Wedgewood Partners commentary for the fourth quarter ended December 31, 2016; titled, “Changing Of The Guard.”
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2016 Hedge Fund Letters
Many shall be restored that now are fallen, and many shall fall that now are in honor. — Horace, Ars Poetica
Wedgewood Partners – Review and Outlook
Our Composite (net-of-fees)i gained +2.30% during the fourth quarter of 2016. This gain compares favorably with the gain of +1.01% in our benchmark, the Russell 1000 Growth Index and unfavorably versus the S&P 500 Index’s gain of +3.82%.
For calendar 2016, our Composite (net-of-fees) gain of +4.55% lagged the gains in both our benchmark (+7.07%) and the S&P 500 Index (11.96%).
Top fourth quarter performance contributors included Berkshire Hathaway, Cognizant Technology, Charles Schwab, Schlumberger, and Tractor Supply. Absolute performance detractors during the quarter included TreeHouse Foods, LKQ, Visa, Mead Johnson and Stericycle.
Top 2016 calendar performance contributors included Berkshire Hathaway, Qualcomm, Schlumberger, Apple, and Priceline. Absolute performance detractors during 2016 included Stericycle, Perrigo, Express Scripts, M&T Bank and TreeHouse Foods.
During the fourth quarter, we trimmed our positions in Express Scripts and Cognizant Technology. We added to our positions in TreeHouse Foods, Visa, and Kraft Heinz. We sold Stericycle. We also initiated new positions in Fastenal and Tractor Supply Company.
Changing of the Guard. 2016 will go down as a seminal year, when so much unexpected change took place at an unprecedented pace. Who could have predicted Brexit, Italy’s constitutional reform, and Trump’s nomination and presidential victory? Financial markets, as always, discount such geopolitical news with ferocious speed. 2016 was the year that interest rates bottomed as the 10-year U.S. Treasury fell to just 1.36%; corporate earnings bottomed after a five-month recession; and oil bottomed after OPEC reversed its two-year strategy of flooding an already oversupplied oil market, breathing life back into a heavily depressed non-OPEC E&P industry and heavily depressed OPEC fiscal budgets.
Even high-yield debt surprised, returning approximately 17% – almost triple the return of investment-grade debt. The early “fear” of a Trump presidency dramatically turned into a bull-run of “animal spirits” after the election.
The biggest winners in the stock market were those stocks that had been crushed in the past year(s). Our top four performers in 2016 were among our worst performers in 2015, as all four posted negative returns in 2015. 2016 will also go down as one of the tougher years for active investors in recent memory. It was an environment in which it was difficult to deliver benchmark outperformance, and while the five-quarter earnings recession ended, out-sized earnings growth was difficult to deliver for most of corporate America. Wall Street is always a demanding mistress who shouts, “Show me the money!” no matter the economic environment.
In a world starved for growth and yield, investors over the past year also continued to shout, “Send us the money!” The C-suite placated their respective shareholders by distributing the lion’s share of earnings in the form of dividends and outsized share buybacks. Wall Street applauded heartily. Indeed, those companies that chose to distribute the bulk, if not all, of their respective earnings since 2012 have been rewarded quite handsomely by Mr. Market.
Specifically, as calculated by Strategas Research Partners, companies that have engaged in share repurchases have been on a winning streak this entire bull market. Dividend payers have been a winning strategy since 2011. In addition, historic QE-monetary policy has also rendered a debt cost-of-capital tailwind to those poorly financed companies not seen since the credit bubble years of 2006 and 2007.
We at Wedgewood Partners philosophically shout, “Reinvest the money!” We have always preferred to invest in higher quality, less-indebted companies that reinvest the bulk of earnings. We believe that such cap-ex/op-ex is the mother’s milk of future earnings growth. Companies, whereby the reinvestment of earnings has been the priority over distributions, have suffered in the performance rankings since 2012, notably so in 2016. And so have we. Also, in such a low-growth environment, a common C-suite strategy is to “buy growth” in the form of mergers and acquisitions.
Looking ahead to 2017 and beyond, we may be at a changing of the guard moment in terms of Mr. Market’s enthusiasm for the recently favored C-suite capital allocation strategies. According to Leuthold & Co., for the first time ever, corporate America returned over $1 trillion dollars to shareholders (over a trailing 12-month period) in January 2016 in the form of dividend payouts and outstanding share repurchases, exceeding the prior cyclical peak set in 2008. Cash returned as a percentage of sales by industry sector tells a similar tale. Most sectors are closing in on respective 2008 peaks.
