 2008.[5] We emphatically argued otherwise and were largely met by deaf ears for a few days until markets quickly repaired themselves and traders grasped how unclear the consequences would be. Our most poignant paragraph from the time is worth repeating today:

The invocation of Lehman here strikes us as a case of “recency bias”—a form of post-traumatic stress disorder that the humans who operate markets exhibit in the aftermath of extreme events. The cleanest definition for the recency bias is that it “is the phenomenon of a person most easily remembering something that has happened recently, compared to remembering something that may have occurred a while back.”[1] Ultimately it is easier to recall recent events, especially when a high level of emotion is involved. Ye the more emotion is involved, the harder it is to cleanly recall a sequence of events with a factual level of detail. This is why every time the markets have had a rough patch since the Great Financial Crisis, some investors wonder whether it will be the next acute phase of troubles. A reality that we often cite in these instances is that it is far safer to fly in an airplane shortly after a crash happens, than just before. This is true because those who are stakeholders in the security of flying are on higher alert for any potential problems in the aftermath of disaster. The same is true in financial markets, with one of the clearest signs today being the very safe capital ratios in the financial sector. If you will recall, the troubles at banks were the transmission mechanism through which problems in markets became a real economic calamity, and while we are never immune from problems in markets, they are far less likely to spread and become really deep when in such good shape.

The U.S. Election has some similarities to Brexit. Ultimately we had what can be called a “populist” vote led by backlash against “elites” with a mandate to protect national interests in an increasingly complex and global economy. The market recovery post-U.S. election was even quicker than following Brexit. While it looks like markets have uniformly surged, the moves have been far more nuanced. The most cyclical sectors have seen the biggest boost, while the most yield sensitive have declined. Technology (in the middle) has done little, if anything. Importantly, most of the forces that have driven this “Trump Trade” were in place well before the election itself.

The cyclical sectors like energy, materials and mining, and industrials had led the way since the market’s strong March. Some of the narrative attribution, suggesting that a major tax reform, a $1 trillion stimulus and a more lax regulatory environment seem overbuilt excuses for an extension of what has been a multi-month rally. There is little evidence that such a stimulus can and will be passed anytime soon. Tax reform might happen sooner, though the consequences are uncertain when considered alongside potential trade tariffs.

The most real rally in any sector since the election is in the financials. We say “real” in this case, because the shift in the yield curve will be consequential for earnings. Bank net interest margins bottomed in Q1 of 2015 and had been trending up, albeit modestly so through 2016.

3

Simply based on the yield curve action, this bottoming in the bank net interest margin will accelerate in 2017. Moreover, while in other areas, the rollback of regulation will be a more complex process, in financials, the administrative rollback of some of the more onerous provisions of Dodd-Frank are easiest. Lastly, and most consequentially, financials started this rally with such outlandishly cheap fundamental valuations that the entire move has taken the sector from substantially undervalued to modestly undervalued. In other words, financials are still cheap. While banks may appear “overextended” on charts in the short-run:

4

There is ample room for acceleration in the longer-term charts.

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What happens with rising rates?:

For several years, we have pointed out how improving household balance sheets created a solid foundation for economic growth.  Last year, we expanded on this argument with a look at how two forces—rising real wages and falling energy prices—were improving the income statement of households in a way that had not been seen in decades. This is not a narrative we see presented often, but the combination of strong balance sheets and improving income statements creates a compelling case why this post-financial crisis recession should continue despite its age.

The balance sheet improvement was enabled by falling interesting rates—households refinanced more expensive debt into cheaper, fixed rate debt that will keep debt burdens benign for the masses for the foreseeable future. Though this also beg a question we have been asked by many since the Federal Reserve Bank raised interest rates in December 2016: “will rising interest rates will hurt the economy?”. We have oft-stated that this dilemma of accepting rising rates versus hurting the economy is a false one. Our view is that rising rates are a reflection of real economic strength and improvement in underlying fundamentals, rather than an actual damper on the economy. This is not always and forever our view, and to that end, we have emphasized that the next recession will come from the Fed tightening rather than any lingering deflation fears. As of today, think of rising rates as a reflection of an improving economy rather than a lid on anything overheating. As the following chart nicely shows, when rates are below 5% and rising, this tends to be very bullish for the economy:[6]

