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Arcadis: Consulting Firm with Unique Specialty in Water

September 10, 2017 in Communication Services, Equities, Ideas

This post by Elliot Turner has been excerpted from a letter of RGA Investment Advisors.

During the [first] quarter [of 2017] 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. 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.

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.

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Nestlé: A “Bond” and a “Venture Capital Fund”

September 10, 2017 in Consumer Staples, Equities, Europe, Ideas, Large Cap, Wide Moat

This article by Tom Russo has been excerpted from a letter of Semper Vic Partners.

Nestlé has long been a featured investment in Semper Vic Partners, largely because of its vast “capacity to reinvest” and its management’s belief in their “capacity to suffer” near-term pain for long-term gain. Nestlé does not possess these capacities because of family control. Rather, I believe, they have enjoyed special success in long-term investing despite short-term pain due to the remarkable culture within Nestlé that has a built-to-last Swiss mindset focused on building for long-term value.

Indeed, I conceptualize my investments through Nestlé in two parts. On the one hand, through our investment in Nestlé, we participate in one of the most attractive “bonds” in financial markets anywhere. This “bond” is the cash flow producing engines that are represented by long- standing product categories and geographies that Nestlé has long dominated. These categories are particularly cash generative and the Nestlé bond can be valued independently of its reinvestment potential. As such, you can imagine how much appreciation has occurred in Nestlé’s “bond value” as declines in global interest rate environments have driven fixed income valuations sharply upwards over the past decade. Nestlé’s “bond” of existing businesses, that support cash flows that could serve as interest, has soared in value over the same period, along with fixed income investments in general.

Nestlé, however, is blessed to have, attached to the Nestlé bond, a Nestlé “venture capital fund.” However, Nestlé is not just any venture capital fund, but one that rather enjoys enormous competitive advantage, as its brands offer product platforms that respond favorably to product innovation due to high consumer loyalty to brands around which such innovation can take place. Nestlé’s venture capital fund enjoys the benefit of industry-leading consumer product experts deploying its almost boundless cash flow streams into regions and products offering promising reinvestment. These managers are multilingual, multicultural – fluent in language and mores of regions of the world through which successful venture capital investments from “Nestlé’s nest” will flourish. Finally, few venture capital operations have access to state-of-the-art deep insights into health, nutrition, and wellness that Nestlé can offer its venture capitalists, both from in-house talent in Nestlé’s Health Science department, with its focus on nutrition and wellness, and from outsourced innovations from a network of global third-party, industry-leading research partners and providers.

Nestlé Corporate Culture – A Look Back, A Look Forward

Nestlé has succeeded during four decades of my ownership largely because they have been able to create and sustain a corporate culture more focused on long-term wealth creation than on meeting near-term earnings’ targets. I knew that I had come upon a different corporate culture as early as the late 1980s and early 1990s, when I first met Nestlé’s then rising star and, more recently, long-standing chairman of the board, Peter Brabeck. I knew after my first few meetings that Mr. Brabeck would be just the sort of leader and caretaker of corporate culture for whom I searched.

I believe that it may even have been during my first meeting with Mr. Brabeck, back in the late 1980s or early 1990s, when Mr. Brabeck first began to interact with Wall Street, that he was confronted with two questions; his answers for which I found to be inspiring.

First, he was asked by a Wall Street analyst, with slight derision due to the general belief at the time in Nestlé’s sleepy culture, what the planning horizon was when Nestlé looked out for investments. Clearly, this particular sell-side analyst and his financial-world colleagues’ worst fears were met when Mr. Brabeck, without missing a beat, responded “35 years, but we break specific plans down into five-year increments.” This was music to my then, still nascent, “long- term gain” mindset, but was obviously not what impatient Wall Street sell-side analysts wanted to hear.

Second, an analyst asked what Mr. Brabeck’s plans were to reduce expenses throughout their presumably bloated operations. Mr. Brabeck’s attempts to describe steps to over time increase efficiency and effectiveness were dismissed as insufficient by this and by several subsequent analysts. In desperation, Mr. Brabeck threw up his hands and exclaimed, “Look, Europe is not the United States; we operate largely in Europe. What do you want from me … to go through the organization with a ‘machine gun’?”

Clearly, Mr. Brabeck suggested again that theirs was a longer-term planning horizon than that which US analysts desired to hear, leaving the audience quite deflated and me elated to have found, in Mr. Brabeck, a leader who could oversee a considerable amount of my investors’ funds. Mind you, part of the appeal, as well, involved just how few other long-term-minded investors there were investing in even as global a leader in its field as was Nestlé. It was extremely difficult in the late 1980s for Americans to invest in Nestlé. When I began to invest in Nestlé, in fact, I was only permitted, on behalf of US investors, to invest in participating certificates of non-voting bearer shares. On top of those limitations, it was also nigh impossible to simply settle, through US-based custodians, Swiss trades for most of my early clients in the mid-1980s.

Caretaker of Corporate Culture

I plan to spend my remaining time in this letter on Nestlé focused more on the culture which I have so admired, first under Mr. Brabeck’s tenure as chief executive officer and, thereafter, during his tenure as board chair. I will refer to many interactions over the three decades of my holdings in Nestlé to reflect how they cumulatively build the culture which today, for the first time ever, will be led by a chief executive officer who did not grow up within the Nestlé family. I hope to provide you with an idea of many of the cultural values shared historically, as well as provide an update into what Nestlé might very well look like under leadership of recently appointed chief executive officer, Mark Ulf Schneider.

I knew at once that Mr. Brabeck would be a person with whom I could safely entrust a substantial portion of my capital under management. Indeed, for most of the 30-year existence of Semper Vic Partners, L.P. and for accounts separately managed over this period in a fashion parallel to Semper Vic, Nestlé, Philip Morris, and Berkshire Hathaway have consistently represented my largest holdings. (Today, for example, their combined positions represent nearly 30 percent of my assets under management.) Currently, Nestlé represents slightly less percentage weight in Semper Vic Partners, L.P. than Berkshire Hathaway shares (10 percent versus 11.5 percent, respectively) and slightly higher than Philip Morris’ shares (10 percent versus 9.25 percent, respectively).

Before addressing overarching aspects of Nestlé’s general corporate culture, a brief review of one of Nestlé’s key innovations, Nespresso, which highlights Nestlé’s “capacity to reinvest” and “capacity to suffer,” should prove instructive. The Nespresso investment was as disruptive at the time proposed to Nestlé’s board as must have been Philip Morris’ then proposed investment into reduced-risk, heat-not-burn tobacco devices to Philip Morris’ board four years ago. Both firms were massive leaders in their long-standing, immensely profitable historic businesses. Both plotted launch of disruptive new products that threatened to obsolete the very business that formed the core of their long-standing franchises.

In the case of Nestlé, the product proposed was a single-serve, high-quality espresso product to be named Nespresso. Given that Nestlé, at the time of proposed investment in Nespresso, had over 40 percent of the global market for soluble coffee, the thought of producing a premium product that could cannibalize the high end (and high margin end) of the supermarket coffee business was very likely not an idea about which Nestlé’s board would have felt most comfortable. Indeed, I understand that the board so feared Nespresso’s cannibalization threat that, over the 15 years that it took before Nespresso broke even, the product was threatened with closure by the board at least a dozen times.

The project, under Mr. Brabeck, stayed on course even with challenges from the board about its wisdom. Mr. Brabeck was most impressed, however, by the premium price point into which Nespresso promised to move Nestlé’s otherwise more mainstream coffee business.

Maybe even more importantly, Mr. Brabeck fancied the end run that he felt Nespresso gave Nestlé’s coffee business around the vice-like grip that supermarkets exercised over instant and ground coffee brands that went to market through supermarkets. Their then threatened endless rise of private label, and pricing pressures that promised to ensue, drove Mr. Brabeck to seek an alternative route to market upon which Nespresso envisioned to entirely rely (e.g., boutiques, Nespresso cafes, telephone marketing, and an e-commerce-exclusive closed route to market).

While Nespresso struggled to make its way to market, Nestlé invested ceaselessly in perfecting the technology, the coffee sourcing by global region, etc. to present consumers with high-end, single-serve products to serve needs of at-home premium coffee not previously thought to exist. Despite Nespresso not breaking even for its first 15 years, the product management team felt that they had the “capacity to suffer” burdening those already high coffee margins in their search for a competitive and premium solution. Though not supported by family owners, Nestlé’s long-term-minded culture endured pain for nearly 15 years. Today, Nespresso generates nearly $5 billion of system revenues and continues to show growth rates well in excess of overall global coffee markets and continues to provide Nestlé with incremental “capacity to reinvest” funds into more boutiques and into opening up more jurisdictions into which to launch Nespresso’s line-up.

Nestlé’s culture had been shaped, for as long as I have invested in its shares, by a host of fitting metaphors and allegories shared to its staff by chief executive officer, and ultimately chairman, Mr. Brabeck. My belief is that the ease by which his motivating expressions could be understood helped keep the firm fiercely focused on building wealth tomorrow despite burdens upfront investments placed on reported results today. A handful of culture-inducing metaphors from Mr. Brabeck appear below.

Athletic shoes. One of the first profound expressions of aspiration to move Nestlé forward, with an enhanced sense of urgency from the culture which Mr. Brabeck first addressed, involved the metaphor of athletic shoes. Mr. Brabeck, a well-known technical mountain climber and sportsman, whose reputation preceded his arrival as chief executive officer, shaped his expressed goals for Nestlé’s culture around shoes. He said that he observed a culture that, upon his ascent to the chief executive officer suite, was lounging about in bedroom slippers. Recognizing how challenging it was to transform culture, he implored all Nestlé members to consider steps it would take for them to migrate up gradually into a more athletic orientation.

From bedroom slippers, to walking shoes, to running shoes, to racing shoes. From hiking shoes, to climbing shoes, to mountain climbing shoes, etc. The culture Mr. Brabeck inherited, he feared, was set with too slow a pace and his metaphors were intended to drive his firm to pick up the pace.

Why not Hershey? A second expression of Mr. Brabeck’s views on cultural awareness of the firm, over which he served as chief executive officer, involved an earlier reputed attempt by Nestlé to acquire US-based The Hershey Company. At the time, Mr. Brabeck had denied interest in the transaction even though the conference room, in which a meeting that I attended at the time, was filled upon my arrival with bowls overflowing with samplings of all of Hershey’s most iconic offerings. In any case, with such indicting confectionary removed from the room before other investors/analysts arrived for lunch, the questions arose from a young sell-side analyst as to “Why was Mr. Brabeck not willing to reach to acquire Hershey? Was it because he was too conservative and preferred to retain his AAA credit rating?” To which Mr. Brabeck’s following reply was instructive again of his ambition for Nestlé’s culture:

Mr. Brabeck responded with several points. First, he suggested that, since he had not indicated a position on the deal, he resented being told by a young analyst that he lacked daring by not being willing to risk his balance sheet to accomplish the acquisition. Mr. Brabeck replied that, as is so often the case, the young analyst thought it would be great to reach for the big deal, diminish Nestlé’s credit rating, and take on incremental financial risk that Mr. Brabeck preferred not to absorb. Second, Mr. Brabeck said that as a mountain climber, he recognized that the most difficult part of a climb was not the ascent, but rather the descent. The descent is where those who deplete their resources racing up the hill find that they run out of reserves and strength to navigate the decline. Mr. Brabeck suggested that the youthful analyst’s declaration that Mr. Brabeck was simply too cautious to take on the easy-to-close acquisition was akin to urging one to race up a mountaintop with reckless abandon, discarding needed clothing and fuel along the way to ascend in record time. So, too, did he wish Mr. Brabeck to abandon his AAA rating which he had, and needed, to reach for a distant mountaintop that he neither needed nor likely could afford. Staying power to have a stronger tomorrow remains part of Nestlé’s culture today, even though analysts today, much like 25 years ago when Mr. Brabeck revealed his mindset for not racing after The Hershey Company, would prefer more action today even if risking tomorrow in doing so.