Lastly, and most disconcerting, is corporate America’s collective debt load, (again, according to Leuthold & Co.) which has skyrocketed and is approaching 25-year highs set back in late 2007. Aggregate long-term debt has once again reached $6 trillion this summer. Furthermore, long-term debt issued by S&P 500 companies has increased by a none-too-small 75%. The debt for dividend/buyback spigot could shut off rapidly even if interest rates do fall back to summer 2016 lows. (The offset, as it were, is that generational low interest rates have lowered the burden to service more debt.)
Combining the aforementioned use of cash flow with copious amounts of debt, the most common C-suite strategy to expend this capital has been for share buybacks and dividend payments. Success in growing sales and income has been found by buying “growth” via mergers and aquisitions. Relatedly, rare is the company that has successfully grown sales or income organically while issuing debt.
Even a quick perusal of the table below will surprise most with the astonishing increase in debt in almost every major industry sector. A few noteworthy comments: The energy sector’s ratios have been inflated by the depressed state of sales after the most dire, 24-month industry correction in decades, and utility companies have embarked on large ratebased plant expansion in recent years.
The nature of information technology has changed dramatically over the past dozen years. Large, well-entrenched industry leaders may not have much growth inherent in their businesses these days, but they generate cash at historically high levels. Debt funded dividend payments and large-scale share buybacks have become the norm during this cheap-debt era in IT.
Health care, consumer staples, and even consumer discretionary companies have broken the mold in their collective embrace of leveraging up their respective balance sheets with long-term debt. The use of this debt is to “buy growth” via M&A, and of course, to fund capital returns to shareholders.
We should note successful examples of the use of outsized debt by our own invested companies. Consider Apple. Apple generates enough cash ($65 billion in operating cash TTM) that even after spending $10 billion in R&D in fiscal 2016, the Company’s balance sheet liquidity grew almost $10 billion, to over $250 billion. This trove is trapped overseas awaiting a change in U.S. repatriation laws – a potentially significant bullish event for shareholders. In the meantime, in order to return this cash back to shareholders, the Company has issued over $75 billion in debt.
Further, and often left unremarked by Wall Street’s finest, is the rapid, and accelerating growth in Apple’s R&D spending over the past few years. Clearly the Company does not need to spend $10-$15 billion per year to sustain the evolutionary upgrades to the iPhone, iPad, Apple Watch and/or new video streaming services. Apple’s nascent automotive program Project Titan may not be at all about creating a complete autonomous driving car (Apple Car), but rather the creation of software that makes existing cars smarter – or even autonomous. Now that is a huge, creatively disruptive opportunity.
Kraft Heinz is a rare example of a company that has issued sizable debt with the goal of increasing sales and earnings – particularly earnings, in the case of Kraft Heinz. The unique, hard-to-copy management style of 3G (entrepreneurial, zero-base budgeting), coupled with low-cost debt, has proven to be quite a powerful combination for driving higher profitability well beyond industry peers.
The Great Bull Market of 2009-2016
Changing of the guard? The Great Bull Market will likely celebrate its 8-year birthday come March. Not only is this bull market one of the greatest in terms of cumulative gains, but also in the remarkable consistency of its positive calendar year gains during its +7-year duration.
Mr. Market’s collective exuberance over the prospect of a Trump administration has once again pushed valuations to historical extremes. By almost every relevant measure, the stock market has priced in good tidings – perhaps too good. P/E, EV/EBITDA, and global P/E multiples are at nose-bleed levels.
Since Trump’s election as the 45th president, the Dow Jones Industrial Average (as of this writing) has posted 18 record-high closings, trumping (bad pun) even Ronald Reagan’s election honeymoon in 1980. In addition to Trump’s surprising victory, we argue that equally as important was the GOP’s continued control of Congress. We are typically fans of legislative gridlock, which allows for a more predictable backdrop against which we can execute our bottom-up process; however, the GOP’s various pledges for fiscal stimulus have helped rekindle cyclical animal spirits, with investors hoping it might ignite upon a nearly a decades’ worth of unprecedented monetary stimulus. That said, in mid-December, the European Central Bank extended its pledge to continue vacuuming up risk-free assets, expanding the program to a staggering $2.4 trillion, which we think could put a lid on debtissued cost of capital, at least until we see more concrete terms for U.S. fiscal stimulus.