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Biggest mistake:

We made more than one mistake this past year; however, numerically what is our biggest mistake does not appear obvious when looking at your account statements. You may have noticed that the best performing stock in the S&P 500 last year was a familiar name: NVIDIA Corporation (NASDAQ: NVDA). We owned this position for a while and earned a decent gain. This gain happens to be a pittance compared to what could have been had we simply held on to the position. For years, Wall Street’s narrative on the stock focused on the declining demand for PC’s and the failure of NVIDIA’s Tegra processor to gain traction in the phone and tablet market. Seemingly overnight that narrative shifted to the surging demand for the company’s server chips. This error of omission reinforces several valuable lessons that we already should have learned, in particular, the value of patience and independent thinking. It also reinforces how seemingly random the search for “catalysts” in company selection actually is. The company’s fundamentals–mainly a pristine balance sheet with gobs of cash & a high margin product with rapid demand cycles–remained essentially unchanged, but the narrative shifted entirely.

This is but one reason we focus on the qualitative and quantitative elements of a company without spending too much time thinking about catalysts. Known catalysts in theory are incorporated into the market’s pricing of a stock, and the unknown by definition cannot be neatly anticipated. Meanwhile, quality companies who generate cash at worst increase in value proportionate to retained earnings and growth, while their multiple changes with the whims of the market’s narrative.

Most valuable lesson:

IMAX (NYSE: IMAX) has been a long-term core position for us, but during the fourth quarter we sold the stock. We have some fears that this could be another NVIDIA for us, though we think there is a legitimate reason behind this sale, and in that reason lies a valuable lesson. Since 2012, IMAX has grown revenues by 32%, with gross profit rising 43% and exhibiting some of the earnings leverage we expected. Unfortunately, net income grew a mere 5.9% and the ROE dropped from near 20% and growing to the low double digits. How is it that a company could grow the top line and gross margin so nicely with none of it flowing through to net income? There are other possible answers, but here the answer is so clearly bad management that we felt compelled to sell and further memorialize our learning here. We would accept the contention that the company hasn’t exactly grown their top line and market share as quickly as we would have liked, yet the results still should have been better and to that again, we fault management.

When we pitched IMAX in the 2013 ValueConferences Wide-Moat Summit[7], we cited management in two of our risk factors for the company, with the most relevant here having been the following: “Little clarity on management’s track record with allocating actual cash flow.” If there is one area where management excels, it is in compensating themselves. We always felt management was promotional and well compensated, but attributed this in part to the “Hollywood” attachment to the commercial film business. When CEO Richard Gelfond was rewarded a special bonus for overseeing an IPO of the company’s Chinese division, we were simply disgusted. In 2014, Gelfond made $10.58 million in total compensation, which surged to $14.5 million in 2015. The stock did ok during this timeframe (rising 23%), but as a proportion of net income, these are some huge numbers that hurt the value in many ways:

  1. The proceeds should have gone to the company’s coffers
  2. The company is valued by the market on a multiple of earnings and this excessive compensation subtracted from it proportionately (for example: the company has traded around a 30x P/E for much of this timeframe. Were Gelfond paid a more modest $5 million instead, the stock would be worth nearly 15% more on a P/E basis, forgetting about the accrued earnings)
  3. Most of the compensation is in the form of RSUs, secondarily in stock options. While the RSUs take time to vest, both forms are dilutive of shareholders. Worse yet, Gelfond habitually sells nearly all his vested shares as they vest.

We also have questions and concerns about the company’s investments happening in the form of ramped operating expense. Our concerns are both in terms of how much they cost, and how they are structured.  IMAX entered into a joint venture to develop and sell in-home private theaters to high net worth individuals.[8] The idea seemingly makes sense as a natural extension of IMAX’ core mission; however, it was structured as a joint venture with a Chinese company. This makes little sense, for IMAX brings the technology and the media to the partnership, while the Chinese company brings little. That this happened at a time when IMAX was looking to IPO its Chinese division entirely is further suspect. Why wouldn’t the company develop this on its own, or with more established Western companies where concerns of governance and the ability to move around cash and other assets is unquestioned?