Route to market. Mr. Brabeck has long suggested that Nestlé will need to maintain flexibility regarding route to market. He excoriated British supermarkets in the 1980s and 1990s over their inexorable march towards ever greater space dedicated to private label. He warned them that consumer preference for branded varieties formed the core for healthy comparison shopping. He suggested that moves too far over to private label would end up pushing consumers away.

Fast-forward to today, e-commence has assumed the disruptive role once played by private label and Mr. Brabeck and his colleagues today search for solutions through partnerships, joint ventures, etc. to continue to pursue non-traditional routes to markets for their products. Nespresso’s boutiques and cafes continue to roll out to capture such direct-to-consumer benefits. Similarly, partnerships with Alibaba Group in China and Amazon.com, Inc. point to Nestlé’s efforts to follow consumers where they shop.

Health, nutrition, and wellness. Nestlé’s pioneering work in health, nutrition, and wellness provides focus for all its business lines as they attempt to globally deliver, at accessible price points, socially responsible food and beverage offerings. Mr. Brabeck and the rest of Nestlé’s culture understands that a growing world and a growing urban world will massively stress traditional practices in sourcing and delivering protein efficiently in an increasingly resource- starved world. Nestlé bears expenses in the billions of dollars annually focused on innovations in product features, routes to market delivery technology, environmental impact of their food and beverage line-up, etc. Today, Nestlé bears such expenses for enhanced future returns, realizing only too well that businesses today operate only by the thinnest social permission to do so, which can be revoked in seconds if firms are viewed to fall short of their social responsibilities.

Nestlé experienced the pace of such challenges over the past several years when forced to respond to allegations, wholly undeserved it turns out, regarding its leading Maggi noodle soup staple of the Indian market. Allegations suggesting that Nestlé intentionally exposed consumers of Maggi’s products to avoidable, potentially lethal, product impurities sent Nestlé’s Indian market consumer trust scores from the high 90s (98 percent) to the high-single digits (approximately 8 percent). Nestlé bore over $500 million in costs remediating their reputation for expenses incurred for claims wholly without merit in the first place. Nestlé and our other consumer products companies, who touch consumers in such daily ways, realize the responsibilities that they must bear at all times to respect and overdeliver on socially responsible standards their communities demand of them.

Nautical Mr. Brabeck. Three expressions over the years involving Mr. Brabeck’s observations about Nestlé’s businesses have surfaced through Mr. Brabeck’s love of the sea. One pair of such observations involved the America’s Cup boat on which Mr. Brabeck was privileged to crew during races years ago. I recall his view on the role of the chief executive officer evolved as a result of that excursion.

When Mr. Brabeck asked his friend, on whose boat he sailed, why his friend did not intervene at all with the skipper who manned the wheel and exclusively sailed the race, his friend replied, “That’s easy … even though I own the boat, the pilot is charged with sailing it. Rather than try to impose my views as owner on the pilot’s choices, I would prefer to let the pilot sail and replace him with another if I felt that he regularly made poor decisions.” Mr. Brabeck found the notion of accountability and ownership/involvement to be quite interesting. I do believe he felt that it had analogues in the relationships between chair (speaking on behalf of owners) and corporate chief executive officers. Second, Mr. Brabeck reflected on a sense of irony with pride when he observed that even though the racing boat’s spinnaker proclaimed allegiance to one of their corporate sponsors, illycaffè, down below deck, Nespresso was the coffee of choice!

Aircraft carrier to speedboats. Finally, Mr. Brabeck began, late in his tenure as board chair, to worry about the possibility of institutional sclerosis. He realized how difficult it was to turn a battleship set in motion and hence began to commend that the model of Nestlé ought to transform from big platforms, that felt as impregnable as battleships, to a flotilla of fast-moving, quick-to- strike speedboats covering the same ground but doing so with greater flexibility and agility.

Works right in practice, though terrible in theory. Mr. Brabeck voiced frequent discontent with Wall Street sell-side researchers (and, more recently, Wall Street activists) who for a long time have pressed on a single-minded drumbeat that Nestlé ought to be only in the business of operating companies and that large equity stakes in other public companies should have played no role in Nestlé’s future since, after all, investors themselves could easily invest added cash in those other businesses if they so desired, not needing, therefore, to have Nestlé tie up its balance sheet in such companies.

Mr. Brabeck’s response to such pleas over the years was “give me a break.” Both investments, L’Oréal and Alcon, were made for modest amounts (i.e., if my memory serves me correctly, no more than $100 million in each case at the start) which had over the years grown in value to well over $40 billion for each holding.

However, in a drumbeat of consensus opinions by analysts over the years, the dream of the ideal (i.e., “purely operating company, no public equity holding”) would have long served as the enemy of the good. The notion that businesses had to be solely operational and had to rid themselves of perfectly productive strategic holdings carried little weight with Mr. Brabeck. The businesses cumulatively added, I believe, nearly $80 billion of value to Nestlé over the decades, an accomplishment for which there should be praise rather than demands for full divestiture of what remains.

Two hundred dinners at home per year. Finally, I learned more about Nestlé’s culture from listening to how Mr. Brabeck participated in Nestlé talent management. Mr. Brabeck suggested how important he took his task, as both chief executive officer and later as chairman, in determining plans for succession planning and career development. Mr. Brabeck suggested that he kept his list of potential candidates for “higher office” well updated and ready to assist when change inevitably occurs. Mr. Brabeck suggested that he felt it to be part of his responsibility, as regularly as his travel schedule permitted, to visit with promising executives, ideally at their home, and ideally over dinner with the executives’ spouses.

While the thought of what I recall he said, about which in hindsight seems almost impossible, that he even attempted to have visits with the top 200 of his most promising reports annually, if possible, impressed me deeply. I was particularly impressed with what I recalled him saying that, whenever possible, he preferred to have such meetings at his colleague’s home, along with spouse, to be equally wise. After all, as a judge of character and capability, a visit to one’s house can be extremely revealing. While individuals can conceal stress indefinitely with the help of support staff at the office, if one is indeed beginning to reach the limits of his or her capacity, where it will likely most show up is in the home and on the faces of their spouses. One who is reaching limits of capacity can be revealed by the ease with which their spouse suggests the executive handles his time away from work. Moreover, the capacity-constrained executive, who seems to still manage smoothly affairs at work, may have a fairly disrupted home setting, which again could suggest that the individual, rather than having additional bandwidth for further responsibility, may have already begun to reach personal limits.

Whether or not the portion of Mr. Brabeck’s comments to me have withstood the passage of time or whether or not I embellish them into what I believe to have been a remarkable practice, I do find the notion of keeping under close scrutiny the list of skilled managers eligible for advancement, whose prior success placed them in running for higher office, to be illuminating.

Advancing up in the list, however, depends on whether Nestlé can independently verify if they had already reached the limits of their managerial bandwidth. Avoiding appointing someone in that later condition will avoid a host of other consequential damages that would inevitably arise when the limited bandwidth of that improperly advanced associate snaps.

Nestlé continues to invest organically to extend existing and already deep franchises in global food, health, and nutrition. Blessed with mature market free cash flows available for reinvestment, Nestlé’s corporate culture rewards management for their search to deliver more gain tomorrow even when such investments cause pain today. Nestlé’s culture continues to allow its management to invest behind roll-out of new products in existing geographies or behind roll-out of Nestlé into altogether new categories or geographies, even when doing so sharply burdens near- term profits. I believe Nestlé’s new chief executive officer plans to continue with the “Nestlé model” while adding enormous talent at setting and at rewarding management for meeting ambitious, long-term specific goals.

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On Moats and Artificial Intelligence

September 10, 2017 in Audio, Information Technology, The Manual of Ideas, Wide Moat, Wide-Moat Investing Summit, Wide-Moat Investing Summit 2017

David Barr and Felix Narhi discussed competitive moats and artificial intelligence at Wide-Moat Investing Summit 2017.

Dave, who serves as chief executive officer of Pender, also presented an investment thesis on Mattersight (Nasdaq: MATR), while Felix, chief investment officer of Pender, presented on Baidu (Nasdaq: BIDU).

The following transcript of selected remarks on competitive moats and artificial intelligence has been edited for space and clarity.

There are two buckets of moats. The traditional definition, as taught by Buffett, is the moat that protects highly profitable, established businesses. Emerging moats are also interesting. With regard to the history of wealth creation, Walmart and Starbucks, for example, compounded shareholder value at high rates before you could put a finger on how wide their moat was. It was in the process of becoming wider. Such companies have emerging moats. Once the moat is wide and large, often the value creation process slows down a bit. We like to look for companies with emerging moats because that is where much wealth creation occurs.

With regard to technology and disruption, increasingly many large legacy moats are being disrupted. Charlie Munger talked about the concept of “surfing” a number of years ago. An early surfer has an advantage because he can catch an initial technology or business wave and ride it for a long time. When a business is accomplishing changes and you catch the wave, you can get a long runway of compounding value. We always look for emerging moats that haven’t been fully identified but potentially have a long runway.

Technological disruption and competitive destruction are bigger forces than we have seen in a long time. These forces favor the “surfers”. With regard to traditional moats — e.g., Borders, Blockbuster, Kodak — two or three decades ago, Kodak had one of the widest moats. It seemed impenetrable. However, anything that could be digitized has increasingly been marginalized. Advances in technology have greatly diminished or destroyed many legacy moats. The basis of competition has changed, and legacy moat owners have often been slow to adapt to change. As a result, a huge amount of wealth has been transferred to the “surfers”.

With regard to where future value comes from, we’re at the early stages of this digitization process. Marc Andreessen, co-founder of Andreessen Horowitz, famously said six years ago that “software is eating the world.” Essentially, a growing portion of today’s analogue world is becoming digitized and value creation has been and will be continue to accrue to the early surfers who are the winner-takes-most digital leaders. The next inflection point on this technology journey is already here today which is artificial intelligence. Jen-Hsun Huang, the founder of Nvidia, last month said that “software’s eating the world, but AI’s going to eat software.” In terms of where tomorrow’s value creation will come from, it’s important to pay attention to some of these secular waves that are emerging.

A problem most people have is conceptualizing exponential growth. An analogy used about artificial intelligence to help put exponential growth into perspective is the story of the invention of chess. One day the inventor of chess showed his King his invention. The King was so impressed with it that he said, “Name your own prize for inventing this,” and the inventor replied, “Well, I’d like to have one grain of rice for the first square, two grains of rice for the second square, four and doubling it so on with each square.” The King thought this was a rather modest request and asked his treasurer to give the required amount of rice to the inventor.

At first, it was by the spoonful, then by the cupful, then by the barrelful. By the time the treasurer finished with the rice need for the first half of the chessboard, he had essentially given one large rice field’s worth of rice to the inventor. That’s still easy to conceptualize. That’s a large rice field, but it is relatable in a human-centric analog world. It’s in the back half of the chessboard where things get crazy. By the time the treasurer reaches the last square of the chessboard, he would have had to have given the equivalent rice fields that covered the entire earth all the way over twice including oceans. That is an unimaginable amount of rice and way more than humankind has ever made. The sheer magnitude of rice reached through exponential growth even when starting from a small number is hard to imagine. In a similar way, we believe many people are going to be surprised by the upcoming advancements driven by artificial intelligence. AI is essentially entering the proverbial “back half of the chessboard” stage of development and innovations over in the next two, three, five, and ten years are going to be mind-boggling and impactful for a lot of businesses.