As for the stock market in 2017, Trump enters office with the headwinds of the aforementioned historically stretched stock market valuations, an economic expansion that began long ago in June of 2009, and a Federal Reserve that has begun tightening monetary policy. Indeed, to those who subscribe to the Atlanta Fed’s theory of “shadow tightening” via the size of the Fed’s balance sheet, the Fed actually began tightening back in 2014. Todate, they calculate the “Shadow Fed Funds Rate” has de facto tightened by as much as 325 basis points. The Federal Reserve, more than Trump’s fiscal or regulatory initiatives, and more too than the prospect of a sharp revival of corporate earnings growth will most likely drive the direction of the stock market in 2017. In our view, the unknown key for the economy, the valuation of stocks, plus the continued appetite for debt-based capital allocation in the C-suite, is: at what level does the rise in interest rates bite hard enough? The peak bite in the Federal Funds Rate in 2000 was 6.5%. The peak bite in 2007 was 5.25%. In today’s debt-ridden economy (government, corporate, and individual), will 2.50%, 3.00%, or 3.50% be the bite that ushers in a changing of the guard in asset returns?
Company Commentaries
Berkshire Hathaway
Berkshire Hathaway continues to carry an outsized weighting in portfolios – in fact, the stock continues to be one of our largest holdings. We believe the Company maintains a long-term competitive advantage, evidenced in its below-average cost of capital, which should become more valuable in an environment of both heightened equity market volatility and/or higher cost of borrowing. 2016 operating results were quite impressive given the headwinds in the bull market-laden, over crowded reinsurance business, plus the stagnant growth at Burlington Northern. The stock did enjoy a post-Trump election pop of nearly 15%. Mr. Market’s early enthusiasm for Trump’s fiscal proposals of lower corporate tax rates, if enacted, would certainly benefit Berkshire’s bottom line. The Company could potentially be a huge beneficiary of meaningfully lower corporate tax rates. If enacted, lower corporate tax rates would have an out-sized impact by reducing Berkshire’s deferred tax liability by boosting the Company’s book value. The Company currently has amassed a massive $65 billion deferred tax liability that Buffett himself has equated to an interest-free loan from the U.S. government. If Trump, and the Republican controlled Congress are successful in lowering corporate tax rates to 15% from the current statutory rate of 35%, the Company’s book value could rise double digits. In addition, given the terrific year-end rally in bank and financial stocks, the nice pop in the Company’s multibillion-dollar holdings, including American Express, Bank of America, Goldman Sachs, M&T Bank, U.S. Bank, and Wells Fargo. Bank of America and Wells Fargo enjoyed outsized gains during the quarter of 42% and 25%, respectively. Berkshire’s bank and financial stock holdings have now reached a cumulative market value of over $57 billion.
Fastenal
Fastenal is a company we have followed and admired for many years. The Company is a distributor of manufacturing and construction supplies – generally consumable parts and products such as fasteners (i.e., screws, nuts/bolts) and various items used in the maintenance, repair, and operations (MRO) of customers’ plants. The company has established a differentiated position in its industry by investing heavily to get itself as close as possible to a generally smaller, less urban customer base than its competitors. This is most evident in its extensive network of more than 2,500 branch locations, which the company effectively uses as selling and distribution outposts to serve its customer base. We contrast this with Fastenal’s largest competitor, Grainger, for example, which has only 300-odd branch locations (and shrinking) despite having twice the revenues as Fastenal. We believe this has led to a fairly healthy segmentation between the Company and its competitors: Fastenal has specialized in smaller, geographically dispersed clients who are more heavily reliant on the Company’s local distribution capabilities, sales expertise, and somewhat more specialized, locally tailored product lines; Grainger and other competitors specialize in larger, more urban clients who have more distribution and service requirements, so these distributors generally focus on more standardized products, in large quantities at the lowest cost. When we observe the healthy, and remarkably steady, returns on investment across the major competitors in the space, we view this as confirmation that the major players, for the most part, have managed to carve out profitable segments of an attractive industry without tripping over each other.
Fastenal has extended its differentiation in recent years through three other initiatives designed to get closer to its customers. First, the Company has installed over 60,000 vending machines in customers’ plants, in which they constantly replenish products customers use regularly in their manufacturing processes. Second, the Company has accelerated the expansion of its Onsite program, in which it basically opens a small Fastenal store within a larger customer’s plant. Fastenal staffs and stocks this mini-location, effectively taking control of a portion of the customer’s supply chain. It is important to note that both the Vending and (especially) Onsite initiatives further integrate the Company into a customer’s operations, helping to make these customers stickier. Third, Fastenal has invested in additional inventories over the past several quarters, while also shifting a higher percentage of its inventory from its distribution centers into its branch locations. This once again is designed to get Fastenal as close to its customers as possible – if the Company has the products its customers need, already waiting in their market, available for same-day delivery, at an attractive price, there is no need for those customers to take their business elsewhere, whether that be to a larger, out-of-market competitor such as Grainger or to an online competitor such as Amazon.