The second big investment is even worse, for we cannot see how it is a natural extension of the IMAX brand. IMAX is developing a spin-class concept called the IMAXShift, which uses the company’s immersive screens to create the backdrop for the class.[9] The company spent the better part of a decade trying to move beyond niche uses and gain acceptance as a format in the entertainment industry only to now invest some of the proceeds from that success in half-baked, uncertain ideas with limited upside. We would be less irritated by these investments were the company clearer on its US-based growth path and what it can do to squeeze out competition from other premium large format competitors. The company was in the pole position by a wide margin. That margin is smaller now, though still present; yet, the company has not communicated any broader plan about growing its share of US theater spend.

Over the course of our holding period, we have tried to reach out to investor relations and management with phone calls and letters to discuss some of our questions. For one reason or another, we have been unable to have a constructive conversation with anyone at the company regarding first, our interest, second, our concerns. We find this surprising in light of our publicly bullish stance. We feel better positioned on the sidelines now.

New Buys:

In the quarter we made three new buys: one a small cap that we will introduce once we complete purchasing our position; second, a position in Expedia, Inc (NASDAQ: EXPE);  third, a position in Under Armour (NYSE: UA). These purchases were spread both before and after the election. We point this out to highlight how little the election actually impacted our fundamental analysis. While we do have concerns about some shifts in policies, we try to account for this in consideration of each position’s business.

Getting Longer the OTAs:

You may have noticed that with the Expedia purchase, we now own the two largest online travel agencies (OTAs). We think there is a solid basis for owning both at this juncture. We view these two positions as one larger wager on the proliferation of the experiential over consumption spending habits of millennials and a growing interest in travel, generally speaking. However, we also think there are considerable differences that make the risk/reward profiles of the two unique from each other.

While both businesses book hotels, airlines, rental cars and to a lesser extent, activities, the main driver of profitability is from the hotel business. Priceline (NASDAQ: PCLN) primarily uses what’s called the “agency model” while Expedia operates a “merchant model.” The agency model means that when a customer books a hotel on one of Priceline’s properties, the transaction is between the customer and the hotel, with Priceline as the intermediary taking a cut. In the merchant model, the customer’s transaction is with Expedia itself, with Expedia in charge of booking the room and handling the payment. The merchant model generates commissions per each room booked; however, the agency model has less risk associated to it, is more easily scaled and has higher long-term margins on the whole (in contrast to a per room margin).

How these two companies evolved to operate with different models is best explained with their respective geographies. Priceline’s major value driver is Booking.com which mostly caters to the European market. While the hotel chains do have a presence in Europe, the continent’s hotel industry is far more fragmented, with a more abundant supply of boutique, individually owned accommodations. In contrast, Expedia mostly caters to the U.S. hotel market, where boutiques are still present, though far less so than in Europe. Hotel chains operate the majority of properties (whether via franchise or direct ownership). Hotel chains prefer the merchant model to the agency model, because the agencies take a cut off the top without taking any of the business risk associated to it. Further, in the merchant models, the chains can use their scale and commensurate leverage to negotiate deals that are unique to their own interests and needs. This difference in business model and thus geography is an important component to our rationale for owning both.

In the beginning of the year, Priceline was as cheap as it has been outside of the Icelandic volcano eruption and Great Financial Crisis, despite an outstandingly consistent business with a solid growth runway. Expedia, on the other hand, was cheap, but not exceedingly so. Priceline was trading at only a slight valuation premium to Expedia despite the agency model’s superior margin profile. Since that time, Priceline’s stock has outperformed Expedia by nearly 30%, creating a substantial valuation gap that we think is unjustified. Expedia’s problems can be summed up by one word–the company needed some “digestion.” The stock had appreciated substantially in 2015 and needed to digest the upmove and the company had made a series of substantial acquisitions that needed some digestion operationally. The two main acquisitions were Orbitz and HomeAway, both of which we really like. Orbitz expands Expedia’s flight-booking capabilities and offers the opportunity to add Expedia’s lush hotel inventory to the offering on Orbitz itself. HomeAdvisor greatly scales the supply of “rooms” available on the Expedia platform, by bringing both HomeAdvisor itself and VRBO into the fray. This also mitigates the risk presented by Airbnb to the hotel industry.