When we look at artificial intelligence, we see a barbell approach. One area where we see an opportunity for companies to dominate and create big barriers is the platform companies. In North America, they include Google, Facebook, and Amazon. In China, Baidu is one of them. These platform companies have massive datasets, huge talent bases, and high-performance computing power. Competing with those companies is a big challenge.

Some smaller-cap companies have built up niche proprietary datasets. You have focused teams who understand the industry and their customers well. They get up every day trying to deliver ROI to customers. We have spent a lot of time investing in technology. Aside from AI, when we look at software companies, we try to find businesses that provide a solution to businesses. Consumers may buy cool technology and trendy things that look awesome. Businesses want either to increase revenue or decrease cost. They want to increase cash flow as a result of any solution they purchase.

About the instructors:

David Barr is the President and CEO of Pender. He is also the Portfolio Manager of several of Pender’s funds. The Pender Small Cap Opportunities Fund, which he manages, has won a Lipper Fund Award in 2015 and 2016 for Best Canadian Small/Mid Cap Equity Fund over both three and five year performance periods. The Lipper Awards recognize consistently strong performance relative to peers. The Fund has also received a Fundata FundGrade A+ Award in each of the last five years, with the Pender Value Fund winning for the first time in 2016, its third year since inception. The A+ ranking is based on an objective rating system that tracks risk-adjusted returns.Mr. Barr holds a Bachelor of Science degree from the University of British Columbia and an MBA from the Schulich School of Business. He earned his Chartered Financial Analyst designation in 2003 and is a past President of CFA Society Vancouver, having also served on its Board of Directors for four years. He remains an active member.Mr. Barr is a regular guest on BNN’s Business Day program and has been interviewed for his opinions on small cap companies, the technology sector and value investing by the Financial Post, The Globe & Mail and other media. In December 2012 Mr. Barr was recognised as one of British Columbia’s “Top Forty Under 40” business leaders by Business in Vancouver. Mr. Barr is an advocate of value investing as well as a true contrarian. He looks for value in unpopular places to find high quality businesses at a price that includes a “margin-of-safety”. Investing in a company trading below intrinsic value decreases the risk and increases the potential for generating significant long term performance.

Felix Narhi is the Chief Investment Officer of Pender. He is the Portfolio Manager of the Pender US All Cap Equity Fund and the Pender Strategic Growth and Income Fund, and Co-Manager of the Pender Value Fund. Prior to joining Pender in July 2013, Mr. Narhi spent over nine years at an independent and value-oriented investment firm in Vancouver. As a Director and Senior Equity Analyst, Mr. Narhi contributed thought leadership and primarily US equity ideas to the company’s Model Portfolio, a concentrated equity portfolio that has outpaced North American benchmarks since its inception in 1994. Mr. Narhi holds a Bachelor of Commerce degree from the University of British Columbia. He earned his Chartered Financial Analyst designation in 2003 and is a member of CFA Vancouver. Mr. Narhi advocates a business-like approach to investing. Sound investing is the process of determining the value underlying a security and then buying it at a considerable discount to that value. The greatest challenge is to maintain the necessary balance between patience, emotional fortitude and discipline to only buy when prices are attractive and to sell when they are dear, while avoiding the short-term “noise” that consumes most market participants.

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No Fear of Missing Out

September 9, 2017 in Commentary, Letters

This article by Abdulaziz Alnaim is excerpted from a letter of Mayar Capital.

“I think that when we know that we actually do live in uncertainty, then we ought to admit it; it is of great
value to realize that we do not know the answers to different questions.” –Richard Feynman

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” –Mark Twain

That time of the year has now ended. The strategists/economists/bankers -the “experts”, have collectively sent their beautifully-formatted reports, done their TV interviews on CNBC, and shared with all of us their “outlook” of where the S&P 500, treasuries, commodities, and major currencies are heading in 2017. The private bankers have paid their visits to their clients and shared their nuanced take on their “house’s view”, marginally differing here and there and further contributing to the charade of perceived accuracy and false sense of certainty.

Doubtless too, you’ve heard from the “cautiously optimistic” crowd, who have hedged their bets and will be able to claim predictive victory whether their clients’ portfolios go up or down over the next twelve months.

The investment industry is obsessed with prediction, but the whole thing is nothing but a tremendous display of overconfidence. History shows us that the predictions that this group of “experts” make are no better than random. Under constant pressure from clients who demand answers, they find them-selves unable to say: “I don’t know”. Perhaps the hardest three words to utter on Wall Street.

Yet the reason those pundits are usually wrong is not that they lack intelligence or data. It’s because what they are trying to forecast is inherently unforecastable. Yet, unfortunately, the investment industry has trained its clients to expect confident predictions, and there’s no short supply of experts willing to make them.

We take the opposite approach at Mayar. We embrace “I don’t know”. We believe that forecasting the future is always uncertain. Some predictions, like the level of the S&P in twelve months, are virtually impossible to make, so we don’t pretend to. Instead, we try to make decisions that require us to make the fewest number of predictions as possible. My colleague Aubrey wrote to you last June about what he dubbed “Occam’s Investment”. That the investment that requires the least number of assumptions is likely to be the better one. We hold that principle dear.

We want to make investments that would produce satisfactory results for us over the long run without requiring us to predict with accuracy several dozen variables to the 2nd decimal point. We prefer to be approximately right instead of precisely wrong. We accept our fallibility, and know that every investment we make will have at least some uncertainty associated with it. That’s why we demand a margin of safety.

We also accept the uncertainty associated with the time required to achieve our goals. Our investment strategy doesn’t work every month, or even ever year. It works over time. It requires a long-term orientation and acceptance of the fact that we will have many short periods of under performance. That acceptance allows us to make deci-sions that might have uncertain or potential negative short-term results, but are very attractive for the long run (see our Partnership Principles #3).

It means that in some periods we may sit on cash patiently instead of making investments that do not meet our criteria. When others are making money betting on the latest trend or fad, we smile and move on. We must genuinely have “No Fear of Missing Out” (No FOMO). It doesn’t make us as interesting as “that guy” at the cocktail party, and we probably don’t have the most interesting dinner conversations, and that’s ok. We prefer boring. Boring works for those who wait. Boring is beautiful.

“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” – Paul Samuelson

It is here that I must emphasize two very important points that the successful execution of our strategy requires: choosing the right partners, and nurturing a healthy relationship with them. We have been blessed to have an investor base that under-stands what we’re trying to do. Our AUMs would have been many times larger had we been willing to accept any investor into Mayar, but we view our relationship as a partnership and a necessary condition of the success of partnerships is an alignment of expectations.

Nurturing a healthy relationship between partners is a shared responsibility. It is our duty to communicate with you honestly, clearly, and regularly. It is your duty to read what we write, ask intelligent questions, challenge us, and hold us accountable to the promises we make. That’s the only way to make sure we are all on the same page.

A word or two about the market…

A hot topic of discussion these days is equity market valuations. If that is not the case in your social circle, you clearly have a much more interesting one than I do! We don’t like to make top down judgements on which markets are expensive or cheap. Our approach has always been to go where we find attractive investing opportunities and let the asset allocation be the by-product of the available opportunity set. So, let us look at what has happened to our portfolio over the past two to three years.

Geographically, our North American exposure It is our duty to communicate with you honestly, clearly, and regularly. It is your duty to read what we write, ask intelligent questions, challenge us, and hold us accountable to the promises we make. 8 peaked at over 82% over the summer of 2014. During that time, over 14% of our portfolio was invested in Europe, and 3% was in cash (difference due to rounding). Today, we have roughly 56% of our portfolio in North America, 33% in Europe and the balance in cash.

You should read these changes to mean that we’ve been finding fewer opportunities in North America, more in Europe, and the rise in our cash balance means we’ve also found fewer attractive opportunities overall. Our valuation discipline has caused us to start reducing our holdings in North America sooner than we should have with the benefit of hindsight. But remember, No FOMO.

So what should you do now, and what should you expect us to do in the current market environment and the coming few months and years?

First, trying to time the market by getting in and out is impossible. We don’t try to do that, and neither should you. We always invest cautiously, but you should expect us to become more cautious as valuations get higher, as is the case today. But that does not mean that we will sell out of the market and go and sit on some beach.

As long as our current holdings are trading at reasonable valuations, we will do much better by holding on to them, even if the ride becomes rockier. Time is the friend of the long-term investor. Compounding is magical. Stay out of its way!

We will adjust what and how much we own based on valuation, as we are always comparing our existing holdings with what is available out there today and to cash. We view our cash position as a by-product of our disciplined investment process. Cash is valuable not because of its relative return – essentially zero – but because cash gives us the option to take advantage of the opportunities that may come up in the future.

Therefore, you can think of our process as comparing our portfolio to both current and future investment opportunities and trying to deploy our capital to the one that presents us with the best risk-adjusted return.

Second, we must remind ourselves that equity markets are volatile. We are pretty much guaranteed to have 20-30% declines every few years and occasionally more, as we had in 2008. We don’t know when these declines will happen unfortunately, and studies show that trying to jump into and out of the market to avoid them costs investors dearly.

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” –Peter Lynch

As long as the investor doesn’t need the money within a year or two to pay for a life event, they are better off staying invested in the market and riding the occasional bump.

Finally, when you entrust us with your capital you should also expect us to manage it wisely across the market cycle. This is a key difference compared to investing in an index fund. As mentioned above, our geographic and asset allocation will change over time in a manner that we believe improves returns and reduces risks. There are periods where you should see us hold more cash and wait patiently.

We hope that you trust that when that happens it is for a good reason. And when the market serves us interesting opportunities within our circle of competence, you should expect us to act quickly and decisively and deploy that excess cash.

We remain comfortable with our current portfolio. It has a free cash flow yield of 6.6% and a forward PE ratio of 16x for a group of companies with substantially above-average balance sheets and returns on capital.

It’s not dirt cheap, but it’s still reasonable both relative to major indices and in absolute, especially because we believe the companies we own should grow at low single digit rates over the next few years.

