Hayden Capital letter for the fourth quarter ended December 31, 2016.
Dear Partners and Friends,
The last quarter of 2016 was certainly interesting. The election of President Trump to the White House caught many off guard. However even more surprising may be the hope-filled “Trump Rally” that ensued in the following weeks – especially after dire warnings by pundits in the weeks before. Between November 7th and year-end, the S&P 500 rallied over 5%.
Notably, this recent rally is driven by multiple expansion, as investors became ever more excited about the business prospects and tax reforms under the new administration. Since businesses are expected to earn more next year, investors bid up the price they’re willing to pay today, and thus priced in these lofty expectations. The risk is these reforms may take longer to implement than the market expects, and the Trump administration may lack the “political capital” to get some of their agenda passed (especially if they continue to alienate core fiscal Republicans).
During this period, our portfolio lagged the broader market. This shouldn’t be of concern, as our portfolio value is structured to rise in-line with the fundamental value growth of our underlying businesses (normalized earnings power growth), rather than multiple expansion (the market’s willingness to pay a higher price).
Especially in today’s market where interest rates have likely bottomed, it’s apparent that multiples will have a hard time expanding going forward and that intrinsic value growth will matter much more in coming years (I talk about this in-depth below). Expecting other market participants to pay more for the same company tomorrow vs. today will be a dangerous game to play.
During 2016, we estimate our underlying companies grew their earnings power by 12.5%. However, this was offset by the multiples the market was willing to pay for our firms declining -4.2%. Combined with the “cash drag” due to our average 26% cash position, we had returns of 3.90% for the full year of 2016. Over the fourth quarter of 2016, our portfolio at Hayden Capital declined by -2.06% compared to a 3.95% gain in the S&P 500.
Some of our cash was deployed into our newest investment, Zooplus (ETR: ZO1), bringing our average cash level down to 21%. However, we continue to wait for better opportunities to deploy the remainder of our cash “war chest”.
Over the next year, we estimate our portfolio companies to grow their earnings power by over 17%. If our estimates are correct and company multiples stay the same, we can expect a portfolio return within this range.
Hayden Capital – The Magic House
Over the past five years, the S&P 500 has risen 98%. Of this, only 23% of the gains have come from earnings growth and 10% were from dividends. The remaining 64%, or two-thirds, was from multiple expansion. The S&P 500 companies didn’t become twice as profitable over this period. Rather, investors were simply willing to pay a 64% higher price for the same company five years later (the forward P/E ratio for the S&P 500 rose from 12x to 18x from year-end 2011 – 16).
Low interest rates meant that the yields offered by bonds were often insufficient to meet investor needs, and thus capital moved to higher risk equities to provide these returns. As with any market, if there are more buyers for the same number of stocks, the price will go up5.
With most investments, there are two components of what an asset will sell for – the fundamental value (the future earnings stream) and the price you’re willing to pay today for each dollar of future earnings (the P/E multiple)6.
To better illustrate this concept, the example I give to clients is that of a “magic house”7. Let’s imagine that you buy a 1,000-sqft house for $1 million (we’re talking NYC / SF prices…). This equates to a price of $1,000 per square foot. However, homes in this alternate universe are special, and the house is able to magically “grow” 15% a year. Thus, next year the house will expand to 1,150-sqft, and 1,323-sqft the year after that.
Now let’s imagine that in this universe, there is no change in housing stock (no homes being built or destroyed, since the homes last forever). There’s also no inflation, and no population growth (deaths-to-births = 1). Because of this, all things equal, the price per sq ft should remain constant (there’s no natural tailwind from inflation or population growth)8.
However, the pricing does change with people’s moods and their feelings about their economic situation. Looking at historical pricing, you know that when everyone is feeling good and flush with cash, homes sell at $2,000 per sqft. And in bad times, they go as low as $500 per sqft. The average in the past few years has been $1,250 per sqft. As such, you’re feeling your purchase at $1,000 per sqft is a very fair price.
Plus, the house (and thus its value) is compounding at 15% a year. If pricing remains stable, your investment will appreciate at this rate every year.
However, homebuyers are not rational. In any given year, the price per square foot homebuyers are willing to pay will change (i.e. a different multiple), depending on their economic situation.
For example, the local bank may be launching a promotion this year, and offering home loans at 0% interest rates (i.e. Yay, Free Money!). Realizing a great opportunity, buyers take out loans and can afford to start bidding up the prices to unprecedented levels of $5,000 per sqft.
Alternatively, there may be a slow-down at the local diaper factory, which is the primary employer in the city. The recent election of an eccentric Mayor has caused uncertainty for the future, which has resulted in drastically fewer people wanting to start families this year.
There are rumors there will be lay-offs, and no one wants buy homes in the area anymore. Home prices subsequently plummet to $500 per square foot.
Eventually however, the bank promotion is going to end, as this is a business after all and they can’t lose money forever. The free money faucet will close, and borrowers will no longer be able to pay as much as they did before.
Similarly, families will become more comfortable under the new administration, and baby making will return to previous levels. Diapers will once again be in demand, and the factory will need to hire those laid off employees back. When these events happen, housing prices will find equilibrium again, and the multiples will mean-revert.
Even if it doesn’t, our downside risk (or the risk of losing your initial investment) is low, so long as we’re confident in the “Magic House’s” ability to continue growing more valuable each year. For example, even if prices drop 50% to the low-end of $500 per sqft, it will only take 5 years before we break-even on the investment.9
However, it’s highly likely that over time, the multiple will revert back to a “fair” multiple.10 Therefore as long as our “house” continues to expand at 15% a year, this is the return we would expect to realize over the long run.
I give this example, to illustrate