With the U.S. hotel industry dominated by chains, one of the primary concerns that impacts Expedia more than Priceline is the hotel industries quest to capture more bookings for itself. HomeAway helps diversify away from this risk. Expedia has also taken smart steps in forging deals with some chains in order to turn this risk into an opportunity. A great example of this is Expedia’s recent deal with Marriott whereby Expedia would provide the technological infrastructure for Marriott’s own booking website while offering the flights, rental cars and entertainment add-ons to those customers who want to book on Marriott[10]). Similarly, Expedia signed a deal with Red Lion Hotels to incorporate Red Lion’s reward program into the booking process for those who secure Red Lion reservations on the Expedia website.

At this point, Expedia is trading at 10x next year’s consensus EBITDA, which we think is conservative. The stock is priced for low single digit growth, yet we think there will be a period of double digit growth on the horizon. Management has a great track record of making accretive acquisitions and driving shareholder value. John Malone, through Liberty Media is the controlling shareholder and board member, and his outstanding long-term record of value creation is an important influence on the company’s culture and values. Together, we think our positions in Expedia and Priceline give us great exposure to an important secular trend (experiential spending), at valuations on the cheap side of fair, with outstanding management teams to ensure shareholders are rewarded.

Athleisure is a Lifestyle, not a Trend

This is but one reason we purchased shares in Under Armour. Under Armour is not per se a cheap stock, but it is high quality with as lush a growth runway as any stock we follow. This past year was a rough one for the stock on the heels of slowing growth, compressing margins and a share class split that raised questions about corporate governance. The share class split is actually a key reason why we felt the time was right in creating an opportunity for us. A picture tells the story neatly.

7

Under Armour had done traditional splits in the past; however, this time, the company opted to do something out of the tech company playbook. Instead of a traditional split, Under Armour split its shares into two classes: the A shares, which would have voting rights, and the C shares which would not. This was an effort for Kevin Plank to keep voting control if he sold his controlling shareholdings down to a level beneath what would afford the voting rights to do so. To some in Wall Street, the optics of this are not ideal, yet to us, we feel a position in Under Armour with or without voting rights is a co-investment as a junior partner alongside Kevin Plank (Founder and CEO of Under Armour)-a smart hustler who built the company from the ground up. When the share split first happened, there was a little more than a 3% spread between the A shares and the C shares. Within a few months this spread jumped into the double digits. After Under Armour’s take-down of long-term guidance in October, the spread surged to more than 20%.  We think there were structural and technical reasons behind the extremity of this spread.

  1. The stock had a large short-interest on account of its excessive valuation coming into the year. After the split, this short interest situated itself in the far more liquid A shares, which at that point were trading with the UA symbol.
  2. Kevin Plank filed a 10b5-1 selling plan that would have him selling C shares, but not A shares.
  3. Baillie Gifford and other large institutions with a mandate to own voting shares sold off their entire C share position to buy A shares (Baillie has carried an 8+% position here).
  4. Lack of awareness-since the UA symbol associated with the stock defaulted to the A shares following the original split, most traders and all analysts focused their attention on those shares and essentially ignored the existence of the C.

One consequence of the widening spread was that the C shares got to our long identified buy price well in advance of the A shares, at which point we established half of our position. This was a nice learning lesson, for in the future we will respect the fact that when everyone on Wall Street values a company according to one share class, a second share class reaching even Wall Street’s undervalued metrics would not trigger enthusiasm. Shortly after completing our position, the company announced a change in symbols that would give the “C” shares the traditional UA symbol, and the A shares, the new UAA badge. As a result, the liquidity profile of the respective shares switched overnight and the combination of the company’s messaging that closing the gap would be a priority and taking this optical though meaningful step towards that end elicited the desired response (at least in part). As shareholders of the “inferior” class, we liked this. As market observers, we found this one of the more interesting experiments in the “price anchoring” bias of traders we have ever seen.

