Value Investing

Semper Augustus 2016 Annual Letter – Sympathy For The Dog

Semper Augustus Investments Group letter for the year ended December 2016, titled, “Sympathy For The Dog – Challenging Dogma, Death Of The Profit Margin, And A (Brief) Berkshire Redux”

2016 Hedge Fund Letters

 

Sympathy For The Dog

Challenging Dogma, Death Of The Profit Margin, And A (Brief) Berkshire Redux

Please allow me to introduce myself; I’m a man of wealth and taste

I’ve been around for a long, long year; Stole many a man’s soul and faith

And I was ’round when Jesus Christ had his moment of doubt and pain

Made damn sure that Pilate washed his hands and sealed his fate

Pleased to meet you; Hope you guess my name

But what’s puzzling you is the nature of my game

I stuck around St. Petersburg when I saw it was a time for a change

Killed the Tsar and his ministers, Anastasia screamed in vain

I rode a tank, held a general’s rank

When the blitzkrieg raged and the bodies stank

Pleased to meet you; Hope you guess my name

Ah, what’s puzzling you is the nature of my game

I watched with glee while your kings and queens

Fought for ten decades for the gods they made

I shouted out, “Who killed the Kennedys?”

When after all it was you and me

Let me please introduce myself; I’m a man of wealth and taste

And I laid traps for troubadours who get killed before they reached Bombay

Pleased to meet you; Hope you guessed my name

But what’s puzzling you is the nature of my game

Pleased to meet you; Hope you guessed my name

But what’s confusing you is just the nature of my game

Just as every cop is a criminal and all the sinners saints

As heads is tails just call me Lucifer

Cause I’m in need of some restraint; So if you meet me

Have some courtesy; Have some sympathy, and some taste

Use all your well-learned politesse, or I’ll lay your soul to waste

Pleased to meet you; Hope you guessed my name

But what’s puzzling you is the nature of my game – Jagger/Richards

Can you guess the name of the protagonist? Many of you would conclude it’s the new occupant of 1600 Pennsylvania Avenue. Some of the verses fit rather well…For others of you, that would have been your guess prior to November 8. Our country has been profoundly divided many times in its history, but we have never observed firsthand such hatred and contempt as today. Of course, the lyrics belong to the Rolling Stones’ Sympathy for the Devil. It seemed a fitting lead.

Semper Augustus

Last year’s letter borrowed its title and the first verse and chorus from Prince’s anthem, Party Like It’s Nineteen Ninety-Nine. Sadly, Prince is once again, and will forever be, The Artist Formerly Known As.

Some observed our timing was forebodingly coincidental. The title and lyrics fit the day as we drew parallels with the market craziness in both 1999 and 2015.

Much of the insanity persisted through 2016, though market breadth vastly improved, and a rising tide lifted the market to all-time highs. Many of the great branded consumer franchises fetch prices rivaling those seen in 1998, the peak of the “new” Nifty Fifty. On insanity, 2016 closed at a political crossroads, with the country divided and many in a manic stupor. Shakespeare would have had a field day if he were alive. However it evolves, we expect the next four years to be jam-packed with entertainment. Tragedy or comedy? Find a safe space, pull up an armchair and behold the tale.

While we sincerely doubt any preternatural correlation with our writing about Prince and his untimely demise last year, we played it safe regardless by awarding this year’s theme to the Stones, because everyone knows they’re going to live forever, especially Keith Richards, the co-author of Sympathy, the epic lead guitar and occasional lead vocalist. With a dedicated effort, I finally finished Keith’s memoir, Life, last year. It was written with James Fox in 2010, and occupied a place among the stack on the nightstand for four years. It’s an incredibly incoherent but interesting history, especially for a lifelong Stones fan. Keith’s remaining brain cells allow him to recount wandering stories while Fox interprets. I found you could only read a few pages and then had to decompress and set it aside for a few days, or weeks, but couldn’t help but come back at times.

This year’s letter begins with a contrast of the things in investing that are within our control and those that are outside our control. We are no more geniuses today for portfolio returns north of 20% last year than we are dolts in years when our portfolio declines in price or underperforms the market. We can control two critical inputs – the quality of the businesses we invest in and the quantity of earnings our businesses produce. By controlling these two essential aspects, satisfactory returns should follow over the long haul. We have no control over stock prices over short periods of time. The stock prices of our businesses will ultimately reflect the earning power of the underlying businesses, thus correlating to things we control. Time is the arbiter of investment outcomes, success comes by controlling the important inputs.

