Coho Capital Management letter to shareholders
January 31, 2014
Please find attached your year-end statement for 2013. For the quarter ended December 31, 2013, Coho Capital increased 11.1% and finished the year with a gross return of 53.2%. Net returns for the year, after incentive compensation and fees, were 42.4%. This compares to a gain of 32.4% for the S&P 500 for the year. Individual results may vary contingent upon a Partner’s timing of Fund investment and high water mark.
When viewing Coho’s returns on a risk-adjusted basis we are pleased with our results. We do not utilize leverage and have not employed options in pursuit of our gains. In addition, we carried double-digit cash balances through the first half of the year as a result of not finding investments that met our criteria.
In our mid-year letter, we shared with you economic data indicating a recovery in consumer household finances.
We wrote, “enhanced financial prospects and improved confidence have enabled Americans to pay down debt and do a better job of managing their bills. This is one of the biggest news stories of the year, but coverage has been minimal with media predisposed to a crisis narrative. We think the economic recovery underway is stronger than the headlines suggest. As the storm clouds clear, investors will regret not buying at today’s prices.”
While the gloom and doom view is still pervasive within the media there is much to be optimistic about including the following:
- The Wilshire 5000, roughly equivalent to the total capitalization of all US equities, has risen from $7 trillion in 2009 to $19 trillion. The “wealth effect” on consumer consumption should not be underestimated.
- Debt payments as a share of income are the lowest since record keeping on the measure began in the early 1980s. As of the third quarter of 2013, the percentage of disposable household income dedicated toward debt servicing was 10.4%, down from 14% in 2007. As a result, US consumers are half a trillion richer than if the debt service ratio held constant with 2007 levels. As Wells Fargo CEO, John Stumpf, put it in an interview late last year, “I have never seen credit this good in my 32 years at the company.”
- Banks’ capital levels are the best since the 1930’s. A combination of equity raises, asset sales and recovering earnings have pushed bank equity to 11.1% of total assets, the highest level since 1934 and well above the average of 7.6% over the last eighty years. A healthy banking sector attracts capital, increases confidence in the economy, and spurs loan creation to start new businesses.
- Corporate balance sheets are flush with cash at nearly 30% of current assets, close to a thirteen year high.
- Congress achieved a rare truce in fiscal wars reaching a bi-partisan budget agreement earlier this month without discordant rhetoric.
- The Federal budget deficit has been reduced by more than half since 2009 with federal debt as a percentage of GDP falling from 9.2% in 2009 to 4.1% in 2013.
With a 32% advance in 2013, there is no question that the market has begun to discount some of the favorable developments. After steady expansion in its price/earnings multiple, the S&P 500 sits at 15.2 times this year’s estimated earnings. While not cheap, valuations are far from expensive with the S&P 500’s price/earnings multiple still below its 50 year average of 16 times. In periods of low inflation, below 2.5%, the market has averaged a price/earnings multiple of 19 times. At present, annual inflation is 2%.
Of course we are not buying the market but instead deploying capital in individual companies whose fortunes and risk/return profiles are often independent of what the market does. That is an important point to remember with much of the business media focused on market prognostication. If someone claims to know what the market is going to do, take your wallet and run the other way.
We fully exited our position in AIG during the fourth quarter, registering a gain of 28%. As detailed in last year’s annual letter, our thesis on AIG was premised upon the company achieving a double digit return on equity (ROE) through a rationalization of its complex web of assets and more disciplined underwriting. A key component of that thesis was dislodged in November when AIG suspended its guidance for a 10% plus ROE by 2015. AIG’s 10%+ ROE target has been outlined in SEC documents and been a key guidepost in communications with investors since the company’s re-IPO process in 2011. We can only conclude that AIG is no longer confident of achieving its goals. With less projected ROE improvement, the rationale for owning
AIG became less compelling. We don’t believe sub double-digit ROE insurers are worthy of price-to-book ratios above one, removing one of the key constructs for a higher valuation.
AIG did not offer a reason for its lower ROE guidance, but recent performance trends were cause for alarm with AIG posting disappointing combined ratios in a low loss environment while its competitors were posting ROEs of 10-15%. Perhaps the writing was on the wall when Berkshire poached the CEO of AIG’s property-casualty division earlier in the year.
We have maintained our stakes in the following positions:
Hartford Insurance warrants (HIG-WT) – HIG continues to transition from an insurance company conglomerate into a property casualty focused entity. The company’s efforts to wind down its variable annuity business have gained traction with scores of policy holders electing to accept a one-time payment from HIG in exchange for surrender of their policy. In addition, HIG sold its U.K. variable annuity business earlier this year to Berkshire for $285M. Progress on the annuity front is important as it could potentially allow a quicker return of capital to shareholders. HIG’s remaining annuity book is fully hedged helping to insulate the company from a market downdraft.
On the property and casualty front, HIG has been successful in pushing through large (8%+) price increases for both its commercial and personal lines of business. It is perhaps not surprising then that HIG, unlike AIG, has guided for ROE of 10% in 2014.
Hartford warrants have rallied 69% from our initial purchase in April, but we believe they remain a compelling value and increased our stake this week.
Yahoo (YHOO) – YHOO was our top performing stock last year returning 103%.
It has been a busy year for CEO Marissa Meyer, who in her first full year on the job executed scores of acquisitions, reoriented the company toward mobile and restored company morale. An infusion of talent and a tilt toward younger demographics, through its Tumblr acquisition, has enabled YHOO to regain relevancy. Domestic operations are showing signs of stabilization but it will take time for YHOO to regain the confidence of advertisers.
While we are pleased with the progress Ms. Meyer has made with Yahoo’s US operations, we have always believed the true value of Yahoo resided in its Asian assets, in particular Alibaba.
“People say China hasn’t created a Steve Jobs but I think they have, I think it’s Jack Ma,” Paul Gillis of Beijing University’s Guanghua School of Management. “
Founded by former English teacher Jack Ma, Alibaba is a phenomenon. The company dominates the world’s largest e-commerce market with