What do we own?

In the early-year selloff we picked up and/or added to some quality companies for the long-term. Our overseas holdings had good price returns; however, the Dollar’s strength relative to the euro was once again a drag on our total returns. Our holdings in the pharmaceutical sector hurt considerably during the year and in the process, our lush returns experienced over the prior two years in that space were handed back to Mr. Market.  Below are our three best and three worst positions during the year. We no longer own one of the leaders and two of the laggards. Total returns are indicated based on the stock’s performance during our holding period within 2016 and are denominated in the US dollar.

The Leaders:

Johnson Outdoors Inc. (NASDAQ: JOUT) +91.0%

GrubHub Inc. (NASDAQ: GRUB) +77.8%

JPMorgan Chase & Co. (NYSE: JPM) +54.7

The Laggards:

Vertex Pharmaceuticals Inc. (NASDAQ: VRTX) -39.0%

Teva Pharmaceutical Industries Limited (NYSE: TEVA) -35.5%

IMAX Corp (NYSE: IMAX) -22.6%

Best books we read in 2016

  • Tubes: A Journey to the Center of the Internet by Andrew Blum- fascinating book for anyone interested in how physical structure that enables the Internet works. This is great for anyone with casual interest and those looking for an investment angle to Internet infrastructure.
  • Algorithms to Live By: The computer Science of Human Decisions by Brian Christian and Tom Griffiths- an outstanding self-actualization and efficiency book. The book takes a mathematical approach to finding optimized structures through which to make decisions about everyday life problems.
  • The Snowball: Warren Buffett and the Business of Life –by Alice Schroeder A thorough biography of Buffett the investor and individual that sheds new light on what makes Buffett so unique.
  • Wages of Destruction: The Making and Breaking of the Nazi Economy by Adam Tooze – A detailed history of the Nazi Germany economy from the economic backdrop behind Hitler’s ascension to power, to the industrial prowess of the wartime industries, to the collapse.
  • Shoe Dog: A Memoir by the Creator of Nike by Phil Knight- Phil Knight’s personal memoir’s of how he ended up founding Nike and leading it to tremendous success. Knight is an amazing storyteller, with a prolific memory for the finest details, and an enlightened world view. Anyone could learn a lot from reading Knight’s telling of Nike’s history.

Thank you for your trust and confidence, and for selecting us to be your advisor of choice.  Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have.  You can reach Jason or Elliot directly at 516-665-1945.  Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards and all the best for a healthy, happy and prosperous 2017,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

 

[1] http://www.rgaia.com/robust-networks-for-the-long-term/ chart from in here

[2] http://www.marketwatch.com/story/dow-futures-frozen-in-place-with-all-eyes-on-jobs-report-election-homestretch-2016-11-04

[3] http://www.rgaia.com/the-yield-curve-is-flat-wrong/

[4] Vote stat and following graph from http://www.politico.eu/article/britains-youth-voted-remain-leave-eu-brexit-referendum-stats/

[5] https://www.bloomberg.com/view/articles/2016-07-04/brexit-is-a-lehman-moment-for-european-banks

[6] https://am.jpmorgan.com/us/en/asset-management/gim/adv/insights/guide-to-the-markets/viewer

[7] http://www.rgaia.com/slide-deck-from-valueconferences-wide-moat-investing-summit-2013/

[8] http://www.imax.com/zh-hans/content/imax%C2%AE-corporation-and-tcl-launch-imax-private-theatre-palais%E2%84%A2-china

[9] http://www.imax.com/content/imax-pilot-immersive-indoor-cycling-studio-concept

[10] https://skift.com/2016/09/06/expedia-is-now-helping-marriott-sell-hotels-on-the-chains-website/

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed.