Crystal Cove Capital Management’s letter to investors for the fourth quarter 2014.
From October 14, 2014 (the inception date of Crystal Cove Capital) to December 31, 2014 investors experienced an 11.3% return compared to the 10.3% return from the S&P 500. While I’m pleased with the modest outperformance relative to the S&P 500, I present a significant caveat with the above results: short term results are extremely difficult to predict. Benjamin Graham prudently commented on this phenomenon: “In the short run the stock market is a voting machine, but in the long run it is a weighing machine.” While there are bound to be periods of subpar quarterly performance in the future for the fund and volatility around results, this does not concern me. My sole goal and focus is to compound your capital and my own capital at the highest risk adjusted rate of return over a long, multi-year timeframe. Trying to mitigate volatility or consistently outperform in the interim is likely to detract from that goal.
Crystal Cove: The Advantage of Being a Long-Term Investor
If one examines the current landscape of investors, you will find that institutional investors dominate. This type of investor includes large pools of capital such as insurance companies, pension funds, and university endowments. The behavior of institutional investors and the funds with which they allocate money is primarily driven by the economic incentives of the people running the funds. Having a significantly negative result in a quarter or a given year can lead to unemployment or a meaningfully negative impact on compensation. While there is nothing wrong with having a short-term mindset, this approach makes it harder to maximize long term returns due to competition and taxes. In terms of competition, the past decade has seen a proliferation in strategies that seek to maximize short-term returns such as hedge funds with event driven strategies or debt funds that attempt to limit volatility. This increased competition makes it tougher for short-term funds to deliver performance. In contrast, there are much smaller sums of money dedicated to permanent / long-term capital vehicles creating less competitive pressure. Besides competition, short-term investing is challenging due to the unfavorable tax code. Short term returns (securities held for one year or less) for taxable investors are taxed at an investor’s marginal tax rate rather than the lower long term capital gains tax rate. To highlight the impact this difference can have on long term returns, I give you the following example: $100,000 invested at a 20% rate that incurs short term capital gains of 35% each year will result in $13 million in 40 years.
Alternatively, $100,000 invested at 20% that only incurs a long-term capital gains tax of 15% in 40 years will result in $125 million. A similar short-term capital gain tax penalty applies to some volatility mitigating mechanisms, such as shorting, which has unfavorable short-term tax treatment regardless of the length of the holding period. Overall, being a long-term investor creates a meaningful competitive and tax advantage.
Crystal Cove: A Mispricing in Today’s Market
There are specific business models that are particularly adept at driving good long-term equity returns that I believe are currently underappreciated by market participants.
Specifically, I’ve spoken with many market participants that are averse to companies with leverage. The economic downturn in 2008 with the coincident freezing of credit markets severely penalized equity investors in highly leveraged companies that were cyclically or secularly challenged, had refinancing maturities, or broke their covenants. This left a mark on many investors leading them to avoid companies with high or even a modest degree of leverage. While this avoidance of leverage can be prudent in many cases, there are cases in which leverage can be enormously beneficial to equity investors with limited additional risk. One such case is a business that displays monotonically increasing cash flows. In this scenario, the growing business naturally delevers without having to pay down debt and the utility like nature of the cash flow minimizes default risk during economic recessions. One industry that displays such characteristics is the cable industry: it has a subscription-based cash flow stream that is secularly growing as broadband penetration increases around the world. Competitive dynamics are relatively benign, especially with broadband, given that it tends to be a monopoly on high speed internet.
Crystal Cove: Liberty Global offers an exceptional risk-reward
One cable company that I think offers an exceptional risk-reward today is Liberty Global. Liberty Global is the largest European cable company with a presence primarily in the strong Northwestern European economies. Liberty Global’s current pre-tax cost of debt is a mid single digit yield driven by low interest rates as well as low spreads driven by investor preferences for low volatile, fixed interest securities. The company’s equity is priced at a low double digit yield. The company’s growth is driven by increased penetration as well as pricing power. On the cable TV side, the business has been increasingly differentiating itself from competitors through innovation including its advanced Horizon TV platform, which offers viewers the opportunity to watch their shows any time, on any device. On the broadband side, Liberty Global has a decisive advantage vs. its main competitor DSL. DSL can only get to 40-50 Mbps speeds even with upgraded VDSL infrastructure whereas cable can currently get to 250 Mbps. The future looks to increase the advantage that cable companies have as Liberty Global can substantially increase its speeds with limited additional capital expenditures. On the other hand, rival telecommunication companies have to spend a substantial amount of capital to invest in a competitive fiber to the home (FTTH) product. Thus far, these big investments have led to poor returns on capital making telcos generally loath to increase their FTTH footprint. Given increasing consumption of over the top video (e.g. Netflix, Amazon Instant Video), there is increasing demand for the high speeds that cable and FTTH can provide.
The management team at Liberty Global is extremely strong and is led by Chairman John Malone, who has a 40 year track record of creating outstanding value for shareholders. He has been particularly successful at utilizing leverage to maximize equity returns. Given the spread between debt yields and equity yields at Liberty Global, Malone is essentially exploiting debt investors who are investing at very low interest rates and short-term equity investors, who are willing to sell stock at current prices. Indeed, much of the free cash flow from the business has been used to repurchase shares over the last decade and management has signaled that they will continue to aggressively repurchase shares. Liberty Global is extremely adept at limiting risk posed by its leverage which usually fluctuates between 4x –5x Debt / EBITDA. It limits leverage risk by terming out maturities (the vast majority of debt is due beyond 2020), having primarily fixed interest rate debt to guard from interest rate risk, hedging currencies so there isn’t a mismatch between debt owed and cash flows generated, and structuring debt at the operating company level that is non-recourse to the parent and other operating level entities to guard from cross-default risk. This prudent use of leverage has dramatically increased equity returns in the past and will continue to