Black Bear Value Fund commentary for the second quarter ended June 30, 2017.

“The areas of consensus shift unbelievably fast; the bubbles of certainty are constantly exploding.” – Rem Koolhaas

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To My Partners and Friends:

Black Bear Value Fund, LP (the “Fund”) returned approximately 1.1% in the 2nd quarter of 2017 (1) bringing the year-to-date net return to 0.3%. This compares to 2.6% for the S&P 500 in the quarter, bringing its year-to-date return to 8.2%.

As many of you already know a substantial amount of the Fund’s capital is my own. Whereas new fund managers spend most of their time raising money, I spend most of my time focusing on compounding my capital and my LP’s capital over the long-term.

A fundamentally-driven and concentrated investment portfolio should outperform various market indices over a long-term horizon with reduced risk of permanent capital impairment. Each investors’ return will vary depending on the timing of the investment.

Black Bear Value Fund

Brief descriptions of the top 5 long positions follow and remain the same as in the 1st quarter.

Alphabet Holdings

Alphabet is the holding company for Google (Advertising/Search) and Other Bets (Ex: Waymo, Nest, Google Fiber). Alphabet is a cash-machine with 40+% returns on capital and a fortress balance sheet (no net debt). Ex-cash and other-bets, Alphabet is trading ~6% free-cash flow yield and grows 15+%. Other Bets obscure the cash-generative abilities of the company as they currently lose money and burn cash. While pricing per click (the price Alphabet gets) has been in decline, the number of clicks (the volume) is growing as more and more people are glued to their mobile devices. Mobile is a lower price point but much higher volume. Think of this the next time you ask your friend or family member to put their phone down – they could be clicking and making you money as an Alphabet shareholder.

The media has made much ado about the “run-up” in the prices of tech stocks. I am cautious about painting broad brushstrokes among very different companies, valuations and long-term fundamentals. Alphabet has been growing like a weed and it is likely to continue. There is limited value in these short term predictions and worrying about them can lead to a lot of wasted time.

The world is getting more connected every day and should be a persistent tailwind. It’s hard to know where Other Bets goes…. but ascribing ingenuity and creativity a negative value seems short-sighted. In other words, if Other Bets never take off and we own Alphabet at a 4-5% yield + growth of 10+%, we’ll be ok. I tend to think they may surprise us.

Berkshire Hathaway

Describing Berkshire in a simple manner is a challenge. Allan Mecham did an admirable job describing BRK as a “meat grinder that relentlessly piles up value year over year (and decade over decade).” Berkshire is trading ~1.5x book value which underestimates its true intrinsic value. We own BRK at a 20+% discount to the combined value of their stock portfolio and their operating businesses (at a 10x multiple). Add in the benefits of investing free money (the float from insurance) and a business compounding at high single digits with wide moats and you get the aforementioned meat grinder.

Over the last decade earnings from Berkshire’s private businesses have compounded ~9% per annum, while the investments (the stocks and bonds) compounded at ~8% per annum. The team of Buffett/Munger and others have created a business that will succeed long into the future with attractive growth prospects.
Interactive Brokers

Interactive Brokers is the lowest-cost automated global electronic broker with a wide variety of clientele. Management owns ~83% of the company and runs the business with a long-term growth mindset. The electronic brokerage generates a mid-single-digit free-cash flow yield today while growing the account base/client equity by 15+% per year. Recent trading activity has been slow which leads to the opportunity to invest. IB recently sold their low-margin market making business, further simplifying the brokerage business, freeing up capital and increasing margins and growth. The stock seems to be punished for having too much capital (it’s overcapitalized by $4+BB or $10+ a share from a regulatory perspective). They want to not only be the cheapest and best broker, but the safest (zero debt on the balance sheet). Over time the combination of a great product at a discount to competitors coupled with an impeccable balance sheet should lead to a healthy compounder with very low risk of permanent capital impairment.

Phillips 66

Phillips 66 is a vertically integrated downstream refiner with varied businesses across midstream (pipelines transporting oil/gas), chemicals and gas stations. Their dependence on refining will be greatly reduced over the next 24 months as new midstream and chemical projects contribute more stable cashflow. Many investors want to see the cashflow from new projects before paying for it. We are comfortable buying today and being patient. Over the next 2 years PSX should be generating free-cash flow in the low to mid teens on today’s stock price. This is largely due to a double benefit of exiting capex cycles (less money out the door) and new projects contributing cash (more money coming in the door). Management continues to buy back stock at cheap prices (15% bought back over the last 3 years) and takes a mindful approach to capital allocation within their business units. A more stable/sticky stream of cash should translate into a more fairly valued company. In the meantime, we encourage management to keep buying back more stock.

21st Century Fox

21st Century Fox is a diversified media conglomerate across cable networks, film and television studios. There has been a litany of bad press related to the workplace at some of Fox’s networks. I am encouraged by the proactive steps management has taken to rid itself of bad actors and am optimistic it will not have long-term repercussions for the business. In time these issues should pass but it is certainly something to be mindful of. We own Fox ~7% free cash flow yield with an ability to grow earnings 5-10% and upside from a variety of ventures. It is a stickier business than most realize as they control quality content and can dictate some element of price. In the age of multiple forms of media delivery, content is king. Fox can continue to increase pricing for affiliates and advertisers if they have content that consumers want to see. As viewers increasingly use DVR’s, the value of live programming increases (sports and news). Fox News continues to be one of the 10 most watched cable channels and is a must to include in most cable bundles. Fox has a wide variety of valuable sports rights (Example: NFL, MLB) which gives them negotiating leverage both with content distributors and advertisers. Longer term investments in HULU (Fox owns 30%) and Star India should add to the growth profile.

Shorts

The Fund has a variety of shorts in fixed-income ETF’s (exchange-traded funds) spread across commercial real estate, high-yield corporate debt and international sovereign debt. We profit when bond prices fall/interest rates rise as rates and bond prices are inversely related. Rates are very low across nearly all fixed income instruments. It seems preferable to own companies at 10-20x present cashflows that are rising 10+% a year as opposed to 10Y bonds at 40x a non-growing earning stream (simple math is when the 10Y treasury is at 2.5%, divide 100/2.5 and that’s your multiple). Remember when you own a bond you do not participate in the upside of the business unless you’ve bought it at a meaningful discount (which one day the Fund hopes to be doing!).

If the current economic situation weakens it will likely impact the overall earnings abilities of the REIT’s and high-yield bond issuers which could also lead to spread widening. While difficult to predict the timing and order of magnitude of a rate-rising event, it seems like a compelling bet given the low-rate environment.

Cash/Overall Prospecting

We maintain ~26% net cash position (ignoring the benefit of the extra cash we have from our shorts). As mentioned previously there will be times we will maintain a large cash position. We have found some interesting new ideas; hence our invested position has grown. That said, opportunities are not abundant and I am comfortable keeping cash on the sidelines to wait for obvious ideas. In the event of a large sell-off (which I am not predicting) there are some great businesses we are prepared to invest in. Unfortunately, their current prices do not provide an adequate margin of safety.

Other

I recently had the pleasure to present on the auto dealers at the ValueX Vail conference in June (slides are attached). Please note they are not a top 5 position for the Fund as of June 30th, 2017.

ValueX is a wonderful conference organized by Vitaliy Katsenelson. It was refreshing and energizing to meet so many talented people who were willing to mutually share their knowledge.

Thank you for your trust and support. I hope you are all having a pleasant summer.

Black Bear Value Partners, LP