Broyhill Asset Management annual letter for the year ended December 31, 2015.
Investing in public markets can be challenging in an average year. Last year was not an average year by any standard. Markets were particularly difficult to navigate. Global equity indices were down for the year. Anything that looked or smelled like a commodity was down a lot. Few investors made money. Most underperformed. Many lost their shirts. According to the Mutual Fund Observer, investors saw losses in:
- 8 of 9 domestic equity categories
- 17 of 17 asset allocation categories
- 8 of 15 international stock categories
- 14 of 15 taxable bond categories and
- 6 of 6 alternative or hedged fund categories
Against this backdrop, opportunities for big gains were limited. Those that bet big on “being right” lost big. Last year, not “being wrong” was far more important. Big gains are certainly far more exciting than avoiding losses, but we’ve never been particularly fond of excitement. We missed most of the year’s big winners, but more importantly, we managed to sidestep most of the market’s landmines. We made some mistakes but generally walked away with minor bruises, rather than critical injuries. As a result, we worked very hard to end the year about where we started.
Broyhill Asset Management - The Value in Value
Given the broad-based underperformance of active management outlined above, investors are naturally beginning to question the merits of value investing. So many of us have learned that outperforming the market is impossible, that some have actually convinced themselves that markets are efficient. Others point to central banks, high-frequency traders and big-data algorithms as impossible competition for value investors. Still others point to the general outperformance of growth relative to value, which has now reached levels not witnessed in over three decades. All good stories; but we’ve heard them before.
For value investors, one variable wall always ensure long-term success – human nature. Central banks can distort asset prices; increased capital can chase smaller and smaller inefficiencies; and exponential growth in computing power and advances in artificial intelligence may account for most of the volume traded in a given day. Logically, one might conclude that competing in such a zero-sum world was an impossible task. But despite these seemingly insurmountable hurdles, we’d suggest that the most important determinant of success remains constant – investors will make the same mistakes they have been making forever because they simply can’t help themselves. Those mistakes (i.e. chasing fads and riding unicorns) will always offer patient value investors an endless pool of opportunity. Returns from value investing will be lumpy, as they’ve always been, but they will come in time.
Value investing requires patience and a thick skin to withstand occasional periods of underperformance. This past year was one such occasion. Investors piled into a handful of “growth” stocks ultimately turning 2015 into a momentum trade. While last year’s gains were driven by an extremely narrow cohort, the current streak of underperformance actually began in July 2014 when value peaked relative to the market. After several years of underperformance, investors are again questioning the “value” in value-based approaches. A longer term perspective may be helpful.
While there have been many periods where value has temporarily underperformed, the benefits of a value-based approach are abundantly clear in the long-run. But in the short-run, investors have driven the premium paid for growth to historic levels. We don’t know how high it will go or how long it will last. But we do know that past cycles have lasted about two years; and that we are about eighteen months in today. We also know that once the cycle ends, recoveries have been powerful. What we cannot know, with any degree of certainty, is precisely when the market will see the value in our portfolio. But we believe the rebound will be equally powerful when it does. Fundamentals eventually matter.
Broyhill Asset Management - Portfolio Update
Our goal is to compound capital over time at an above average rate while taking below average risk. If given the choice, we’d clearly prefer profitable years versus stagnant or falling values.
Unfortunately, this is not a choice we get to make in any given year. Until that changes, it’s important to keep in mind that markets don’t accurately reflect changes in value day-to-day or even year-to-year. So the only thing we can do is figure out what something is worth, buy it below that price, and wait.
After a year of waiting, we believe the current gap between price and value for our portfolio companies is more attractive today. And as this gap closes, we expect more acceptable returns. In the interim, we will spend most of our time thinking about the value of our investments, rather than worrying about their price. You should too. Given the dramatic volatility in market prices since year-end, we discuss the underlying value in our five largest holdings below.
Time Warner Inc.
Time Warner Inc. (TWX) was our largest individual investment as of year-end. It was also our biggest loser last year declining nearly 23% in 20151. Last year’s poor performance was driven by both broad-based sector weakness as well as stock-specific challenges. Earnings multiples in the media sector compressed from 18x to a low of 12x as crowded longs sold stock in response to minor subscriber declines. As a result, investors valued TWX at a 25% discount to the market in December versus the 20% premium 21st Century Fox (FOX) was willing to pay for the same shares little more than one year ago.
We don’t believe today’s price is representative of the value at TWX; however, we do understand investors’ frustration. In 2014, the company refused to engage with FOX to explore an offer then valued at $85 per share. The logic? Its board claimed their strategic plan would create significantly more value than any proposal that FOX was in a position to offer. Roughly one year later, TWX shares hit a low of $63 as it became clear that this plan was out of reach.