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This document is prepared by Mayar Capital Advisors Limited (“MCA”), an Appointed Representative of Privium Fund Management (UK) Limited (“Privium”) which is authorised and regulated by the Financial Conduct Authority (“FCA”) in the United Kingdom. It is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation. Within the EEA Mayar Fund (“the Fund”) is only available to Professional Investors as defined by local Member State law and regulation. Outside the EEA, the Fund is only available to Professional Clients or Eligible Counterparties as defined by the FCA, and in compliance with local law. This document is not intended for distribution in the United States (“US”) or for the account of US persons, as defined in the Securities Act of 1933, as amended, except to persons who are “Accredited Investors”, as defined in that Act and “Qualified Purchasers” as defined in the Investment Company Act of 1940, as amended. It is not intended for distribution to retail clients. This document is qualified in its entirety by reference to the Private Placement Memorandum (together with any supplements there to,“the PPM”) of Mayar Fund. Please see the section of the PPM on information required by Securities Laws of certain jurisdictions. This document is provided for information purposes only and should not be regarded as an offer to buy or a solicitation of an offer to buy shares in the fund. The prospectus and supplement of the fund are the only authorised documents for offering of shares of the fund and may only be distributed in accordance with the laws and regulations of each appropriate jurisdiction in which any potential investor resides. Investment in the fund managed by Privium carries significant risk of loss of capital and investors should carefully review the terms of the fund’s offering documents for details of these risks. Mayar Fund follows a long-term investment strategy. Short-term returns will vary considerably and will not be indicative of the strategy’s merits. This document does not consider the specific investment objectives, financial situation or particular needs of any investor and an investment in the fund is not suitable for all investors. Investors are reminded that past performance should not be seen as an indication of future performance and that they might not get back the amount that they originally invested. This document is confidential and solely for the use of MCA and the existing and potential clients of MCA to whom it has been delivered, where permitted. By accepting delivery of this presentation, each recipient undertakes not to reproduce or distribute this presentation in whole or in part, nor to disclose any of its contents (except to its professional advisors), without the prior written consent of MCA. Comparison to the index where shown is for information only and should not be interpreted to mean that there is a correlation between the portfolio and the index. The views expressed in this document are the views of MCA and Privium at time of publication and may change over time. Where information provided in this document contains “forward-looking” information including estimates, projections and subjective judgment and analysis, no representation is made as to the accuracy of such estimates or projections or that such projections will be realised. Nothing in this document constitutes investment, legal tax or other advice nor is it to be relied upon in making an investment decision. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any taxpayer for the purpose of avoiding tax penalties. Tax-related statements, if any, may have been written in connection with the “promotion or marketing” of the transaction(s) or matter(s) addressed by these materials, to the extent allowed by applicable law. Any taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor. Prospective investors should inform themselves and take appropriate advice as to any applicable legal requirements and any applicable taxation and exchange control regulations in the countries of their citizenship, residence or domicile which might be relevant to the subscription, purchase, holding, exchange, redemption or disposal of any investments. Each prospective investor is urged to discuss any prospective investment in the Fund with its legal, tax and regulatory advisors in order to make an independent determination of the suitability and consequences of such an investment. No recommendation is made positive or otherwise regarding individual securities mentioned herein. No guarantee is made as to the accuracy of the information provided which has been obtained from sources believed to be reliable. The information contained in this document is strictly confidential and is Intended only for use of the person to whom MCA or Privium has provided the material. No part of this document may be divulged to any other person, distributed, and/or reproduced without the prior written permission of MCA.

A Thesis on the U.S. Airline Industry

September 9, 2017 in Equities, Ideas, Industry Primers, Transportation

This article by Phil Ordway has been excerpted from a letter of Anabatic Investment Partners. In it, Phil discusses the rationale behind Anabatic’s recent investment in the equity of three U.S.-based airlines.

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The premise of our investment is simple: The next few quarters are uncertain at best, but I believe that industry demand and earnings will be far higher over the next several years. The question, then, is whether certain individual businesses have the resilience to reap the benefits of that growth, and whether the offered price gives us an attractive return with room to be wrong. In both cases I believe the answer is yes.

Most domestic airline equities suffered sharp price declines this summer due to a confluence of factors, and I believe this creates an attractive opportunity over a multi-year horizon. As always, the test remains our willingness to own these securities – partial ownership stakes in businesses – for the next five or 10 years. On that basis, I’m comfortable having a material portion of our capital invested in these companies.

Before going further a brief comment on the industry is required. (There is more background information in the Appendix.) The domestic airline industry has undergone a dramatic restructuring in the past 5-10 years and I think it will support a bright future. I’d had an interest in the sector for years, but a combination of inertia and an ingrained bias against airline investments had kept me from doing any meaningful research. When I finally did, beginning in the summer of 2016, a few features stood out:

Industry structure and financial strength. Competition remains tough in many individual markets, but consolidation has changed the overall pricing dynamic and created a level of profitability and stability that is unprecedented in the industry. Current operating margins are generally in the 10-20% range – a level that generates ample free cash flow – and I estimate that most airlines will generate significant profits even in a downturn. Balance sheets and cost structures are also far healthier and they will be able to withstand future cyclical downturns and exogenous shocks.

Fares and fees. It is far cheaper to fly in the U.S. today than it was a few decades ago but pricing is also far more rational. This is still a high-fixed and low-variable cost business, but consolidation has enabled the airlines to compete without destroying each other in the process. As a partial offset to lower inflation-adjusted fares and the recent capital spending, the airlines now generate material revenues and high-margin profits from non-ticket fees and loyalty/mileage programs tied to credit cards. Cyclicality has not been eliminated but it has been muted to a large degree.

Ultra-low-cost carriers (ULCCs). Customers want low prices, and that simple fact dictates the entire business model. An airline taking a passenger from point to point is offering something close to a commodity, and price is by far the most important factor in the purchase decision. There is some customer loyalty for certain companies, and mileage programs can help, but these are not true brands that affect behavior on a large scale.[1] A customer with his own money is likely to pick an airline that will save him $50, and the business with the lowest cost will often win in these circumstances. Low costs that are “reinvested” in lower prices can also create an enormous advantage over time. Airlines like Southwest and Ryanair are good examples of these concepts, and when I pulled my head out of the sand to look at what made them two of the world’s most successful businesses what I saw would be familiar to any analyst looking at Costco, Amazon, Nucor, or IKEA. A cost advantage is hard to establish and easy to lose, but if maintained it makes life miserable for the competition. In the U.S. market the ULCCs have a material and growing cost advantage that will enable years of future growth at attractive margins and returns on capital.

The history of the industry is littered with bankruptcies and failures, and it always pays to focus on the potential for loss – more on that below. Right now I see far more pessimism than optimism in the market, and that bodes well for bargain-hunting investors. There have even been some prominent articles in the media positing “the death of the ULCC model” or “a return to the bad old days of the airline industry.” In my opinion, the facts point to just the opposite.

The most prominent fear today seems to be centered on price competition. After a multi-year ULCC boom that peaked in 2014, unit revenues had been falling for two years before picking up in early 2017. In June, however, United kicked off a new round of price matching at its hubs, and the competition has since spread across the industry. The network carriers believe that their most valuable assets are their hubs and they are defending their home turf to prevent an upstart low-cost competitor like Spirit or Frontier from taking too much volume.[2]

The network carriers are not, however, picking a fight – they’re matching Spirit and Frontier’s fares, not undercutting them. Network carriers do have low marginal costs on flights at their hubs (thanks to the flow of connecting traffic), but it is the ULCCs with the long-term advantage in direct, point-to-point competition.[3] The network carriers are also taking a loss on a substantial portion of the seats they sell at the ULCC-level prices via their new “Basic Economy” fares.

Ironically, Basic Economy is a good thing for the industry and the customer. “Unbundling” fares so that customers pay only for the services they want is rational and keeps total fares down.[4] Basic Economy also delineates and limits the amount of capacity dedicated to ULCC competition, checking their growth without destroying anyone’s margins; it validates and spreads the low-fare-plus-ancillary-fees model; and it gives the networks another tool for price segmentation. With growing demand, this does not have to be a zero-sum game.

When a recession or some exogenous calamity strikes the industry, I believe the recovery will be swift. United – and Southwest, to a lesser degree – just suffered a major disruption from Hurricane Harvey.[5] Despite thousands of cancelled flights and an immediate spike in jet fuel of 20-40%, United still projects solid profitability this quarter. Over a more meaningful period, Southwest hasn’t posted a full-year GAAP net loss in 44 years and counting. It has been profitable and growing across numerous recessions and shocks, and it grew almost uninterrupted through the 2007-09 financial crisis. Now the rest of the industry looks more like Southwest – and vice versa – than ever before.

Spirit has also been profitable each year since its conversion to a ULCC strategy took hold in 2007, and it remained profitable through the financial crisis as well. From a starting level of $763 million in 2007, Spirit’s sales never dipped below $700 million in any full year. Sales had doubled by 2013 and they have nearly doubled again since 2013.

A lower growth rate would not be a surprise over the next five years, although the ULCCs should grow a few points ahead of the industry pace and it is hard to imagine a world in which demand does not grow over multi-year periods. With any demand growth, a low/mid-teens operating margin and incremental returns on capital above 20% should enable strong investment returns.

So why is there so much pessimism right now? I think part of the explanation lies in a deep skepticism of the industry. That skepticism was well deserved for several decades, and it initially deterred me from even looking at the industry. Despite undeniable improvements it’s as if investors are just waiting for the other shoe to drop. Old ideas can be hard to break.

The other part of the explanation, which may be even more important, stems from a myopic focus on the immediate future. As Joel Tillinghast recently wrote in his book Big Money Thinks Small, investors often skip the hard, important question (“What’s it worth?”) and instead answer an easier question (“What comes next?”). Increasing price competition, higher fuel costs, war on the Korean peninsula, a recession, a terrorist attack, a catastrophic hurricane (or even two catastrophic hurricanes) – there are plenty of reasons to worry about “what comes next.”[6] None of these developments are welcome, of course, but their short-term impact can swing the pendulum too far in the direction of pessimism. The fear of further price declines can also create its own feedback loop, and fear alone may be responsible for keeping market prices at bargain levels.

At current prices, investors are getting an approximate earnings yield of 8-12%. The worry, of course, is that recent industry conditions were a mirage in the desert, setting the stage for future earnings will be far lower. That is a valid concern – it is a cardinal sin to buy a low-quality company at what looks like a cheap price due to earnings that are temporarily inflated. As noted above, though, I think the opposite is true: these are better-than-average companies heading into a period of growth. I don’t discount the potential for volatile earnings – the path is certain to be bumpy – but in my opinion this industry is just now entering a period of prosperity.

Another piece of good news that might be overlooked is that the U.S. airlines can now reinvest profitably in their businesses. For decades they were forced to spend mountains of capital on investments that were unlikely to offer any meaningful return. Today, most capital expenditures come with returns above 15%, and as such most airlines have been spending heavily in recent years to upgrade their fleets.[7] Spirit and Frontier have two of the youngest fleets in the industry, and American and Alaska each have younger fleets than their direct peers. With the newer technology also comes better fuel efficiency, a savings that can be 10% or more compared to older aircraft.

The ULCCs have an especially strong incentive to reinvest their earnings. As a small share of the overall market, they have room to grow before they begin to compete head-to-head. Along the way they can stimulate additional demand, as low fares encourage more people to travel or to switch from other modes of transportation.[8] As demand fills up the plane the carrier’s margins and cash flow expand, funding reinvestment opportunities. Spirit and Frontier combined have about 6% of the capacity in the U.S., and I believe that share will grow over time in addition to the growth in demand for air travel across the industry.

Capital allocation is a point of strength as well. After decades of fighting a losing war with their balance sheets, airline executives can now have thoughtful deliberations about the best use of their capital. Airlines are still capital intensive, but the free cash flow pouring out of the business and the credit card programs allows large investments in equipment with plenty of cash leftover for debt repayment, dividends, repurchase, joint ventures, and other strategic investments.[9] Significant debt reduction funded out of operating cash flow in recent years has left many airlines with moderate debt levels and plenty of interest coverage it the case of a downturn.[10]

None of the analysis presented above is new or notable. Most analysts (not all, but most) would agree about the core concepts of demand growth and a low-cost advantage. Many would even agree about the favorable investment prospects over a period of several years. Far fewer seem willing to wait and ride out the inevitable volatility to earn that return.

What we offer is patience. The industry remains unpredictable, and I have no reliable way to forecast exactly what the rest of this year or next year will bring. Oil prices, macro conditions, and geo-political events make these companies almost impossible to model with many analysts’ preferred degree of (false) precision. But a forecast of financial metrics down to two decimal places isn’t necessary so long as I’m right about the future success of the business model, the overall industry conditions, and the price we’re paying today.

A strong collection of like-minded partners gives us a significant advantage. With that in mind, current partners are often the best source of new partners, and we welcome your referrals.

APPENDIX

If you pardon the flood of acronyms and jargon, this table conveys most of what is important about the industry. The majority of industry capacity is controlled by the three network carriers – each with a unit cost excluding fuel of ~10-11 cents – and Southwest, which used to have a major cost advantage but is now closer to the network carriers than the ULCC segment in terms of cost.

