JDP Capital letter to limited partners for the first quarter ended March 31, 2016.
For the first quarter the JDP Capital Fund was down 1.63%. Including dividends, the S&P 500 was up 1.35% in the same period. Since inception in October 2011, we have earned 79.59% after all fees and expenses, or 13.90% annualized.
Warren Buffett: If You Own A Good Business, Keep It
JDP Capital – Review, Thoughts and Outlook
The primary positive contributors of our first quarter performance were: Carrols Restaurants (TAST) +23%, CyrusOne (CONE) +23.1% with dividend, and Liberty Broadband (LBRDA) +11.7%.
The primary detractors were: Bank of America (BAC.WS.A) -33.1%, ALJ Regional Holdings (ALJJ) -5.2%, and Axtel S.A.B (AXTELCPO) -2.5%. In January we added slightly to our smaller positions when prices declined, but remained disciplined around fundamentals to justify a full allocation.
Please see the Q1 2016 Portfolio Review & Strategy Presentation for more detail around our holdings and their performance.
The negative-sentiment-trade that had been gaining momentum as a result of low-growth headlines and recession fears peaked in early February with the S&P down 9% within the first 28 trading days. Weak companies with rich valuations were cleaned out, but the selloff overshot and dragged down the bulk of US stocks that were more-or-less fairly valued in our view.
The then subsequent recovery rally and net gain for S&P that followed, emphasized the inefficiencies created by extrapolating macroeconomic data to come to a single conclusion about a market comprised of thousands of very different businesses with varying valuations.
Advantages of public markets
In the US alone there are roughly 8,700 public companies with a market cap over $1 million, and more than 2,300 with a market cap over $1 billion. We view the market as a conduit to buy pieces of businesses at prices that we could not get if the same businesses were sold privately. Public market investors have access to a diverse universe of companies and unique situations. This includes access to some of the best management teams and capital structures money can buy. Even top-tier private equity firms do not have access to the vast opportunity set that a public equity fund has of the same size.
But the benefits of liquidity can feel like a curse when pricing drifts far from company fundamentals. For investors like us who can tolerate delayed satisfaction, this rollercoaster creates inefficiencies that make it possible to earn returns greater than the risk taken. Acting within this framework is a huge advantage and provides the ability to look past market anxiety to invest in specific companies at prices that would not be available in more certain times.
JDP Capital – Competitive advantage, earning power, and circle of competence
The bulk of our portfolio is comprised of small and mid caps with meaningful, yet niche, competitive advantages. We invest when earning power becomes deeply undervalued, often due to a transition that requires a longer time horizon than the market’s attention span.1 We look for simple ideas where the thesis might not be visible in a traditional screen, but where we can leverage our experience, contacts and research capabilities to form a contrarian view. Each of our holdings possesses a particular geography, scale, brand, market position, hard assets, contracts, etc. that protects the earning power we pay for. The greatest challenge in our investment process is identifying and understanding the risks to these value drivers.
Our loss in CJES last year taught us how fragile earning power can be when competitive advantage is determined by the graces of commodity prices. Originally we underwrote a cheap oil well service business, overemphasizing quality of management, scale, reputation and returns on capital. We got too close to the cog to see the wheel and missed how quickly the company would be taken to its knees with sustained low oil prices.
Remaining disciplined around sticking to what we understand is the first step in not losing money. This means having the courage to take the time to figure out the relevant value drivers, regardless of how attractive the balance sheet or operating history of a company is.
We see stock investors continuing to be frustrated with valuations that reflect low or negative interest rates; not a doomsday threat, just a lack of endless “no brainers” like we had five years ago. However staying away from stocks altogether in protest of the global rate environment is a mistake. There are attractive pockets of growth and undervalued segments of the market today that will look like “no brainers” in five years from now.
Excluding energy, the S&P’s earnings + dividend yield (2016e) is over 8% by our calculation. Considering US GDP growth of 2% – 3% and interest rates well below 1%, the S&P’s valuation does not keep us up at night. The bulk of large US companies remain more attractive than investment-grade fixed income or private asset valuations that we observe of similar caliber.
JDP Capital – Selected Portfolio Update
Bank of America, A warrants—(BAC.WS.A)
Bank of America A warrants (2019) were our biggest loser in the quarter and took away from an otherwise strong performance in a difficult quarter. Looking back, we were too early in our timing and size of the position, but remain highly confident in the Bank’s turnaround progress. We also think the warrants have a more attractive risk/return profile compared to the stock due to the implied leverage, long-dated timeframe, and the small-cap profile of the warrants that limits access to smaller funds like ours.
BAC’s earning power is becoming increasingly more visible within the core business units as the quarters go by. Our confidence in the opportunity is rooted in medium-term operational execution progress that is unlocking existing earning power that was otherwise being masked. We think the market has dramatically mispriced the business by making the stock a proxy for the perception of rate hikes and, more recently, oil prices.
We also see a growing competitive advantage and earning power over smaller/regional banks due to BAC’s enormous scale, balance sheet strength, and technology leadership in mass-market consumer banking products. This combination will help drive margin efficiencies, grow profitability, and continue attracting new deposits, even in a low interest rate environment. At a price of ~10% below tangible book value, and growing 8% – 9% annually, BAC stock is a bargain at $15 per share today. However at $4.30 the A warrants imply a 2019 valuation of ~$17.20 per share for BAC, which grossly undervalues the Bank’s earning power over the next three years.
Carrols is well on its way to unlocking earning power that had not been obvious in prior quarters. TAST ended the year with 705 Burger King restaurants, adding 55 stores towards the end of 2015. Restaurant-level EBITDA grew by 87% to $36.8 million in the fourth quarter. Sales were up 18.7% with same store comps up 5.1%. We were also impressed with the 4.2% increase in the average check (receipt), and the gain in customer traffic.
TAST has a unique set of competitive advantages that will allow it to grow faster than the broader fast food industry. The most important advantage being the “right of first refusal” contract on 2,000 franchisees that gives us first dibs on acquiring any restaurant for sale within the territory. This also provides special merit to management’s acquisition strategy of buying restaurants for low single digit multiples of cash flow where operations and marketing can be improved to drive higher sales.
TAST is just starting to see the benefits of larger scale and a lower cost of capital. We think the market is underestimating the near term free cash flow potential of the company. Historical CapEx will be freed up for acquisitions as it completes the re-imaging of old stores to the 20/20 refresh model. Future acquired stores requiring the remodel expenses will have a lower impact on cash flow considering the larger store base. We also look forward to eventual buybacks and an investment-grade bond rating.
Lastly, we think TAST’s recent 2016 guidance of ~$950 million in sales, and $80 – $90 million in EBITDA underestimates the company’s potential this year. Projections do not include acquisitions or meaningful improvements to underperforming stores. At a valuation of ~0.63% EV/sales and 6x our estimate of EV/2016 EBITDA we believe stock remains undervalued.
Our portfolio has material advantages over indexes that are fairly valued and dependent on surprise data to justify a higher valuation. I am excited about our growth profile and weighted-average upside that is at least 50% above the current value today.
We are narrowly focused on a handful of companies that we could not dream of getting control of at the prices paid. More than half the portfolio is comprised companies without any bulge-bracket investment bank coverage. All of our holdings have significant pent-up earning power that may not be obvious in traditional screens, but apparent when viewed over a non-traditional time horizon.
Please feel free to contact me with any questions.
Thank you for your support.