Put bluntly, management has lost credibility. They flat out rejected a premium bid for the company then put together a dog and pony show designed to demonstrate shareholders were better off independent. Less than a year later, they lost the pony. Needless to say, we are disappointed, but we do not believe recent price declines reflect intrinsic value. While near-term earnings expectations have fallen, we believe long-term earnings power at TWX (a greater determinant of intrinsic value) is far higher.
Time Warner has one of the best collection of media assets in the world2 but the company’s most valuable asset (i.e. HBO) is being weighed down by the weakest link (i.e. Turner). HBO is a crown jewel: it owns much of its content; it generates consistent and growing cash flow; it is a premium distribution platform for programming. Yet the market values Netflix at a price nearly equivalent to the entire market capitalization of TWX, while HBO is being valued like a business in secular decline. If John Malone were running TWX today, he’d already have an HBO tracking stock. Others might suggest this value is best realized outside of the TWX umbrella3. We have no preference as to who highlights the value; if current management fails to do so in short order, we believe someone else will.
Oaktree (OAK) is a top-tier alternative asset manager with assets under management (AUM) over $100 billion today. AUM has grown steadily for the past five years even while the company distributed $50 billion to its investors. The majority of AUM is invested in vehicles with a ten-year average life. This makes for an incredibly sticky asset base with economies of scale, resulting in consistently high returns on capital. The business itself is rather simple. Oaktree earns most if its money in one of two ways: 1) it charges management fees based on its assets under management; and 2) it generates incentive fees based on the performance of these assets.
A smaller, but not insignificant, portion of their earnings is derived by the firm’s investments in its own funds, as well as its 20% ownership of DoubleLine (a rapidly growing asset on OAK’s balance sheet).
While shares of OAK declined 4% during the year, many of the company’s peers experienced priced declines on the order of 30-40% in 2015. We believe this validates the strength of Oaktree’s moat. The business is more conservatively managed than peers with several countercyclical characteristics: a larger percentage of earnings are driven by sticky management fees rather than lumpy incentive or transaction fees; investments are higher up in the capital structure; and long-term performance has been driven by protecting capital in difficult markets. Most importantly, we believe Oaktree’s normalized earnings power has increased as the company has historically raised capital in distressed markets. In other words, capital raised during times of stress is likely to translate into higher management and incentive fees when markets recover.
We increased our investment in OAK throughout the year and have continued buying on weakness since year-end. Downside risk appears well supported by current asset value, with significant upside potential as considerable cash is put to work. OAK earns fees below 1% on average today, yet future fees on $17 billion of committed capital (not yet generating management fees) will be closer to 1.5%. As a result, margins should expand significantly as capital is invested at increasingly attractive valuations. And contrary to conventional wisdom, Howard Marks and team are a blatant exception to the golden rule of investing – OAK has generated its greatest returns on its largest funds. This should bode well for future incentive fees and consequently, future returns on our investment.
Shares of SeaWorld (SEAS) gained 15% last year despite a constant barrage of negative headlines. New CEO, Joel Manby, presented his vision for the company at an Investor Day in November. We think the idea of “turning the parks inside out” is a step in the right direction. Our initial diligence on Manby led us to believe he was a shrewd capital allocator. That is becoming increasingly clear after a few months on the job, as new management has more or less scrapped plans for a massive capital investment in San Diego and identified 200 to 250 basis points of costs to take out of the business over the next couple years.
Clearly SeaWorld still has some hair on it.4 We don’t mind a little hair so long as we can quantify the downside and capitalize on a well-informed view different from consensus. Increased disclosure at the company’s investor day helped us do just that. SEAS has not yet disclosed the data supporting the charts below but we can eyeball the slices to get an estimate within reason.5 If we assume Tampa and Virginia represent 40% of SEAS EBITDA, then Busch Gardens (and the two water parks located in Tampa and Virginia) generated nearly $140 million of the roughly $360 million total EBITDA estimated in FY15.
Busch Gardens Tampa is an extremely well-positioned park. Williamsburg has been voted the World’s Most Beautiful Park for 25 consecutive years. These are prime assets. At the same time, our research points to a lot of low hanging fruit at Busch Gardens – fruit we think Mr. Manby is well positioned to pick given his operating experience at regional parks.
If we value Busch Gardens at 10x currently depressed EBITDA (SIX has traded from a low of 8x forward EBITDA post-bankruptcy to a more recent 14x), these parks might be worth $1.4 billion today. Net debt stands at $1.5 billion today, so in a worst case scenario, Busch Gardens would provide management with plenty of flexibility to eliminate almost all of SeaWorld’s existing debt. More important are the implications for the SeaWorld stub.