From there, the letter delves into a rare “aha” moment in which a previously sacrosanct investment truth is dispelled. Letting go of long-held biases and convictions, particularly those shared by others, is difficult. After much thinking, we now conclude that profit margins mean reverting to a historically observable range is now an irrelevant concept because the amount of capital required to produce a dollar of revenues has grown. In this case, capital is not capital expenditures, but the combination of equity and debt employed in the business. If a range exists for profit margins, it is now higher than conventionally believed. Many won’t agree (I do) with our conclusion. To support the hypothesis, we compare two companies side by side on a common size basis to demonstrate what really matters in investing, and it’s not the profit margin.

We then wade back into the swamp with a brief follow-up to last year’s dive into Berkshire Hathaway. We’ll answer a couple questions raised in response to the letter, then go off the reservation with a persnickety diatribe about some Berkshire intrinsic value numbers moving around in last year’s Chairman’s letter. Finally, we conclude with a current intrinsic value estimate for Berkshire and an updated ten-year expected return for the shares. An appendix, with updated tables, supports our Berkshire valuation methodologies.

Money Dog

Amazon Claus came early last year, he came often, too, delivering Phil Knight’s recently released memoir, Shoe Dog, on Christmas Eve. The book proved a wonderful holiday read. Unlike the Keith Richards memoir, which took four years to work through, I read Mr. Knight’s over two nights.

Like is widely known as one of the world’s largest athletic apparel companies, but it’s much more than that. It is an icon, one of the world’s great consumer brands, and Mr. Knight’s memoir is a wonderful accounting of the firm’s founding and its pre-IPO years. For the investment crowd, the story is a great example of the value of growth. I hadn’t known that Phil Knight was a public accountant for many years, including many of the years when he first founded and led the business, then known as Blue Ribbon Sports. If Phil Knight did anything well, and most of what he did was great, it was understanding the exponential growing demand for what he was selling and his push to meet that demand at nearly all costs. Most accounting-oriented investors would have passed early on, given the debt used to finance exponentially growing inventories. Many of his bankers shortsightedly did.

There are great lessons from the book – hire and surround yourself with the best talent whenever you find it, control your distribution, ensure product quality, and perhaps most importantly – have enormous fun along the way – make sure your work is also your play. In the memoir, Mr. Knight reveals that “shoe dogs” are those whose entire lives and passions are consumed by shoes. Phil Knight lived, breathed, ate and drank Nike, and it is obvious he loved every minute of the game. He was and is the consummate Shoe Dog.

The holidays are a reflective time, and while reading Mr. Knight’s memoir, it dawned on me that investment managers are dogs, too. Phil Knight became the top shoe dog. Investment managers are, well, just, dogs. But if an absolute passion for the shoe business earned its most devout the moniker shoe dog, then why not “money dog” for those consumed by the discipline of value investing!

In 2015, when our investment returns were down, despite the median stock in the major indices being way down, we were regardless in the doghouse. Bad dog! You lost money. Your largest position cratered 12.5%. Shame. We get it, nobody likes to open a statement and see a shrinking balance. However, rising prices don’t affirm that the process is working, and falling prices don’t confirm the process is broken. You are neither right nor wrong because the market agrees with you in the short run. Last year’s letter was penned to approvingly show our “owners” we weren’t bad at all, that dogs can control only what they can control. We argued that as investors we can’t control or predict stock prices in the short-term, that it’s the underlying earning power of the business that matters, and that, we can control.

2016 was an attaboy year from the start. Throughout the year, despite a drag from an increasing stockpile of cash from realized gains that are now more than 20% of assets, our performance roughly doubled the 11.96% return posted by the S&P 500.

Time passes, and Semper Augustus is now in its 19th year, and I am now navigating my second quarter century as a professional money manager. Believe me, although we try to remind everyone that we can’t control prices, when prices decline, we have to remind ourselves of that as well. There is nothing to test your conviction in a business or investment like a declining price. Rising prices confirm an investment thesis (in some cases prematurely). Rapidly rising prices can bring the opportunity to reduce or eliminate position sizes when the after-tax proceeds can eventually be invested in lower price, higher earning situations. We always strive to control two variables – business quality and price. Time to get back out on the hunt!

Semper Augustus: Intrinsic Value Update – The Case For Active Management

The 2000 Report Usefully Projected the Long-Range Result

Last year’s letter walked through the history of an intrinsic value report we have run since March 2000, used to contrast the valuation and expected return of our portfolio with that of the S&P 500. Sixteen years on, the report demonstrates its utility.

The first Intrinsic Value report run on March 31, 2000 suggested we should earn our earnings yield of 6.4% per year, plus another 2% to 3% per-year as the discount on our portfolio holding at the time accreted upward to our appraisal of intrinsic value for each holding. Our stocks earned 8.6% per year since the running of the report through year-end 2016. By contrast, the index had an earnings yield of 2.5% at March 31, 2000, and needed to fall roughly 60% to attain our appraisal of fair value. As such, the earnings yield of 2.5% was the base case expectation for the annual return of the index for a long, long time, and a case could be made for the index spending substantial time in negative territory. Since March of 2000, the index returned 4.4% annually, and has yet to work off much of the excessive valuation that existed 17 years ago. By our math, the index still needs to fall somewhere between 33% and 50% to reach fair value.