Load factors used to swing in a much wider range, and at the low end the operating losses were substantial. Breakeven load factors vary by airline, of course, given the differing price and cost structures, but in general breakeven load factors have improved as the industry has evolved. For most airlines the breakeven load factor is in the 70s, and with a load factor in the 80s the profits are substantial. (Ryanair, as an exemplar, has recently had load factors near 97%.)


Source: company filings with the SEC and Anabatic analysis. Market data using closing prices on September 5, 2017.     * Sum in bold, average in bold italic as appropriate     1 Share of total domestic revenue passenger miles for the year ended December 31, 2016.     2 Available seat miles (in millions). One seat available to be flown on a flight for one mile is one ASM.     3 Passenger revenue per available seat mile, or unit revenue — the ticket revenue and non-ticket revenue (including all fees and charges) per available seat mile.     4 Cost per available seat mile, or unit cost — the cost to fly one seat one mile.     5 Unit cost excluding fuel.     6 Unit cost excluding fuel, adjusted under varying definitions to exclude unusual/one-time impacts and gains (losses) on asset disposals, fuel hedges, etc.     7 Utilization, calculated as revenue passenger miles divided by available seat miles.

This snapshot of financial metrics and valuation based on 2016 results is instructive, with the usual caveat that past is not prologue.


Source: company filings with the SEC and Anabatic analysis. Market data using closing prices on September 5, 2017.     * Sum in bold, average in bold italic as appropriate     8 Operating income divided by revenues.     9 Operating income divided by enterprise value (current market capitalization plus preferred equity plus debt plus operating leases capitalized at 7x).     10 Free cash flow (adjusted to reflect the cash flow available for allocation: generally, net income plus D&A less our estimate of required capital spending) divided by current market capitalization.     11 Net income divided by current market capitalization.     12 Operating profit less estimated income taxes divided by invested capital (debt plus common and preferred equity plus capitalized operating leases).     13 Net income divided by book equity.

Ultra-low-cost carriers

Southwest is a great business success story, and its strategy drove much of the post-regulation industry in America and the rest of the world. Ryanair copied most of the Southwest playbook and executed it to perfection in Europe, where it is now the largest European airline by passenger traffic. (Beyond some of the obvious differences among European and American travel options, Ryanair has the advantage of competing against legacy carriers that have been far less successful than the major American carriers.)

The ULCC model has its critics, but the results are undeniable. A recent survey ranked 75 airlines around the world based on operating margin.[11] Three of the top four – Allegiant, Ryanair, and Spirit – were ULCCs. (The other was Alaska, which came in third.) ULCCs fill a large, underserved segment of the market, they bring lower fares to all airline customers, and they make a lot of money in the process.

The linchpin to the ULCC model in the U.S. has been Bill Franke. A former attorney with a variety of business experiences, Mr. Franke helped pull America West out of bankruptcy in the 1990s. Ever the astute business student, Franke was a pre-IPO investor in Ryanair and a longstanding competitor against Southwest. Both experiences taught him the power of lost costs, and he took that lesson to heart. After he hired an executive team at America West that today runs must of the industry, he retired on September 1st, 2001. In the aftermath of the 9/11 tragedy he founded his own private equity firm, Indigo Partners, to invest in airlines. The results have been spectacular, and the companies he has founded or managed (Tigerair in Singapore, Wizz Air in Hungary, Spirit and Frontier in the U.S.) have reshaped the industry.

Indigo Partners is now the sole owner of Frontier. In the 2nd quarter of 2017 Frontier filed for a long-awaited IPO, but Frontier decided to postpone the offering as the price competition (primarily from United) heated up during June. The timing is uncertain but I think it is likely that Frontier will eventually go public, with Indigo selling a small portion of its shares in the offering.

The obvious next step would be a merger with Spirit. Mr. Franke was the major shareholder and chairman of Spirit from 2006-2013, and he oversaw the creation of its current business model. In 2013 he sold his stake and resigned from Spirit to buy Frontier. In less than four years under Indigo Partners’ ownership Frontier has completed a successful transformation to the ULCC model. Mr. Franke has spoken openly about the desirability of ULCC consolidation, and the benefits of added scale are obvious. The urgency is low, however, as both airlines are doing well and competing head-to-head on fewer than 20% of their routes, by my estimate. Spirit also has to complete a new deal with its pilots and avoid any material shifts in its strategy or fleet composition if a Frontier merger is going to happen. I believe the logic is inescapable, but Mr. Franke is a patient manager and investor and it may be several years before a merger is consummated.

Culture

The most common complaint – from customers and investors alike – often pertains to the customer experience. For the ULCCs, those complaints often miss the point. If a traveler can afford a first- or business-class ticket, there is no comparison to a ULCC flight. For everyone else, the differences are subtle to the point of being almost arbitrary. Basic Economy is further narrowing the gap between the experience of flying the network carriers and the low-cost carriers. If a carrier can deliver a reliable service between destinations, there is no evidence that customers want to pay enough to justify in the investment in frills and amenities. People love to complain about airline service, but they also vote with their wallets several hundred million times per year and the results are clear – what they want are low fares with reliable service.

Outside of the debate about service quality, much of what makes the experience of air travel experience so frustrating is shared at the airport by all passengers. In my opinion, a significant part of what passengers hate about flying is out of the airlines’ control. TSA lines, decrepit terminals, air traffic control delays, and slow ground transportation are often a source of frustration that ruins the experience of flying even if the flight itself is acceptable.

That said, airlines do control many aspects of the flying experience and most of them leave a lot to be desired. Simple customer service problems often metastasize in a Petri dish of stress and weak culture. Small issues can spiral out of control and cause the airlines to shoot themselves in the foot, as we’ve seen several times in recent months.

Southwest had (and mostly still has) a unique, friendly culture that engendered both employee and customer loyalty. That culture has been an invaluable advantage over almost five decades. Alaska also has a unique and positive culture that it uses to its advantage.[12] Most other U.S. airlines, however, have a culture that would rank somewhere between average and poor. If Spirit or another ULCC could replicate a Southwest- or Ryanair-esque culture it would be huge advantage. I do think progress is being made, but changing a company’s culture might be the only thing harder than changing a company’s cost structure. In either case, eventual success will take years if it comes at all.

Co-branded credit cards and loyalty programs

Most people are familiar with airline-branded credit cards, but as the airlines’ agreements with the card-issuing banks have been recut in recent years it has become a profit center for the airlines that may still be underappreciated. Each of the individual programs is worth many billions of dollars to American, Delta, United, Southwest and Alaska. (The other U.S. carriers have far smaller programs that are not as valuable.)

Just as the competition for high-value cardmembers at Costco caused a price war between American Express and Citi, the recent contract negotiations with many of the major airlines yielded large price increases. Airlines hide behind exclusive contracts with the banks and the premise of “trade secrets” to avoid disclosing detailed numbers. Approximations can be made, however, and airline executives are on the record confirming that it is a significant and high-margin part of the business. Based on my estimates, it is reasonable to believe that the airlines get 1.5 cents or more per “mile” on the billions of miles sold to the banks each year.[13] That cash flow also benefits working capital, as the cash comes in as soon as the miles are sold but the revenue is deferred until passengers redeem the travel or other awards. Along the way, of course, some miles are never redeemed (what’s known as “breakage,”) at a rate that may approach 10-30%, and some miles are redeemed for non-airfare awards on favorable terms to the airlines. As such, the margins for the miles sold by the airline are far higher than in the rest of the business. It is reasonable to assume that the profit margin on this business is in the 30-50% range, if not higher.[14]

Alaska may be smaller than the Big Four of American, Delta, United and Southwest, but it may have the best loyalty program in the industry. It has made enrollment growth on its card deal with Bank of America a major priority in its Virgin American integration and its overall growth plan, even tying a small portion of employees’ incentive pay to the program. The numbers are significant – Alaska disclosed $900 million of 2016 cash flow from its loyalty programs – and I believe they will only increase over time due to organic growth and the Virgin America acquisition. American, as another example, could see an incremental cash flow benefit of $500 million to $1 billion per year starting in 2018, and given that it is due to a price hike the incremental profit margins could be close to 100%. Delta expects the $2.7 billion of 2016 revenue it generated from its American Express partnership to hit $4 billion by 2021, and the incremental $300 million per year should yield very high margins.[15]

Airlines also benefit from generating revenues that are not directly tied to the airline business. In an industry downturn or recession the use of credit cards and the resulting cash flow from the mileage programs may decline, but it likely to decline far less than the airline business itself. That cash flow will provide a material cushion over time.

Airlines’ Bankers (co-branded airline credit cards are lucrative — and growing more so — for both big banks and the carriers)

Source: Bloomberg.



[1] Alaska may have one of the best airline brands in the country, if not the world. Its loyal fliers often choose Alaska if the price is close, and the company rewards its customers with award-winning customer service. Alaska serves very attractive markets on the West Coast and it recently acquired Virgin America to expand further in California and on the East Coast. The integration is ongoing, but if Alaska can retain its cost advantage over the network carriers, maintain its culture, and capture the attractive growth in its markets, the future is bright.

[2] Scott Kirby, president of United, was responsible for the first implementation of this strategy in 2015 when he was in a similar role at American. That price competition did make a dent in unit revenues, but all of the U.S. airlines still posted exceptional profits in 2015 and 2016. A large part of the boost in profits was the drop in oil, but even if fuel jumps 25-50% (as it just did after Hurricane Harvey) I estimate pre-tax profit margins would still be in the 5-15% range, depending on the company. A rise in fuel costs would also be somewhat of a benefit to Spirit, as it would widen the gap between its cost and fares and those of its competitors.

[3] Operating a hub is an expensive proposition and one that the ULCCs largely avoid. ULCCs also do not have to incur countless other costs that are required at a full-service airline. Labor and fuel are the two biggest expenses for any airline, and ULCCs maximize their efficiency on both fronts. Another significant cost advantage stems from the ULCCs’ labor force – as younger/newer airlines that are growing more rapidly than their peers, the ULCCs can attract younger pilots at lower pay with the offsetting benefit of more rapid career progression and more flexible work schedules. With labor representing a quarter to a third of operating expenses, the savings are significant.

[4] Spirit now gets more than 40% of its passenger revenue from fees and charges. The total revenue has declined from about $130 per flight per passenger in 2012-2014 to $107 in 2016, but the average non-ticket revenue has been close to flat. And yes, the ULCCs’ all-in fares – with all fees included – is still lower than the average fares on other carriers.

[5] United Airlines’ CFO Andrew Levy recently said that Hurricane Harvey created “the largest operational impact in the company’s history.” (http://wsw.com/webcast/cowen43/ual/) The company has grown and changed since prior disruptions, and Mr. Levy wasn’t trying compare horrific human tragedies. But from a business-only perspective it is worth noting that the result is not financial distress but lower quarterly earnings guidance and a pre-tax margin that is still estimated to be 8-10%.

[6] Spirit has the added complication of a pilot contract negotiation that is in arbitration. During the 2nd quarter the negotiation resulted in some minor but material work disruptions by some pilots, and further labor problems would be a major concern. Most of the other carriers have agreed to new labor contracts in recent years, and in almost all cases the unit costs will be rising. The relative differences, of course, are all important, and Spirit should retain a large advantage even if the contract, as expected, results in an incremental $1 billion of pilot wages over the life of the deal.

[7] By my calculation, all of the major U.S. carriers are earning a return on invested capital (after-tax net operating profit over the sum of debt, equity and capitalized leases) of 10-25%. Leverage varies, but that results in a return on equity of approximately 15-40%.