If we estimate $1.4 billion of value at Busch Gardens, this implies the company’s remaining parks (SeaWorld, Discovery Cove, Aquatica, Sesame Place, etc.) are worth about $1.7 billion. On $220 million of EBITDA (which is greatly depressed today), that represents a 7.5x multiple for the SeaWorld stub. The last time we saw amusement parks trade around that level was in the wake of Lehman’s collapse. And investors who bought in at those prices have done extraordinarily well since then.
CDK Global Inc.
CDK Global (CDK) is the largest technology provider to auto dealerships. The firm, which was spun out of ADP in 2014, is deeply integrated into its customer base, which relies on CDK for workflow processes which range from advertising and marketing to sales, financing, parts, and service. CDK’s systems are the IT backbone of its customers, so changing providers is simply not an option for most dealers.6 This is a remarkably resilient business due to long-term service contracts with regular price increases. If you’ve bought a car sometime in the past decade, you may have noticed that outside of your local doctor’s office, there is perhaps no other industry slower to embrace new technology (no offense Lambo). Said differently, there is little threat for technological disruption on the foreseeable horizon.
We initiated our position in CDK shortly after the spin and watched the stock rally 32% through year-end 2014, followed by an additional 18% gain last year. As value investors, we are naturally programmed to buy on the way down and sell on the way up. This is how we operate most of the time, as a rising price often coincides with a shrinking margin of safety. Plus, buying on the way up just doesn’t “feel right” (as my son would tell you when the seams on his socks don’t perfectly line up). Yet, we have been actively increasing our ownership on pullbacks, and as a result, CDK is one of our largest positions today. Why?
Our initial research on the stock identified CDK as a classic spin-off given ADP’s large institutional ownership base (likely to sell their new position in CDK given the stock’s relatively small market capitalization and resulting position size), lack of research coverage (only one of six analysts rate the stock a buy today) and potential for margin improvement. Based on our work at the time, we felt we were buying CDK at a fair price. With the benefit of hindsight and continued research efforts, we later realized CDK was a rare bargain - one we should have bought more aggressively. While the upside potential from today’s levels is certainly reduced, the range of outcomes has narrowed as well, and the distribution is now skewed far to the right.
Management held the firm’s first Investor Day in June 2015 where it outlined plans for 4-5% annual revenue growth over the next three years resulting in nearly 15% margin expansion from lows near 20% to 35% by FY18. Apparently, a number of investors were not completely satisfied with the $1 billion in free cash flow the firm plans to generate over the next three years; in August, Bloomberg reported that CDK was prompted to explore a sale.7 More recently, in December, CDK announced a plan to return $1 billion in capital to shareholders including an accelerated share repurchase agreement to buy $250 million of stock within six months. We expect more to come. If the market does not reward the company’s significant earnings acceleration, we believe another interested party will.
Kennedy Wilson Europe Real Estate PLC
Kennedy Wilson (KWE LN) advanced 18% in 2015 yet shares still trade at a discount to our estimate of book value. Our investment thesis continues to play out as expected. KWE provides investors with a private equity style real estate platform with upside through active asset management along with workout of distressed debt. Global demand for European real estate is driving yields lower and valuations higher. Despite being one of the largest real estate IPO’s in London’s history, the stock remains “under the radar” of most institutional investors.
Last year, KWE tipped its toes into the Spanish and Italian real estate markets, while exiting £95.7 million of assets at a 21.8% unlevered return on capital. The fund yields 3.5% based off last quarter’s run-rate and our interests are well aligned with management given KW’s 18.2% ownership of KWE, which itself is 21% owned by insiders.
Broyhill Asset Management - Cash & Concentration
After nearly seven years of smooth sailing, many of our investments purchased earlier in the bull market have appreciated and now trade near fair value. Consequently, we were net sellers of securities last year. At the same time, it has become more challenging to find bargains in the stock market. While we added to several existing investments as markets turned lower mid-year, the spike in volatility did not last long; and the quick retreat was not steep enough to generate sufficient bargains or to justify putting a substantial amount of dry powder to work. Consequently, we established no new positions in the second half of the year, and our limited activity generally resulted in greater cash balances at year-end.
That cash reserve served our investors well during the summer’s volatility, when we suffered a fraction of the losses experienced by the broad market. It is serving us equally well today. And we expect it to serve us better in the future when greater bargains present themselves. While many institutions are forced to remain fully invested at all times, we are fortunate to be in a position of strength. While they are unable to deploy capital into opportunities when bargains become more widespread, we are adding to our most compelling positions at increasingly steep discounts.
For most of the year, we resisted the temptation to chase short-term returns available by buying what everyone else was buying. Instead, we purchased additional shares of our highest conviction investments as markets turned lower. In doing so, we believe we increased the quality of the portfolio and reduced risk by shifting capital from fairly valued companies in favor of those with greater margins of safety. Our portfolio is now more concentrated in our best ideas as a result.