We became increasingly interested in the stock around the middle of the year, as we saw Fastenal’s valuation begin to imply an accelerated decline in its end markets, particularly energy and manufacturing. However, our research from our energy holdings helped inform us on this score, as we see North American energy production approaching an inflection, which should help reinvigorate manufacturing-heavy energy service and support industries. We also noted that both presidential candidates were pitching large infrastructure spending projects which would be supplemented by a federal highway bill passed in 2015 – the first long-term bill in over ten years after a series of short-term stopgaps that did not allow states to plan any large or long-term construction projects – and could begin to generate some demand in the near future as states begin to implement spending plans. That said, with the stock trading at or near post-recession lows on most valuation metrics, we did not believe we needed any of these potential catalysts to emerge in the near future, but we were happy to have the possibilities in front of us.
Overall, over a multiyear timeframe, we believe Fastenal should be able to continue to grow at an attractive pace for several years, particularly due to the Company’s continuous reinvestment and explicit focus on profitability. With the stock trading at valuation multiples similar to the last recession, and with key end markets already having been in recession for two years with signs of potential recovery emerging, we think Fastenal represents an excellent long-term investment opportunity for portfolios.
Charles Schwab
Charles Schwab was a top performer in the quarter as the company stands to benefit from the continued normalization of U.S. monetary policy. Despite a single federal funds rate hike during calendar year 2016, market expectations for further rate hikes have dramatically risen in the face of potential fiscal stimulus and higher inflation expectations.
While we understand the market’s desire to discount the near-term “embedded option” of money market fee waiver relief at Schwab, we continue to invest in the Company for its industry-leading pretax profit margins and asset gathering capabilities, which we think are a byproduct of their consistent productivity investments made over the past few decades. We think this positions Schwab well in the increasingly commodified financial services industry, as the Company’s low-cost model and scale allows them to pass savings on to advisors and clients in the form of competitively lower fees, in exchange for mid-single digit platform asset growth. Combined with modest rate relief and continued productivity gains, we expect Schwab to continue posting earnings per share growth in the mid-teens.
Stericycle
We liquidated Stericycle from portfolios after we determined that the Company’s competitive advantage in its core regulated medical waste (RMW) business was not as robust as we had seen during the past five years of our holding period. Prior to the erosion in the economics of their core RMW business, we remained optimistic about Stericycle’s business. Despite recent stumbles in their non-core hazardous waste business and slower than expected integration of newly acquired Shred-it, the RMW business continued to serve as the engine to double-digit growth in free cash flow. We previously believed that Stericycle’s unrivaled scale had served to insulate its RMW profitability from competitive pressures, including customer push-back associated with consolidating end-markets, as many of Stericycle’s most profitable customers – particularly individual physician practices – have been consolidated by managed care organizations over the past several years. However, over the past few quarters, management began disclosing that the long-term contracts associated with these newly consolidated customers were coming up for renewal at significantly lower prices. It is not clear to us why the Company gave up this pricing, given that the market has few large-scale alternatives to Stericycle. Suffice it to say, these contracts are in place for several years (sometimes five years or more), and while the Company can spend this time recovering economics through more cross selling, this strategy is unproven and potentially dilutive. As such we lost conviction in Stericycle’s ability to defend its excess profitability in RMW, and subsequently liquidated our positions.
TreeHouse Foods
TreeHouse Foods was a relative detractor from performance during the quarter after a confluence of a few unfortunate, though we think transient, events. The Company unexpectedly missed its quarterly earnings estimates and reduced 2016 guidance, despite having had a few wins earlier in the year not long after closing the Private Brands acquisition in January. The Company reiterated, however, its long-term accretion guidance for Private Brands. From the time the merger was announced (late 2015), we had seen multiple areas where we think this longer-term guidance is still understated. Because of our belief in this cushion management built into their original guidance, we remain comfortable that they will be able to hit their long-term growth expectations, despite these shorter-term issues.
On the same day the Company announced its disappointing Q3, the company also announced that their COO, Chris Sliva, was leaving the company. He turned up as the new CEO of a small food company a few days later. Fortunately – the only bit of good news on the day – Dennis Riordan, the retiring CFO, reversed his retirement on this news, announcing that he would stay on as President/COO for as long as he was needed.
The market took all of this news badly, combining the poorly timed management changes with what we view as unrelated short-term issues in Private Brands, and concluded that there were serious institutional issues with the company. We think we just had a confluence of unfortunate events. After speaking with management, we remain comfortable with the depth and breadth of the Company’s executive leadership, which is heavily supplemented by the engagement of their board of directors. We also continue to be quite optimistic about the long-term potential of the combined Private Brands and legacy TreeHouse businesses. As the largest manufacturer and distributor of private label grocery products in the U.S., we believe TreeHouse should benefit from the secular shift toward private label, particularly in higher margin natural and organic segments, while driving out costs in lower growth segments, through unmatched scale in both manufacturing and distribution. We remain optimistic about the significant upside reward at TreeHouse, relative to diminished downside risks, and added to our positions on weakness during the quarter.