The 2015 and Current Vintage Reports

At last year’s writing, our Semper Augustus stock portfolio traded for 12.1 times normalized earnings, which gave us an earnings yield of 8.2%. If our businesses produce profits consistent with our analysis, then the earnings yield effectively becomes our base expected return over a ten to fifteen-year horizon. Additionally, our stocks traded at 80% of intrinsic value, which allowed for 25% upside to fair value as the discount accretes over time. At 80% of intrinsic, we’d expect to earn an additional 2-3% per year in addition to the earnings yield. Adding these together, our long-range expected annual return from year-end 2015 was about 10.2 to 11.2% (about 2-3% above the earnings yield – not meant to imply precision that doesn’t exist).

Our stocks generated a total return of 27.6% in 2016. You would naturally assume that most of the discount to intrinsic value which valued our stocks at 80 cents on the dollar would have been “used up” by last year’s gain. By simple math, our stocks should now be closer to 95% of intrinsic value, and the expected annual return would mostly consist of the current earnings yield. So, where are we today?

Our stocks are trading at year-end 2016 at a higher, but still cheap, 13.5 multiple to normalized earnings, giving us a 7.4% earnings yield, which becomes our new base case return expectation for a ten to fifteen-year horizon. Importantly, our stocks still trade at a sizable discount to intrinsic value of 82% of value,
giving us 22% upside should the gap close.

How can we still have a healthy discount to intrinsic value? A portion of the long range expected return did erode thanks to the outsized return for the year. Adding a similar 2-3% per year accretion of the discount, our long-range expected annualized return is now logically a bit lower, 9.4-10.4% versus 10.2-11.2% as calculated last year. We therefore shaved 0.8%, or 80 basis points, from the expected long-term annual expected return. The shave is largely due to the expansion in the portfolio’s P/E from 12.1 times to 13.5 times, effectively accounting for 11.5% of last year’s gain. But where did the rest of the gain come from, and why is the portfolio still similarly undervalued?

Death Of The Profit Margin – A New Permanently High Plateau

The “laws of economics” have characterized the after-tax profit margin as a value that reverts to its historical mean over time. We argue not that the profit margin is what’s important in investing, but rather that changes in the amount of incremental capital required to produce a dollar of profits, and the return on that incremental capital, is far more important.

Much of the investment world fixates on profit margins. Are they low? Are they high? Are they just right? Do they mean revert? When will they mean revert? What are they telling us about valuations? How do they interact with P/E multiples? We killed a forest of trees writing about this question in earlier client letters.

The profit margin simply measures how many dollars of profit are created for each dollar of sales. It is the same as return on sales: After-tax profit / revenues = profit margin.

Hold the Pickles, Hold the Lettuce – Profits Your Way

Profits are calculated three different ways. Conventionally, Standard & Poor’s calculates two types of profits, “operating” earnings and “as reported” earnings. Operating earnings measure income from product (goods and services) and exclude corporate (M&A, financing, layoffs) and other unusual or nonrecurring items. As reported earnings measure income from continuing operations, and are also known as GAAP (Generally Accepted Accounting Principles) earnings. GAAP profits are after write-offs and write-downs.

Pro forma earnings are a third variety, largely favored by managements and stock promoters. Managements have incentives, often related to their compensation, to make profits and profit margins look as healthy as possible. Shock of shocks. Many, therefore, insist on calculating profits using pro forma earnings, which excludes all kinds of expenses such as non-recurring or non-cash expenses like share based compensation. This is misleading. When managements provide pro forma earnings or cash flow calculations as supplemental to their GAAP profits, they are almost always higher than their GAAP earnings. Pro forma is the equivalent of saying if you don’t count the 3 touchdowns the other team scored when our star linebacker was hurt, and you count our touchdowns that were called back for holding and the illegal block in the back, we won the game 14-0 on a pro forma basis. Please ignore our 21-0 defeat on the scoreboard.

At Semper, we begin with GAAP earnings and make any number of adjustments, both upward and downward, to adjust for a more economic, cash driven reality. The adjustments we make are in no way made to flatter results, we have no incentive to do that. We are trying to properly measure economic profitability and also properly measure the amount of capital employed in a business. Some of our methods produce earnings calculations that are materially different than under GAAP. Sometimes you find businesses where economic profitability is far in excess of convention, and other times you find businesses where reported profits are well in excess of what can be economically expected to be earned over time. Here is a table providing a general comparison among the methodologies:

Semper Augustus

See the full PDF below.

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