[8] Spirit estimates an average 35-40% year-over-year increase in passenger traffic on routes it entered between 2007-2016.  (Source: https://goo.gl/j6XbSa)

[9] Buybacks are often misused, but in the case of the major U.S. airlines the recent past has been encouraging: American, Delta, United, Southwest, and Alaska have reduced their share counts by 35%, 16%, 24%, 21%, and 14%, respectively in the past 3-5 years. Those repurchases were all made at attractive prices and not done to the detriment of the balance sheet (most companies reduced debt at the same time). It is also encouraging that most airlines have made massive investments in their fleets using operating cash flow. (Source: company filings with the SEC)

[10] Pension obligations are a material liability at some airlines, although most of the plans are well funded and can be supported by operating cash flow in the normal course of business. Operating leases must also be capitalized in any consideration of overall financial leverage.

[11] Source: Airline Weekly

[12] For anyone who hasn’t experienced Alaska firsthand, this article (“Why Little Alaska Airlines Has the Happiest Customers in the Skies”) explains the culture pretty well. https://goo.gl/RfTD7V

[13] Note that a “mile,” as used in the context of a loyalty or frequent flyer program, does not compare to an actual mile in the context of the business. An average one-way flight (a “stage length”) is just over 1,000 miles, and an average coach fare on that trip might be $80-$120 on a ULCC, $140-$175 on LUV/ALK/JBLU, and $180-$200 on UAL/AAL/DAL. That same trip would likely require 10,000 – 15,000 “miles” or points. So if each of those “miles” was sold to the issuing banks at $0.015-$0.020, that would bring revenue equal to or exceeding most of the cash fares, with all of the breakage falling straight to the bottom line.

[14] United disclosed ~41% net margins in its loyalty program segment in 2005 documents related to its bankruptcy proceeding. (Source: SEC and bankruptcy court filings — https://goo.gl/KtDFgn and https://goo.gl/NMDYSP). Those disclosures ended in 2006 but prices have generally moved in favor of the airlines since that time. The business has also grown: in 2005 it was 5% of operating revenues, and that number is closer to 12% today. (Source: https://goo.gl/i9Dty4)

[15] Source: company filings with the SEC (https://goo.gl/t7m3c9)



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Deutsche Bank: Transforming Under New Leadership

September 9, 2017 in Deep Value, Equities, Europe, European Investing Summit, Financials, Ideas, Large Cap

This article previews an idea presentation at European Investing Summit 2017. It is authored by Samuel Sebastian Weber.

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Don Yacktman Articulates Value Investment Philosophy

September 8, 2017 in Equities, Featured, Full Video, The Manual of Ideas, Transcripts, Wide Moat

We had the pleasure of sitting down with famed fund manager Don Yacktman in 2013 for a wide-ranging conversation on his investment philosophy. The conversation is packed with wisdom and insights into value investing.

Don Yacktman is a legend in the investment business. Prior to founding Yacktman Asset Management in 1992, Don served as portfolio manager of Selected Financial Services and Stein Roe & Farnham. He holds a BS magna cum laude in economics from The University of Utah and an MBA with distinction from Harvard University.

Watch Don talk about the “wildcard” in investing:

A few highlights from the exclusive conversation:

“The wildcard in investing is the money that’s retained at the corporate level and reinvested for the investor by the management of the company. That usually is still the bulk of the cash flow.”

“The bottom line is that it’s dangerous to have a hurdle rate based on treasury bonds that are 3% or 3.6%.”

“Protecting money in our view means avoiding dumb decisions, permanently losing the capital that you have. At the same time, we also feel somebody needs to be proactive.”

“…it’s a matter of objectively looking at the headline of disappointment and saying, at what price are we willing to own this business — and trying to be objective about it while looking at the forward returns.”

“One [options] is a dangerous one, which is acquisitions, because too often the ego overrides the economics, and this is where it gets scary.”

“We vote against every stock option plan.”

“A company that has a 40% share of the market doesn’t make twice as much as somebody who has a 20% share. They’ll make four times as much. But in the process, one needs to bring down the price to benefit the consumers and expand the market.”

“Retailing is a tough business to begin with. It’s a very competitive business. It is very difficult to create loyalty.”

Enjoy the full conversation:

printable transcript

(The following transcript has been edited for space and clarity.)

MOI Gobal: You’ve spoken a lot about looking at everything as though it were a bond. Could you explain how that affects your thinking about riskier assets, about equities?

Don Yacktman: In any investment, you lay out the money today, and you have future cash flows coming in from that investment. Typically in a public company, one of those is through a dividend. When you buy the stock you know what the dividend is and, based on your historical experience, should have a reasonably accurate assessment of the reinvestment rate on that dividend.

The wildcard in investing is the money that’s retained at the corporate level and reinvested for the investor by the management of the company. That usually is still the bulk of the cash flow.

The wildcard in investing is the money that’s retained at the corporate level and reinvested for the investor by the management of the company. That usually is still the bulk of the cash flow. So to some degree, in effect you’re franchising, you’re entrusting that money to the management to do a decent job on the reinvestment rate.

Any time you’re projecting out into the future, there’s going to be a range of outcomes, because nobody can predict it with absolute certainty. The more predictable the outcomes, the higher-quality becomes your valuation process. And the lower the quality, the more risk there is, either financial risk or economic risk. The range of outcomes will become wider and wider. One has to take that into account in trying to assess the rate of return hurdle that you feel is adequate to justify an investment.

The business model is also important because a business ultimately boils down to what you buy and pay for. On the business model side – if you were to draw a grid and have one axis be fixed assets – the other be economic sensitivity, you could plot any company. The reason we look at it that way is because we’re really looking for businesses that earn high returns on tangible assets.

The central tendency is for those kinds of businesses to be businesses that have low fixed-asset components and low cyclicality. Three of our top four holdings happen to be Pepsi, Procter & Gamble and Coca-Cola, all of which fit that profile — they’re in effect like our AAA bonds. As long as you can buy them with an adequate rate of return, those become excellent investments. Then you start to look at lower-quality things based on the predictability of the cash flows.

MOI: When we think about it that way, where it starts with let’s say the thirty-year U.S. treasury bond rate, and then all the other available assets get priced off that, could you talk to the challenges for an investor when that benchmark is perhaps manipulated or artificial, as some have suggested?

Yacktman: That’s a good question. If you look historically, we’re hitting the hundred-year anniversary of the Federal Reserve System. Over the last hundred years we have averaged 3% inflation, so a dollar’s gone to roughly a nickel. And over the last fifty years, it’s been 4% so it’s accelerated slightly. At the current time, we’re below trend line — or you could maybe say that we’re driving the trend line slightly lower by coming back closer to 3%.

The bottom line is that it’s dangerous to have a hurdle rate based on treasury bonds that are 3% or 3.6%.

Whichever number you use, it’s dangerous to project out inflation rates that are substantially below those kinds of very long-term numbers. If you take that and look at it, long-term bonds have had a central tendency to sell at about a 3% premium to inflation. That puts you at the 6-7% level. In equities, add another 3% over that, so you’re up at the 10% level. If you look at the fifty-year numbers, you’ll see that with inflation at 4%, equities have been a little over 10%, so those numbers hold pretty close. The problem is, those are fifty-year numbers. One-year numbers are going to vary dramatically.

The bottom line is that it’s dangerous to have a hurdle rate based on treasury bonds that are 3% or 3.6%. In the last fifteen, sixteen, or eighteen months, they’ve gone from 2.5% to 3.6%. Those are well below historical numbers, and that’s one of the dangerous problems today, because you’re looking at numbers that are way below historical numbers. It’s driving equity values to much higher levels because people are basing it off current rates of long-term treasuries rather than the trend line or reasonable rates.

MOI: You’ve talked about looking for “escalators” as an investor. Do you feel that approach — looking for great businesses that create value over time — suits you even better is in the current environment of such low interest rates? Does it help protect you against inflation in better ways than some other investments?

Yacktman: Yes. There are two elements that strike me with that question. One is that, yes, I’m a conceptual thinker, so we think of them as “beach balls” being pushed underwater, with the water level rising. We’d rather own the escalators than the moving sidewalks, in other words, businesses that are building underneath, building value at a more rapid rate.

It all starts with price. Price is the key determinant of any of these. But the more you can buy better businesses at a good price, the better off you are than buying poor businesses.

Today, because we’ve had a cyclical upturn in the economy and profit margins have increased for the more cyclical side of the economy, what’s happened is that the spread between the really high-quality businesses and the lesser-quality businesses has narrowed — just like the premium for a lower-quality bond is too close to where it is for a high-quality bond.

Today, as we look at the market, the best values are in the very high-quality market area. You’re really not being compensated adequately to take on a lot of additional risk.

MOI: It seems ironic that these types of investments — the great businesses that have great reinvestment opportunities — are available at attractive prices given that interest rates are so low and there is potential for inflation down the road. Do you agree with that, and why do you think that’s the case?

Yacktman: Another thing has been that in an environment of a weak economy, these companies have tended not to increase their prices as much, because they want to maintain market share. They’ve had a little bit of pressure on the cost side, so their profit margins have been squeezed a little. They’ve looked a duller from a rated growth standpoint and people are not excited about them. They’re not high unit growth businesses. They just have enormous market shares.

They become a little dull (as dishwater), and they have lagged the S&P on top of that for the last three years. When you have a situation like that, people tend to move away from it because they’re rearview mirror investors, although driving a car and looking in the rearview mirror doesn’t usually work very well. But they aren’t as excited, and so they’re moving away from them in a lot of cases.

MOI: Am I correctly reading into this some latent pricing power that’s available with those businesses, that perhaps the managements are not looking to exploit in the near term, but you have confidence that they do have the pricing power to not only keep up with inflation but even more so down the road?

Protecting money in our view means avoiding dumb decisions, permanently losing the capital that you have. At the same time, we also feel somebody needs to be proactive.

Yacktman: Yes, that’s well said. At some point, things tend to come more into a normal pattern. And yes, the pricing power is there and will come back as the economy comes back.

MOI: You have stated that your investment goals are first to protect the client’s money and second to grow the money. What are the key investment considerations when it comes to protecting money?

Yacktman: Protecting money in our view means avoiding dumb decisions, permanently losing the capital that you have. At the same time, we also feel somebody needs to be proactive. Because of that historical inflation rate, you get eaten alive if the money is just put under a mattress. It requires being proactive and investing to the degree that you can find opportunities that exceed your cost of capital — so that’s how to protect.

On the growth side, we want to have the best risk-adjusted forward returns we can with a goal of beating the S&P from one market peak to the next peak.

MOI: Could you speak a bit about the role of portfolio management when it comes to these goals and considerations?

Yacktman: In our view, it leads to a pretty concentrated portfolio, because we’re looking for the outliers, the ones that are in the tail of the so-called bell curve, although I’m not sure it’s always a bell curve — the ones that stand out.

The more money one can pack into the top ten or fifteen ideas, the better off we feel you are — and ironically taking less risk as a result. Although most people see that as a risky approach, we see this as a less risky approach.
It’s clear that one needs to understand the concepts of risk-adjusted forward returns and the business model and the price — because it’s what you buy and what you pay. That’s what the business boils down to.

MOI: Are these considerations different when one thinks about the short term versus the long term? Is there anything an investor needs to think about differently, let’s say over the next couple of years versus the next twenty years?

Yacktman: The time horizon needs to be very long to use the approach we do. The one thing that comes with that is a requirement for patience. Because of our goals and our process, we will not beat the market every quarter; we will not beat the market every year. We’re looking at a peak-to-peak cycle and trying to both protect and grow the clients’ money through that whole cycle. The long term is very important.

The danger is that investors can end up churning their wheels if they start to look at short-term phenomena. Unfortunately, most people can’t look beyond a one-year, two-year, or maybe a three-year time frame. It’s very difficult for investors to have that kind of patience, and particularly because most investors are not as sophisticated — they don’t understand the process.