Tractor Supply Company
Like Fastenal, Tractor Supply Company is a company we have long admired. Management has executed a disciplined retailing strategy where they have carved out a niche, serving rural land owners with higher than average incomes. The Company has very deliberately positioned itself to be distinct from its competitors, namely Home Depot, Lowe’s, and, to a lesser extent, Wal-Mart, primarily by locating itself in more rural locations and focusing on merchandise that caters to the maintenance needs of a rural lifestyle, in a one-stop shop format (i.e. all-terrain vehicle replacement parts and feed for livestock as pets).
We think the Company’s profitability and value proposition will be insulated over time as they have made key tradeoffs to avoid competing with big box retailers, without necessarily impairing returns. As an example, we found evidence that the company’s real estate strategy, on average, has been to simultaneously locate Tractor Supply Company stores further from “big box” competitors, while getting into more densely populated markets. Meanwhile, the Company has managed to lower the build-out and rental costs of their new stores as they have continued to expand the store base aggressively, leading to improved returns – something that is particularly difficult in the brick-and-mortar retail world, where typically new store openings generate a lower level of sales and profitability than mature stores (naturally pressuring return on investment as the company grows). We assume the Company’s continuing store base expansion, as well as a conservative assumption on same store sales, should enable the Company to grow revenues in the mid-to-high single digits over the next several years, with earnings per share growth in the double digits, driven by a combination of flat to modest margin expansion as well as stock buybacks.
When we purchased the stock, it was trading at about 18X NTM earnings, near a five-year low (and well below the nearly 30X seen a few years ago), a rarity in a market where valuations have been extended. The stock had been hit by a few issues in 2016. First, unseasonable winter weather caused a short-term blip in results early in the year; weather, unfortunately, is a recurring risk for this and most other retail businesses, but we do not view odd weather as a long-term, relative issue. Later in the year, the Company was hit by sales weakness in their energy – and agricultural-located geographic markets. However, we think we are closer to the end of a multi-year downturn in these markets, or at least near an inflection point, but recessionary expectations for the Company’s end-markets continue to be built into the stock. So with little risk from further adverse macroeconomic developments, we were pleased that we were presented with an opportunity to establish a position in what we view to be a very high-quality company, generating excellent and stable or improving returns over time, with an above-market growth rate, all at a historically cheap multiple.
Visa
Visa’s valuation came under pressure following the election early November as the market saw a rotation out of higher-multiple tech and financial securities and into more cyclical names. We used this opportunity to increase weightings across accounts as valuation levels became more attractive.
Visa has consistently grown its revenue, EBITDA, and earnings double digits as it has played a key role in facilitating commerce’s multi-decade move away from paper-based transactions. The Company effectively represents the collective economic bargaining power of many of the United States’ and, more recently Europe’s, credit and debit card issuers – particularly banks. Visa has tremendous scale in card transaction processing, as they facilitated over $5.7 trillion in credit and debit volume across more than 120 billion transactions, during their fiscal 2016 – well above 2015 levels. Going forward, we fully expect to see this growth trajectory continue, with added help from the integration of Visa Europe which, as we’ve discussed previously, should help drive double digit accretion.
Conclusion
Wedgewood is pleased to announce the promotion of Sheila Kilper to Chief Compliance Officer, succeeding Bill Thomas, who is focused on his role as President. Sheila has been employed with Wedgewood since 1992 and has been a compliance officer at the firm for the last 15 years, where she has been key in creating and implementing Wedgewood’s compliance policies and procedures. Her previous role at the firm was as a registered representative. Sheila earned an accounting degree from Webster University in St. Louis. Prior to her time at Wedgewood, she worked at Mark Twain Bank. Sheila has been an incredible resource for the firm over the last 25 years and we are excited to have her at the helm of the Compliance Department.
We hope these Letters give you some added insight into our portfolio strategy and process. On behalf of Wedgewood Partners, we thank you for your confidence and continued interest. As always, please do not hesitate to contact us if you have any questions or comments about anything we have written in our Letters.
David A. Rolfe, CFA
Chief Investment Officer
Michael X. Quigley, CFA
Senior Portfolio Manager
Morgan L. Koenig, CFA
Portfolio Manager
Christopher T. Jersan, CFA
Research Analyst
