Black Bear Value Fund 1Q17 Commentary

Black Bear Value Fund commentary for the first quarter ended March 31, 2017.

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"The way to get started is to quit talking and begin doing." - Walt Disney

To My Partners and Friends:

Black Bear Value Fund, LP (the “Fund”) returned approximately (0.6%) for the 1st quarter of 2017 (1). This compares to 5.5% for the S&P 500. A fundamentally-driven and concentrated investment portfolio should outperform various market indices over a long-term horizon with reduced risk of permanent capital impairment. Each investors’ return will vary depending on the timing of the investment.

Brief descriptions of the top 5 long positions follow.

Alphabet Holdings

Alphabet is the holding company for Google (Advertising/Search) and Other Bets (Ex: Waymo, Nest, Google Fiber). Alphabet is a cash-machine with 40+% returns on capital and a fortress balance sheet (no net debt).

Ex-cash and other-bets, Alphabet is trading ~6% free-cash flow yield and grows 15+%. Other Bets obscure the cash-generative abilities of the company as they currently lose money and burn cash. While pricing per click (the price Alphabet gets) has been in decline, the number of clicks (the volume) is growing as more and more people are glued to their mobile devices. Mobile is a lower price point but much higher volume. Think of this the next time you ask your friend or family member to put their phone down – they could be clicking and making you money as an Alphabet shareholder.

The world is getting more connected every day and should be a persistent tailwind. It’s hard to know where Other Bets goes…. but ascribing ingenuity and creativity a negative value seems short-sighted. In other words, if Other Bets never take off and we own Alphabet at a 4-5% yield + growth of 10+%, we’ll be ok. I tend to think they may surprise us.

Berkshire Hathaway

Describing Berkshire in a simple manner is a challenge. Allen Mecham did an admirable job describing BRK as a “meat grinder that relentlessly piles up value year over year (and decade over decade).” Berkshire is trading ~1.5x book value which underestimates its true intrinsic value. We own BRK at a 20+% discount to the combined value of their stock portfolio and their operating businesses (at a 10x multiple). Add in the benefits of investing free money (the float from insurance) and a business compounding at high single digits with wide moats and you get the aforementioned meat grinder.

Over the last decade earnings from Berkshire’s private businesses have compounded ~9% per annum, while the investments (the stocks and bonds) compounded at ~8% per annum. The team of Buffett/Munger and others have created a business that will succeed long into the future with attractive growth prospects.

Interactive Brokers

Interactive Brokers is the lowest-cost automated global electronic broker with a wide variety of clientele. Management owns ~83% of the company and runs the business with a long-term growth mindset. The electronic brokerage generates a mid-single-digit free-cash flow yield today while growing the account base/client equity by 15+% per year. Recent trading activity has been slow which leads to the opportunity to invest. IB is in the early stages of shutting down their low-margin market making business freeing up capital and increasing margins and growth. The stock seems to be punished for having too much capital (it’s overcapitalized by $4+BB or $10+ a share from a regulatory perspective). They want to not only be the cheapest and best broker, but the safest (zero debt on the balance sheet). Over time the combination of a great product at a discount to competitors coupled with an impeccable balance sheet should lead to a healthy compounder with very low risk of permanent capital impairment.

Phillips 66

Phillips 66 is a vertically integrated downstream refiner with varied businesses across midstream (pipelines transporting oil/gas), chemicals and gas stations. Their dependence on refining will be greatly reduced over the next 18-24 months as new midstream and chemical projects contribute a more stable cashflow. Many investors want to see the cashflow from new projects before paying for it. We are comfortable buying today and being patient. Over the next 2 years PSX should be generating free-cash flow in the low to mid teens on today’s stock price. This is largely due to a double benefit of exiting capex cycles (less money out the door) and new projects contributing cash (more money coming in the door). Management continues to buy back stock at cheap prices (15% bought back over the last 3 years) and takes a mindful approach to capital allocation within their business units. A more stable/sticky stream of cash should translate into a more fairly valued company. In the meantime, we encourage management to keep buying back more stock.

21st Century Fox

21st Century Fox is a diversified media conglomerate across cable networks, film and television studios. We own Fox ~7% free cash flow yield with an ability to grow earnings 5-10% and upside from a variety of ventures. It is a stickier business than most realize as they control quality content and can dictate some element of price. In the age of multiple forms of media delivery, content is king. Fox can continue to increase pricing for affiliates and advertisers if they have content that consumers want to see. As viewers increasingly use DVR’s, the value of live programming increases (sports and news). Fox News is one of the 10 most watched cable channels and is a must to include in most cable bundles. Fox has a wide variety of valuable sports rights (Example: NFL, MLB) which gives them negotiating leverage both with content distributors and advertisers. Longer term investments in HULU (Fox owns 30%) and Star India should add to the growth profile.

Cash

The Fund has a lot of cash/treasury bills right now (~37% at quarter end). I am not making a macro/stockmarket call and continue to look for interesting ideas to invest in. We take a multi-year and patient approach to the investment horizon. Admittedly it’s more fun to have obvious ideas raining down from the heavens but alas. Having dry powder on the sidelines is something that is necessary though unexciting. The benefits of cash only prove themselves over time and in the short-term make you far less popular in investor meetings. As a reminder, I am a significant LP in the Fund so rest assured that the investments and associated cash levels are considered with care and discretion.

Forecasts/Predicting the Future

Investment managers are frequently asked to predict a variety of issues ranging from the economy to the trajectory of the stock market and the policy impacts from the U.S. and foreign governments. Many are surprised when I say “I’m not sure.”

Watch CNBC and you will see lots of absolute predictions with limited accuracy. The projected confidence of many fund managers leads investors/friends/family to follow the opinions of whomever sells it best. Coming up with a range of outcomes or saying “I don’t know” can make one sound uninformed or stupid.

Our mission is not to predict the variables above. We are looking for good investments with low-risks of permanent impairment of capital. Let’s highlight some of the things people are excited about:

Lower corporate taxes/repatriation of foreign cash
Less regulation
Loosening of constraints on banks’ balance sheets stimulating further growth in the economy

Lost in much of the excitement is the acknowledgement that there are a lot of hard to know questions/issues facing the world. This is also not an exhaustive list: