Black Bear Value Partners LP letter to investors for the third quarter ended September 30, 2017.
“What is right is not always popular and what is popular is not always right.” – Albert Einstein
To My Partners and Friends:
Charlie Munger: Invert And Use “Disconfirming Evidence”
Black Bear Value Fund, LP (the “Fund”) returned approximately 3.0% in the 3rd quarter of 2017 (1) bringing the year-to-date net return to 3.3%. This compares to 4.4% for the S&P 500 in the quarter, bringing its year-to- date return to 14.2%. We opened to new investors as of March 1, 2017 and have returned 5.0% as compared to 7.6% for the S&P 500 in that period. We have maintained more than 25% cash balances during this time as well as a large short position across fixed-income related ETF’s.
As many of you already know a substantial amount of the Fund’s capital is my own. Whereas new fund managers spend most of their time raising money, I spend most of my time focusing on compounding my capital and my LP’s capital over the long-term.
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 (many of the descriptions are similar to last quarter as not much has fundamentally changed). While Interactive Brokers is no longer a top 5 position it remains a meaningful position to the Fund at quarter-end. My feelings about the quality of IBKR’s business, management and overall trajectory have not changed, only the price we have to pay for the stock.
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 media has made much ado about the “run-up” in the prices of tech stocks. I am cautious about painting broad brushstrokes among very different companies, valuations and long-term fundamentals. Alphabet has been growing like a weed and it is likely to continue. There is limited value in these short-term predictions and worrying about them can lead to a lot of wasted time.
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.
Describing Berkshire in a simple manner is a challenge. Allan 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.
Insurance is a core business for Berkshire. Concerns are being voiced by some sell-side analysts about the impact from recent natural disasters. Without sounding callous, these kinds of events and their costs are short-term in nature for Berkshire. Losses can impact their competitors both through inadequate reserves and weak balance sheets. Berkshire typically benefits both by having the most stable balance sheet (ability to pay insurance claims) and write new policies that are priced better (a price more reflective of the risk). These natural disasters have a long-term impact on the people involved and we would prefer not to make money based on others misfortune but this is the nature of insurance at times.
Liberty Sirius XM Group
Liberty Sirius XM Group is a tracking stock for Liberty Media’s ~70% stake in SiriusXM. We own SiriusXM at a ~20% discount to where the underlying SIRI stock trades. Sirius operates satellite radio in the US providing 140+ channels to their 31mm subscribers for monthly subscription fees. SIRI is a sticky subscriber model with high margins (high 30’s) trading ~6% free-cash-flow yield. At our discount, it is closer to ~8% free-cash-flow yield. Management has used free-cash-flow to shrink their share count by ~20% over the past few years. This investment suffers from multiple avenues of negative investment sentiment.
- Tracking stock: Tracking stocks are hard to understand
- Auto: We are at peak auto so there will be less of these systems sold every year
- Technology: Who needs satellite radio when people have all sorts of ways to listen to music
From a high level, it seems like the headlines/concerns ignore or lose focus of some key points.
- Tracking stock: John Malone and Liberty have been terrific partners across a variety of businesses and intend on closing the 20% gap between the tracker and the underlying stock
- Auto: We are likely at peak auto but there are opportunities for increased volume from used cars and increased price due to unique content (Howard Stern, ESPN, CNBC etc.)
- Technology: Terrestrial radio is their biggest competitor and while new technology is easy to use, so far, they lack the content the Sirius listener wants. This is something to keep an eye on.
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 24 months as new midstream and chemical projects contribute 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 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 continues to be 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.
ETF’s (exchange-traded funds) and passive investing are the topic du jour in the investment community. Passive investing is a good idea when not taken to extremes and indexing equities is appropriate for most people. History has shown us multiple examples of how a good idea can be taken to extremes resulting in excessive risk-taking and catastrophic outcomes (see 2007 financial crisis). Indexing illiquid junk bonds with limited legal protections is asking for trouble if the waters start to get rocky. If investors head for the exits en masse (aka everyone sells) it is hard to picture how liquidity will be provided for these high-yield corporate securities. Note these “high yield” bonds have a current ~5-6% annual yield. When high yield prices inevitably decline and there is a need for liquidity these structures may fall apart.
The Fund continues to hold a variety of shorts in fixed-income ETF’s (exchange-traded funds) spread across commercial real estate, high-yield corporate debt and international sovereign debt. We profit when bond prices fall/interest rates rise as rates and bond prices are inversely related. Rates are very low across nearly all fixed income instruments. It seems preferable to own companies at 10-20x present cashflows that are rising 10+% a year as opposed to 10Y bonds at 40x a non-growing earning stream (simple math is when the 10Y treasury is at 2.5%, divide 100/2.5 and that’s your multiple). Remember when you own a bond you do not participate in the upside of the business unless you’ve bought it at a meaningful discount (which one day the Fund hopes to be doing!).
If the current economic situation weakens it will likely impact the overall earnings abilities of the REIT’s and high-yield bond issuers which could also lead to spread widening. While difficult to predict the timing and order of magnitude of a rate-rising event, it seems like a compelling bet given the low-rate environment.
We maintain ~28% net cash position (ignoring the benefit of the extra cash we have from our shorts). There will be times we will maintain a large cash position. Opportunities are not abundant and I am comfortable keeping cash on the sidelines to wait for obvious ideas.
Hurricane Irma proved to be a great test of the Fund’s ability to function smoothly despite a natural disaster. Things continued without missing a beat. We have multiple safety nets for backup/recovery systems (though this was not necessary during or after the storm).
Small change to note as I reduced the initial investor contribution minimum to $250,000. I think this will open the Fund to some terrific long-term minded LP’s who are more comfortable in this ballpark. As the Fund grows I will likely revisit the Fund minimum.
Thank you for your trust and support.
Black Bear Value Partners, LP