Corsair Capital Management commentary for the third quarter ended September 30, 2016.
Dear Limited Partner:
[drizzle]For the third quarter ended September 30, 2016, Corsair Capital was up an estimated 2.5%* net, after all fees and expenses, bringing our 2016 performance to 3.1%*. Corsair Select was up an estimated 3.2%* net, after all fees and expenses, bringing our 2016 performance to 4.4%*. Since inception in January 1991, Corsair Capital’s compounded net annual return is 12.6%. Since inception in January 2004, Corsair Select’s compounded net annual return is 10.8%.
Equity markets continued to rise in the third quarter as interest rates generally continued to decline around the globe. The bull market in bonds (i.e., declining interest rates) has now lasted some 35 years, dating back to October 1981 when the yield on the 30-year Treasury bond reached 15.23% – what a difference a generation or two makes. Just a few years ago Sub-Zero only meant an appliance brand and not the investment return on much short-term sovereign debt!
As we have discussed in a number of our past letters, very low returns on bonds have all sorts of investment implications, not the least of which is very high theoretical equity valuations based on dividend discount or discounted cash flow models. Likewise, this great reduction in interest rates caused by purchases of bonds by Central Banks (in the hopes of stimulating inflation and growth) has forced investors to look for yield outside of fixed income securities. As one investment pundit put it, “dividend paying stocks are the new long-term bond.”
Another investment theme of late has been the popularity of investing into index funds (both ETFs and mutual funds). Over the years, the pendulum has swung back and forth between active management and passive investing. Lately, the pendulum is clearly in the passive camp, taking with it money flows out of active managers’ hands and into the index funds. This movement of funds means, on the margin, there is selling pressure on non-index names and incremental demand for the individual stocks in the major indices. For a while, this movement of money exacerbates the situation as investors flock to what currently is working (to us, akin to market flows in 1998 and 1999). However, for the long-run, we believe this means non-index stocks are under-owned and undervalued, while the opposite is true for those in the major indices.
Furthering this investment theme, Central Banks have recently started to buy stocks in addition to their vast bond purchases. In particular, it is thought that the Bank of Japan, the Swiss National Bank, and an affiliate of China’s Administration of Foreign Exchange have been large buyers of global equities, likely on a market weighted indexed basis. We believe this buying has clearly buoyed the largest stocks within the largest global indices.
In a recent interview, Joel Greenblatt, Columbia University professor and professional investor, describes the futility of investors chasing recent investment trends. “Multiple studies will tell you there is very little correlation between the past one, three, five [year periods] and the next one, three, five. So people should really look for managers that follow a process they can believe in and stick with over the long term.” Greenblatt furthers this point by mentioning his discovery that the best performing fund between 2000 and 2010 was up 18% per annum. However, on a dollar-weighted basis, investors in the fund actually lost money (!) as they chased after good performance and left after the poor years.
As we start the last quarter of the year, interest rates have ticked up a bit. Some analysts believe this is due to new regulations that affect prime money market funds, which took hold as of early October. As a long delayed reaction to the financial crisis of 2008, when regulators became concerned about the potential collapse of certain money market funds holding Lehman Brothers debt, these new rules allow prime money-market funds to impose redemption fees and/or halt redemptions in times of market stress. While these rules might make the “system” safer in the long-run, in the short-run, investors have reacted by leaving these funds. Some believe this shift in holdings has, in turn, caused a rise in the cost of hedging currencies for overseas investors looking to pick up yield amid ultra-low or negative rates at home. Thus, higher interest rates here are needed to make their swaps worthwhile. Once this shift in money market holdings is over, however, it is quite possible for hedging costs to normalize to previous levels and for interest rates to tick back down.
Finally, the election season is upon us. What can we say that hasn’t already been said elsewhere? No matter who is elected President in November, there will be a large portion of the population very unhappy with the result. Of course, this is well known. Less well followed here in the U.S. are the elections in Italy, including a referendum on changes to the Italian Constitution. Prime Minister Matteo Renzi has warned that if he does not get the authority to proceed with reforms, he will resign, which might put Italy inadvertently on Britain’s European Union exit path. While the betting is currently with the Prime Minister, this is a reminder that shortterm pot holes are an inevitable part of the investing game.
Generally speaking, our outlook is for slow growth around the world with interest rates remaining at below historical average rates. We expect to continue to own a U.S.-centric portfolio quite different than that of the S&P 500. Most importantly, we believe our 26-year investment practice of investing in companies going through change will continue to stand us in good stead over the long term.
Corsair Capital Management – Portfolio Update
The largest contributors and detractors for the quarter were:
Quintiles IMS Holdings (“Q”), an investment we featured in the Appendix of our Q2 2016 investor letter, rose 24% for the quarter. The stock’s performance was driven by strong standalone Q2 results at both Q and IMS. Q reported revenue and adjusted EPS above consensus expectations and raised full year EPS guidance. Most importantly, after a disappointing book-to-bill in Q1, Q posted a book-to-bill of 1.6x at its core Product Development segment for Q2, which eased concerns and allowed investors to focus on the pro forma company. IMS posted an EPS “beat and raise” as well for the quarter, providing significant momentum for the shares as the announced merger with Q drew closer to completion in early October. Our view is that the new combined company’s earnings power will grow toward $8.00 per share by 2020 and is a high-quality business deserving an earnings multiple of 20x or more. Q stock closed the third quarter at $81.06.
Voya Financial Inc. (“VOYA”) increased by 16% during the third quarter as investors began to regain confidence in its ability to manage through a protracted low interest rate environment. As we noted in our last letter, VOYA’s stock has struggled over the past 12 months due to concerns around earnings and capital sensitivity to interest rates. During the quarter, VOYA gave investors