They look at the world and get bombarded by the news media about the danger of this or the danger of that — as opposed to taking into account the whole allocation process and what it’s all about.

…it’s a matter of objectively looking at the headline of disappointment and saying, at what price are we willing to own this business — and trying to be objective about it while looking at the forward returns.

MOI: I want to go back to the bell curve you mentioned. You stated that in very disruptive periods, typically the tail of that bell curve gets elongated, and there are more opportunities. Am I right in concluding that when the times are not particularly disruptive, you are better off with the high-quality businesses? When there is a disruptive period, you may be rewarded by looking elsewhere?

Yacktman: There is a tendency for the more defensive things to look better in the later stages of a cycle, because they’re lagging and people are getting more excited about things that are more dynamic. The key is to be totally objective.

There are three different times when opportunities tend to present themselves. Just like the yields go up on bonds when the price comes down, we see the same effect happening in stocks. It’s just that stocks sometimes come down for the right reasons, too.

The disruptive periods are — the massive one where you have a market decline like in the 2008-2009 period — that creates enormous amounts of opportunity.

Then you have a situation where something hits an industry, like a dramatic change in healthcare. You’ll see many more opportunities in a period of disruption because of an industry situation than a unique disruption because of some event that has occurred at a company and it’s singular to that company. In each case, it’s a matter of objectively looking at the headline of disappointment and saying, at what price are we willing to own this business — and trying to be objective about it while looking at the forward returns.

MOI: It really does go against this common notion that people throw around, that term of safety and they want to look for safe investments. What you’ve just described is really when it comes to idea generation, going to where the trouble is where the uncertainty is high as a source of opportunity, where others really try to avoid the uncertainty as investors.

Yacktman: Again, it’s a time horizon issue. What people view as uncertainty may be an uncertainty in the short term but may not be as uncertain in the long term. But yes, people get scared because of short-term events and the market tends to be this manic depressant. It tends to be disruptive.

An average stock fluctuates about 50% from low to high in a twelve-month period. But occasionally, you get these outlier situations whether again for the company, an industry or the market as a whole.

MOI: Now, with the approach that you’ve employed so successfully over the years, what would you say is the most difficult aspect of it?

Yacktman: The most difficult aspect is to totally understand decision-making by managements. What we have found is that you like to look at their history and what decision-making process they go through. They really have about five options – to put the money back in the business, R&D, marketing, cost reduction, distribution. And if you have a big market share, marginal unit growth can provide enormous rates of return on incremental unit growth, so that’s very important.

One [options] is a dangerous one, which is acquisitions, because too often the ego overrides the economics, and this is where it gets scary.

But the companies, after their infancy, start to generate excess cash and so they have to examine four other options.
One option is a dangerous one, which is acquisitions, because too often the ego overrides the economics, and this is where it gets scary. The second one is share repurchase – at least you know what you’re buying. But again in both cases it’s do they have discipline in price? Next one is letting the shareholders have it back through a dividend. And the last one is just sitting on it.

And how they behave, we have found, is much more important to know than what they say they’re going to do because sometimes there’s a gap between what they say they’re going to do and what they actually do. But one needs to take that into account.

As an example, a few years ago we had a much smaller investment in Hewlett-Packard than we would have had just because we were very nervous about their capital allocation process. And they actually exceeded our worst expectations with the Autonomy acquisition where they, in our opinion, grossly overpaid for it. Those are the kind of things that become surprises in a negative sense that can also be a surprise in the positive sense.

In the case of News Corp. [NWSA] a few years ago when they wanted to buy the rest of BSkyB [London: BSY], we were a little nervous, because we were worried about them overpaying. And then of course the British parliament got unhappy with them and prevented them from doing that. And so they had to go to Plan B, which we liked better than Plan A, which was buying back their stock which we thought was a much better use of cash based on the price of stock. And so they moved that way and it ended up being a dramatic plus from what our expectations were.

MOI: Given that you allocate such importance to the role of management, have you ever been tempted about just following the jockey and perhaps compromising on business quality and price considerations believing that management is really the right one and that’s the key to the investment thesis?

Yacktman: That can happen on occasion, but it’s rare. I remember back when I ran Selected American buying some fireman’s fund because of Jack Byrne, as an example, where I had a high degree of confidence in Jack Byrne.

But it took him years, much longer than I’d anticipated, because basically he had to move away from the business model he had, which was less than stellar to try to improve the business model and to take advantage of the values, the underpricing of the model.

What I guess I’m saying is the ideal thing is to have a good business with a good manager and a good price obviously to go along with it. It’s a lot easier when you have the wind at your back than when you have the wind at your face.

Good managers generally will change the wind direction. But as investors, you can control the sails. You can’t control the wind, so you become much more dependent on it. I’d rather see the machinery humming than the machinery just littered and not doing much.

MOI: When it comes to management, would you be able to give us an example of a CEO, a capital allocator that perhaps is underappreciated by the world in how they go about business, and then it would be a good example to study, to really understand how to think about management, and what to look for as an investor?

We vote against every stock option plan.

Yacktman: Depending on timeframe, going back years ago when it was still a public company, I thought Bill Stiritz when he handled Ralston did a great job. He started with a company that before him had “deworsified.” He shrunk it to its most profitable core, grew the core, bought back stock, did so many things correctly. That was a sterling example.

The one that stands out in the last maybe decade or so and partly because it’s so heavily family-owned is Lancaster Colony [LANC] which is a smaller company. But they’ve shown incredible discipline in capital allocation, gradually moving into better businesses and being very careful.

We vote against every stock option plan. They had virtually no stock options. They’re very careful that they’ve done special dividends, they’ve done share repurchase, they’ve done an awful lot of things right.

MOI: If we think about investing and approach it from various angles, you’ve kindly told us about how one of your sons came to you and explained investing, roughly meaning buying above-average businesses at below-average prices, and on average that’s going to work.

And it reminds me a bit of Seth Klarman’s quote when he says that value investing is simple to understand but difficult to implement. The hard part is discipline, patience and judgment. Those three words, and you’ve mention patience earlier in the conversation today, would you tell us a bit what that means to you, discipline in investing?

Yacktman: Discipline means to continue to have a process and utilize that process over and over again so that it becomes a repetitive thing, because you have confidence, you’ve developed it. There is no substitute for knowledge and grinding it out.

My son Steve who works with me was talking to a group at a college and a question came up about a company and he said, have you read the 10-Ks and the 10-Qs? And they looked baffled like that was a surprise, and he said I do.

A lot of this is just digging it out, and really understanding the business model, and understanding all the nuances. Clearly, we’re never going to know the company as well as the management knows it, because they’re insiders. They see it every day. But really trying to understand it and so it does become a grind-it-out process.

MOI: How do you develop and nurture patience as an investor? How do you withstand this noise that tends to shrink the time horizons of most?

Yacktman: It’s interesting. When we were in downtown Chicago early on, we’d get a lot more bombardment from people because our accessibility was there. When we moved to the suburbs, it dropped off dramatically. And the less noise one gets from Wall Street, the better off you are.

Now that doesn’t mean we’re going to move to Fiji, but moving to Austin even reduced it more because there are fewer people that come through. And so it’s important to step back, and not get caught up in the 24/7 news cycle, and just turn off a lot of that stuff. Just avoid it and concentrate.

Yes, I’ve commented that our office sometimes comes across more like a library than it does a trading desk at a New York brokerage firm.

MOI: What does the word “judgment” mean to you? How should an investor go about improving judgment over time?

A company that has a 40% share of the market doesn’t make twice as much as somebody who has a 20% share. They’ll make four times as much. But in the process, one needs to bring down the price to benefit the consumers and expand the market.

Yacktman: To me, that means objectivity, really thinking through the process, and being as objective as one can, recognizing that in our business, we’re basically wrong almost all the time because nobody buys everything at the bottom and sells everything at the top. It’s a matter of recognizing that.

That doesn’t mean we can’t be well above average, but there is a degree of probability in this and that recognizing that we’re all human, and we’re going to make mistakes, and don’t try to defend the indefensible.

When one makes a mistake, admit it, learn from it, move on, and try to improve on what the mistake was so that we don’t repeat it over and over again.

MOI: To come back to these escalators as you refer to them, how do you judge whether a company has a moat and the sustainability of that moat?

Yacktman: Usually the moats come as a result of big market shares, which ultimately what it amounts to is a low cost position. In other words, you can get a moat, say if you’re a mining company because you find a vein of some particular product or commodity and it’s right at the surface let’s say, you just happen to luck out, and it’s just real cheap to get at – that can happen.

But the majority of the time, it becomes a result of just doing correct big business principles, continuing to make the product better, and not compete on price but on quality. You make the quality better and so as a result of that you start to get more sales, which then in turn gives you a chance to drive down the cost because of the experience curve.

A company that has a 40% share of the market doesn’t make twice as much as somebody who has a 20% share. They’ll make four times as much. But in the process, one needs to bring down the price to benefit the consumers and expand the market.

That’s one of my concerns about Apple is that whether they’ve held up their pricing too much, creating enormous profit margins that are simply unsustainable. Better to give up some of the profit margin and build such a strong position that it’s very difficult for other people to attack your position.

MOI: If Apple represents that one side, would you say the Coca-Colas of the world, or Procter & Gamble or Pepsi, they’re on the opposite side? Or do you feel they’re not optimizing the price recently and they have potential to do a better job extracting profits over time?

Yacktman: It’s a combination of two things. One is in the case of the Cokes and Pepsis is that their businesses are a little bit more mature. They’re little more like cash cows, so to speak. But once you’ve established an enormous position and the business has matured to the point where unit growth is slowing down, then you can lose it. But somebody really can’t take it away from you.

Apple, you still have enough disruption because of technology change. I can’t tell you what a cellphone’s going to look like ten years from now any more than anybody else can. But my guess is that people will still be using Tide detergent, a very high percentage of them, just because of the solidified position of that market share and what it does for them.

Retailing is a tough business to begin with. It’s a very competitive business. It is very difficult to create loyalty.

There are going to be some exceptions to the rules but those are the basic rules that I see. That’s why technology is very tough even when somebody has a big market share, because you can have disruptive changes. And sometimes it can just be technology entering something that previously didn’t have it.

Think of what happened to the encyclopedia business with the result of the Internet. It basically disappeared. You changed the whole model of accessing information from a book to online and the ability to change it. That would be an example of disruption coming from technology.

MOI: If we go back to the role of management, you’ve stated that companies like Procter & Gamble or Coca-Cola can lose their market share but nobody can really take it away from them. What are the ways a company like that can lose its market share?

Yacktman: Probably the best way I can give as an example again, if you go back to the 1970s, Budweiser and Schlitz both had about the same market share in beer. I’m not a beer drinker but as I understand, Schlitz basically found a process that made it a lot faster to produce the beer and so they could do it cheaper, but they ended up creating a product that the marketplace didn’t like.

And as a result of that, there was a dramatic shift and then it was all over. Budweiser took over the market basically and ended up with about half of the beer market before it went private or before InBev in effect bought them. Here’s a case where they just made a tremendous error.

Coke made a huge error when they came out with new coke but you’ll notice how quickly they adapted to that and came back with Classic Coke, recognizing that they could have destroyed the company. Again, some of these things become just making the correct decisions. And if you blow it, then recognizing quickly you’ve blown it, and go back and improve it.

Look at what’s happened in the last few years with J.C. Penney and how they had this tremendous change in business model and it was a disaster. I don’t know if they’re redeemable but we’ll find out.

MOI: In a case like that, it seems that there are examples of great capital allocators who have tried their hand in retail. What would you look for in a case like that when it comes to management? Or do you feel that management could never really persuade you even if it had a great case for turning it around it, and so on, and allocating capital in a way that an investor would want? Do you feel management could ever convince you to invest in those businesses, which are not your typical escalators?

Yacktman: Ever is a long time. The question is have they reached the point of no return? Retailing is a tough business to begin with. It’s a very competitive business. It is very difficult to create loyalty.

This conversation was recorded in November 2013.

Mental Models: Leaking Balloon or Coiled Spring?

September 8, 2017 in Commentary, Letters, Macro

This article by Tom Russo has been excerpted from a letter of Semper Vic Partners.

One of the most astute Wall Street professionals I have had the pleasure of spending time with over the years is Raphael Bernstein. Mr. Bernstein’s decades-long involvement as a senior investment banker at Bear Stearns left him wise in the way of Wall Street. At one particular wise moment, Mr. Bernstein posed a question to me about one company whose investment performance had up to that point lagged, despite my particular interest and my passion in its “value.” Mr. Bernstein asked me whether I thought the investment prospects for the company under review seemed to be more like “a coiled spring or a leaking balloon.”

Clearly, my response to Raphael’s question about the company whose prospects I still highly esteemed was that, without doubt, it was more the former than the latter … a spring whose very coil promised to give our portfolio a very nice, sustained boost in performance once it began to release.

Well, much like my response to Raphael’s query decades ago, today I believe that that portion of investments which I oversee on your behalf through your portfolio of “global value” equity holdings is no “leaking balloon.” The portfolio, indeed, as I reflected on the promise of our companies at year-end, possessed the ability to spring sharply forward as the coil releases returns.

Indeed, I believe this to be the case because within the portfolio are concentrated holdings in leading global companies that possess the capacity to grow value during periods like the past three or four years, even when markets for whatever reason chose not to value increases in intrinsic value derived from such reinvestment. This disconnect between growing intrinsic value through effective reinvestment in promising geographies and adjacent categories can last for prolonged periods of time.

I surely believe that the past several years have been so characterized for many of Semper Vic Partners’ core holdings. Equity investors have taken their eyes off specific investment in specific companies, even when those companies carefully, year in and year out, exercise their highly value-creating “capacity to reinvest.” Globally, today’s investors have moved increasingly in sync together into index funds, in general, and into the mother of all index funds, the Standard & Poor’s 500, in particular. Investors are blinded by risks attendant to such crowd behavior on Wall Street. Induced by index funds’ lure of low management fees, investors increasingly mistake low cost advisory fees with low risks. I believe that they do so at their own peril.

Capital flows into indices and as well as into Exchange-Traded Funds (ETFs), the country cousins of the big index funds, have occurred at increasing rates over the past four years. Today they reach stampede proportions. Their allure has even driven upwards the value of the US dollar since, on balance, global equity investors who increasingly have switched to US-based index funds over the past three years have had to trade in their euros, renminbi, rubles, etc. for the greenback, the only currency through which you can settle purchases of S&P 500 index funds.

This incremental demand for dollars to underwrite the purchases by foreigners of US-based index funds contributed to the very rise in the value of the dollar that has created a headwind for Semper Vic Partners’ returns over the past several years. The increased value of the US dollar effectively “devalued” reported operating income sourced from abroad and “devalued” reported period-end valuations of our foreign equity holdings upon translation into US dollars.

Many of the above factors have led global investors to fear that my style of long-term, fundamental, research-based investing, for businesses capable of reinvestment, resembles more the “leaking balloon” than “coiled spring.” The broad switch to US equity market indexation which has grown at a torrid pace over the past four years has driven capital away from the internationally based businesses that form the core of our portfolio. Capital flows from those holdings have restrained growth in their market value, tightening the coil for later springing into higher valuations. International investors’ moves into US-based equity index funds have had a secondary effect of contributing to the rise in the value of the US dollar, which I believe to represent another spring coiling for release as the US dollar, I suspect, will inevitably retrace its advance if/when capital flows return to invest in other markets.

Macro forces and global capital flows create for Semper Vic Partners reasons discussed above that I believe support the view that we possess more “coiled springs” than “leaking balloons” in our portfolio. However, despite the above macro influences on our portfolio companies’ share prices in the near term, I am nonetheless acutely aware of competitive dynamics across our entire portfolio which might lead some to believe that the very franchises which I have preferred to invest in over decades may themselves be once grand balloons that now leak. I am acutely aware of such threats to our branded consumer products companies’ long-standing, durable “competitive moats.”

The world is evolving so dramatically and along so many different axes that investors absolutely have to be sensitive to the increased probability of risks of “leaking balloons.” One need only consider some of the following realities that our portfolio companies confront. For investors who prefer consumer brands, due to their historic ability to invest mature market free cash flow to expand their franchises into emerging markets, and due to their ability to take advantage of latent brand appeal to offer increasingly within arm’s reach products that enhance consumers’ lives, the world seems to present increased risks, some of which are discussed below.

First, there is the risk of digital dislocation and disruption. Consumers today, especially trendsetting younger consumers who historically have been first adopters of products introduced around the world, are increasingly influenced by trends of social media. Their brand loyalties are less gripping. Gone are the days, for instance, when Budweiser represented over 55 percent of the US domestic beer consumption. Today, in fact, brand Budweiser may have dipped below 20 percent in some trendsetting California markets, like San Diego.

Second, the ability through e-commerce to access alternative products outside the tight channel of traditional routes-to-markets allows competitors’ products to enter markets once blocked to them. Alibaba Group, Amazon.com, Inc., and others will make sure that such products can find their consumers.

Third, economies around the world, especially developing and emerging markets, confront a host of pressures not felt to this extent over the past thirty-plus years. Indeed, during the first thirty-plus years of my career in investing globally, I have had the blessing of a gentle tailwind. Governments around the world were increasingly transparent. Consumers around the world enjoyed growing Gross Domestic Products (GDP) per capita and growing consumer disposable incomes. Relatively borderless trade around the world offered first-time prospects of work, with concomitant ability to purchase long-admired and aspirational products but heretofore unaffordable and inaccessible.

Finally, there is the very real possibility of increasing political fraying of many of the multilateral agreements and global alliances, upon which we have rested for post-World War II global balance, which have begun to be unwound. We have absolutely no idea either how far and fast such unwinding will go or who will benefit and/or lose from such developments. It is clear, however, from my perspective, that we are entering into the most disruptive and unconventional period of time economically, politically, and socially that we have seen in the modern era. The prospects alone of resettling over 10 million refugees adrift due to just the past five-year’s worth of Middle East conflict dwarf imagination when trying to consider how societies will absorb such demographic disruptions. Borderless trade of consumer products, which formed the basis of great gains for our portfolio companies over the past three decades, seems to be potentially a victim of rising nationalism and potentially restrictive trade policies.

Despite possible threats alluded to above, I do take comfort on several levels that our holdings will continue to balance risk and reward as effectively as I can find amongst the seemingly endless other investments available.

I base my continued enthusiasm for the “coiled spring” that is our portfolio on several broad fronts. First, I return to core values which, in my case, have typically been borrowed from experiences expressed by Warren Buffett. In this case, as the list of uncertainties described above mounted, I continue to fall back on Mr. Buffett’s observation about the political, economic, and social upheaval he confronted back at the dawn of his investing career. There were countless reasons why not to invest at that time, but Warren suggested that rather than retreat to cash he simply sought best investments possible to confront the risks head-on and attempt to eke out returns. He fondly observes that, had he waited for green lights for all three components of risk discussed above, he would still have his first $10,000 waiting to be invested.

Second, I comfort myself on the ability of our companies to react. This statement is particularly true, for instance, in our business’ growing willingness to respond to new business practices, consumer preferences, etc. shaped by the digital revolution underway in consumer products companies. Compagnie Financière Richemont SA, for instance, recently announced strategic partnership in China to engage Tencent’s WeChat subsidiary to power up one aspect of their digital commerce strategy in China. China has begun to experience sharp recovery in demand for Richemont’s aspirational jewelry, Pernod Ricard’s cognac, etc. Similarly, Nestlé’s diverse product offering featured this past year, on an exclusive Alibaba site, a dedicated range of offerings that celebrated Nestlé’s 150th anniversary as a company.

Our portfolio companies increasingly have to obsolete their own long-standing consumer brands by launching their own craft and artisanal competitive products, realizing that no one should be better to take share from the market leader than themselves. Philip Morris’ recent launch of its highly disruptive product, IQOS, provides a great example of this phenomenon. Finally, all of our companies are invested deeply into new ways of consumer communication, relying on new digital campaigns, new sampling campaigns, new direct-to-consumer marketing through high-touch human interaction, etc.

Third, I comfort myself on the very reality that for every country in political, economic, and social free fall, there are counter examples of companies coming out of darkness. Even while Turkey, Russia, Venezuela, Syria, North Korea, etc. descend into political and economic turmoil, other parts of the world advance. I am particularly mindful of two of South America’s most long-standing, dysfunctional, and corrupt countries, Brazil and Argentina. It is impressive to think that they have, for the first time in decades, seated governments that have come to power by popular vote with a clear mandate to rout out corrupt practices that have held both countries back for decades. It is the same within many of our companies who, despite having products or geographies that suffer setbacks, enjoy a portfolio breadth and geographic breadth that allows for other regions to advance, often allowing our companies to more than make up for setbacks elsewhere.

Finally, I take comfort from our companies’ long-standing competitive advantages, realizing that brands that deliver billions of servings a day do enjoy the benefit of consumer long- standing habit and preferences. I take comfort from the fact that the problems which will confront the world, most notably population growth and scarce resources such as food and water, are in the sweet spot for our portfolio companies that in most instances possess global leadership in important areas of corporate social responsibility. They express that responsibility themselves by innovation into best corporate practices that address local needs, reduce harmful byproducts of their businesses, and increasingly attend to shared programs with local governments to address their consumers’ needs in environmentally safe and sustainable fashion.

Our portfolio companies in Nigeria, for instance, will bring the scale and insights of their products over the coming years that will help them build from their already enormous base of business today to meet the demand if indeed the population of Nigeria does grow from 190 million people today to over 500 million in two decades. Nestlé and Unilever, with affordable food services through their Maggi and Knorr brands, will deliver food and nutrition economically around the world in markets like Nigeria, India, China, etc. Nestlé, for instance, sells over 80 million Maggi bouillon cubes a day in Nigeria!

Moreover, they will be able to provide solutions on vast scale that will be demanded of them as they alone will likely have the capacity to develop solutions required to deliver food, beverages, and branded consumer products to increasingly urban societies. The world will become far more populous, far more urban, and far younger, on average, over the coming decades. I prefer confronting those problems and challenges by investing in companies with vast reach such as Nestlé, who operates in over 125 countries, with a workforce exceeding 300,000, with unrivaled primary research in food, health, and nutrition, and secure in its mission to source health and nutrition solutions worldwide.

On a final note, I believe we are privileged to approach the threats of “leaking balloons” that arise due to a handful of challenges described above and countless others not addressed herein with a portfolio of company managers who approach our companies’ ability to navigate the challenges described with world-class alignment of interests and low agency cost risks. Even though I recognize how hard it is to oversee companies with such global scale, I am sure that the corporate cultures with which we address those challenges are amongst the best. Though occasionally cultures may fall from their own illustrious past (e.g., Wells Fargo’s recent cross- selling compensation snafu), I believe that the focus on the long term (most notably in our family- controlled companies) and the capacity for managements to not have to do what is asked of them by short-term-minded financial world participants position us well. We can rely on our preferred management bench to meet challenges that all too quickly can convert “coiled springs” into “leaking balloons” if our corporate focus and cultures were to weaken.

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