Broyhill Asset Management - Investment Activity
Valuations across the globe are significantly greater than they otherwise would be absent government intervention. It’s “easy” to make money in such an environment (said the levered long FANGster); it’s harder to refrain from buying expensive assets that keep going up; and it’s much harder to part ways with past winners. Yet, our concerns about deteriorating credit conditions and economic weakness have made us increasingly uncomfortable holding more fully valued and highly leveraged positions.
Most sales were for the right reasons – we liquidated a few positions which had approached our estimate of fair value. During the fourth quarter, we exited two of the year’s largest contributors to performance. Cedar Fair (FUN) gained 23% in 2015. Northern Tier Energy (NTI) gained 35%. We held both investments for multiple years. We also liquidated our position in Green REIT (GRN LN) at a premium to NAV as our constructive stance on Irish real estate is more accurately reflected in today’s price. While a local investment in GRN LN would have gained 25% over our holding period, currency losses offset the gains in our dollar-based position and we exited the trade roughly flat.
Other sales were made to actively reduce credit risk across the portfolio. We first purchased shares of General Motors (GM) in client accounts in February 2014 as consensus overreacted to the announced recall due to faulty ignition switches.
After a volatile two years with little evidence that the market would reward GM with a higher multiple, we fully exited the position in the fourth quarter near the highs of the past three years. While the stock still appears “cheap” the auto cycle is two years closer to maturity, excesses in subprime lending are accelerating and credit markets are weakening. As this is not a business we are comfortable owning forever – the industry has worked hard to earn its reputation for capital destruction – we decided to take our chips off the table rather than hold the position through the cycle.
We also liquidated our position in Ares Capital (ARCC) in the fourth quarter as the stock’s strength did not appear to reflect underlying weakness in the credit markets. We made money on this investment but believed it was unlikely that ARCC's underlying loans were marked anywhere near the depressed levels of public bond markets. Consequently, we felt that selling ARCC around book value was a better decision than liquidating our credit allocation at a big discount to par value. While we actively worked to reduce credit risk in the portfolio during the year, this was by far our most costly mistake.
Broyhill Asset Management - That $&!!@?!? Canary
We have been concerned about rich asset prices for some time. While stocks remain near all-time highs, bond markets began to decline in price last year. All else equal, as something falls in price, we are naturally inclined to own more of it. Consequently, we felt lower prices in credit markets provided a greater margin of safety than equity investments, and subsequently shifted a small portion of our equity allocation into credit over time. As it turned out, those lower prices turned out to be the canary in the coal mine.
While we were fully aware of diminishing liquidity in credit markets, we believed technical selling pressure would decline over time and prices would gradually reflect higher fundamental values. We proactively avoided direct exposure to energy and commodity sectors of the equity markets during the year, but we drastically underestimated the corresponding downside of our non-energy credit exposure. We incorrectly assumed that most long-term investors shared our understanding of the strategy and would stay the course.
We were wrong. And subsequently, Third Avenue’s reputation, built over the course of a generation, was severely impaired in a day. As we said at the outset, human nature ensures that investors will make the same mistakes they have been making forever, because they cannot help it. On average, this one cost us less than 100 basis points last year, although it felt ten times worse since we should have seen it coming.
Broyhill Asset Management - Bottom Line
While the returns in energy and commodity related sectors have been disastrous over the past year, domestic stock indices have held up surprisingly well. We believe it is only a matter of time until recent tremors spill over into broader markets. Consequently, we are taking measures to ensure we have a plan in place to capitalize on opportunities that may come our way in the not-too-distant future. As Dwight Eisenhower said to the National Defense Conference in 1957, “Plans are worthless, but planning is everything . . . The very definition of "emergency" is that it is unexpected, therefore it is not going to happen the way you are planning.”
The institutional performance derby has created an increasingly short-term orientation obsessed with benchmarks and peer groups rather than true risk – the probability of losing one’s capital. We will continue to focus on risk management and on long-term, full-cycle returns for the benefit of our investors. Market indices may be expensive, but we don’t need to own an index. When we see bargains, we will buy them. We remain cautious, but are finding interesting ideas all the time. Big opportunities don’t come along every day. When it’s raining bargains, we’ll reach for a bucket.
Until then, we will be patient as equity returns are lumpy by nature and we have no control over when value is recognized by public markets. As Warren Buffett stated in various letters to shareholders at Berkshire Hathaway, “Inactivity strikes us as intelligent behavior . . . Lethargy bordering on sloth remains the cornerstone of our investment style.”
“It shows much more courage to remain dry and sober when the mob is drunk and vomiting; but it shows greater self-control to refuse to withdraw oneself and to do what the crowd does, but in a different way.” - Seneca: Letters from a Stoic