Wedgewood Partners letter to clients for the first quarter ended March 31, 2016; titled, “Berkshire Hathaway: Still The Greatest Growth Company Wall Street Has Never Heard Of.”
Wedgewood Partners – Review and Outlook
Performance for Wedgewood Partners’ Large Cap Growth composite portfolio during the quarter ended March 31, 2016 (net-of-fees) was +1.00% compared to the Russell 1000 Growth benchmark’s gain of +0.74% return and the S&P 500 Index’s gain of +1.35%.
Relative contributors during the quarter included Berkshire Hathaway, Apple, Stericycle, Schlumberger, and Kraft Heinz.
Berkshire Hathaway completed its largest acquisition in its history, closing on Precision Castparts for over $37 billion in total consideration. Berkshire Hathaway will continue to favor purchasing operating businesses, as opposed to securities, given the rapid growth of cash flow and management’s long-held policy of retaining all earnings. We continue to believe that Berkshire Hathaway is under-rated as a growth company, as very few companies of this size retain all of their earnings for reinvestment – a hallmark of growth. In fact, of U.S.-based companies with a market cap in excess of $50 billion, there are just eight that have 0% earnings payout ratios (last 12 months). Notably, over the past decade Berkshire Hathaway’s retained earnings have grown from $47.7 billion to $187.7 billion.
If Berkshire Hathaway is not careful of the company it keeps, at least on this score, then it “risks” being misconstrued as a growth company! (Please note: Alphabet and Priceline Group are also in the portfolio.) Readers will note too that three of the four “FANG” stocks are listed in the table below. We will have more on Berkshire Hathaway later on in our Letter, but for a precursor on how un-loved the shares of Berkshire stack up against the beloved FANG stocks, please digest the table below from Semper Augustus Investments Group.
Relative detractors during the quarter included Express Scripts, M&T Bank, Perrigo, Visa, and Alphabet.
Express Scripts sold off after their largest customer by revenues, Anthem, threatened to sue the Company for issues related to contract pricing. We believe the lawsuit has little merit based on our research. Further, despite the contract running through 2019, we believe the market has already priced in the complete loss of the Anthem business, with shares trading near all-time low valuations, at just 10x consensus 2017 estimates. We believe the rapidly increasing supply of high-cost drugs and therapies continues to drive secular demand for Express Scripts’ best-in-class cost-containment services, which are insulated by the Company’s scale and increasingly rare independence.
After a very difficult relative performance year in calendar 2015, our process performed much more favorably during the volatile first quarter of 2016. While our product is “focused” in the sense that the number of holdings in our portfolio are substantially less numerous than those of most active managers, we believe that the portfolio still has ample diversification, particularly across business models, as we stick to “best of breed” companies, meaning that we usually find just one good idea for a given business model. When we see lopsided performance, similar to what we’ve seen over the past five or so quarters, we try to remind ourselves – and our clients – that, despite what many might think about focus, our diversification (by business model) and our position limit size (which is 10%) make it very difficult for just a handful of companies to account for all of the relative performance. For example, during the first quarter of 2016, we owned 19 companies across composite portfolios, where 13 of them contributed positively to outperformance, and just six detracted. The result of having the majority of our stocks outperform was, unsurprisingly, a quarter of outperformance. This compares to calendar year 2015, when we owned 23 stocks, and just six outperformed while 17 underperformed. With such a large number of our companies behind the benchmark in 2015, it was difficult to chalk up the underperformance responsibility to any single business model. Instead, that responsibility laid at the feet of a woefully out of favor investment process.
Even with our focused portfolio, we believe that our investment process should drive our performance, more than any single or even a couple of big winners or losers. For example, looking at each of the past five calendar years, we have never outperformed the Russell 1000 Growth Index in a calendar year if portfolios had substantially2 less than half of the stocks in the portfolio outperforming. The corollary is that we have never underperformed if we had less than half of the stocks underperform. That might seem obvious, but we reiterate that it takes more than just a few good ideas to drive long-term performance in our focused portfolio. While some focused managers might rely on a couple of “big positions” (i.e. several different companies with the same business models, and/or more than 10% of the portfolio in a single position) to drive things, it is our process that is the “connective tissue” across our holdings that manages both risk and reward.
During the quarter, we initiated a new position in a familiar name, Charles Schwab, which we have owned in years prior, and liquidated our positions in M&T Bank Corp.
We also added to Priceline, Apple, Kraft Heinz, and Stericycle, all due to attractive valuations. We trimmed Qualcomm to fund our Apple purchases, as we continue to limit our collective weighting in those two companies, given that the supplier-customer relationship is quite meaningful to Qualcomm’s future cash flows. Both companies were trading at similar ex-cash multiples, but we have relatively more conviction in Apple’s future prospects.
Wedgewood Partners – Company Commentaries
During the quarter, LKQ continued to execute on its mid-single digit organic growth plus M&A strategy. In addition, the Company provided a convincing case for its continued execution at their first-ever Investor Day. The Company also announced the acquisition of Pittsburgh Glass Works for $635 million in enterprise value and finalized the acquisition of the RHIAG group of Italy.
LKQ is both the largest distributor of aftermarket collision parts in North America and the largest distributor of mechanical aftermarket parts in Europe. We think scale is critically important to most distribution businesses, and LKQ is no exception. In North America, LKQ’s primary customers are collision repair shops that often participate in volume programs organized by casualty insurers looking for low-cost but high-quality repair parts. These collision repair shops must turn their repair jobs over relatively quickly or risk losing out on volume business. As such, LKQ’s unmatched product availability and fulfillment rates are differentiators in the eyes of the Company’s customers, while cost-conscious insurers provide another impetus for low-cost, aftermarket collision parts demand, so we expect LKQ’s profitability to reflect the return on the inventory and distribution capital expenditure risks that LKQ takes on behalf of its customers.
LKQ’s organic revenue growth consists of increasing the penetration of after-market parts to collision and mechanical repair shops, as well as increasing route density. Increasing this “base” off which LKQ can organically grow, is their long-held approach of acquiring several under-scale competitors per year. As we have seen over the past few years, LKQ has