Value Investing

Black Bear Value Partners 4Q18 Letter

Black Bear Value Partners commentary for the fourth quarter ended December 31, 2018.

Black Bear

“In theory there’s no difference between theory and practice, but in practice there is.” -Yogi Berra

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To My Partners and Friends:

Black Bear Value Fund, LP (the “Fund”) returned approximately -3.2% in the 4th quarter of 2018 bringing the YTD net return to +3.3%. This compares to -13.8% for the S&P 500 in the quarter, bringing its YTD return to -4.4%. The HFRI index returned -8.6% in the 4th quarter bringing the 2018 net return to -6.4%. As a reminder, we do not seek to mimic the returns of the S&P 500 and there will be variances in our performance. We own a concentrated portfolio that will deviate both to the up and down. In 2018 we had an average cash balance of ~12% (not counting cash from shorts) and an average short position of ~41%.

We managed to make a little bit of money on both our longs (stocks we own) and our shorts (investments we are betting against). While we are pleased with our 2018 performance, it is just 1 data point. This is a long-term game, which means we can and will underperform. Markets can be fickle, and we will need to maintain our patience and discipline during those trying times.

Thank you to our partners, both old and new. Allowing me to invest on your behalf is a sacred relationship. You, our partners, are a huge source of our competitive advantage. You allow for the freedom and patience to invest for the long-term, and in periods of market turbulence, have allowed for focus. Our partnership base has been growing and we have welcomed some terrific, like-minded investors. We want to grow smartly with a long-term mindset and are trying to make the best 10-year business decisions which can often be at odds with short-term gratification. We are trying to grow smartly with great LP’s. So far, mission accomplished, so again I send my thanks.

One of the best surprises of this endeavor has been new relationships and friendships with fellow fund managers, many who are below the radar. My sense is many of these fund managers will become more familiar in the years to come. I count myself as fortunate to call them my friends.

Thank you to my wife, Lauren and our kids. For better or worse, I carry our investments with me in my head everywhere I go. I have an abundantly patient wife who puts up with the umpteenth discussion on airlines and media companies. We will likely all be at the Berkshire Hathaway annual meeting as I try and indoctrinate capitalism into a 4 and 6-year-old. If you see us come say hi.

As a reminder, a substantial amount of the Fund’s capital is my own. I focus my time and energy on compounding our capital over the long-term. While I would like to grow our assets, I am not prepared to spend tremendous amounts of time pitching and marketing. In time, I believe money goes where it’s treated best. Together, we are building a partnership with deep and long-lasting roots.

Each investors’ return will vary depending on the timing of the investment. I would caution those reading that our portfolio is shown at a point in time and can change for a variety of reasons.

Performance Summary

Black Bear Value Partners

(1) Performance figures represent actual performance from inception.

Top 5 Businesses We Own

Brief descriptions of the top 5 long positions follow. These positions comprise ~62% of the portfolio at year-end.

Alaska Airlines (10.6% of assets)

We have discussed Alaska in previous letters and recently gave an interview on it to Value Investor Insight. For a more detailed discussion please refer to previous letters or the article which can be found on our website: www.blackbearfund.com

When I look at airlines I see 2 businesses: a transportation/seat-distribution business which has cyclicality and a sticky cashflowing credit-card business with limited cyclicality. Large amounts of cash are generated by the airlines selling miles to banks irrespective of airline capacity or ticket prices. There is limited disclosure by the airlines so the sell-side focuses on predicting the unpredictable. This translates into volatility and opportunity.

At a high-level I think we own Alaska at ~9-10x earnings and ~10-12x free-cash-flow.

An advantage we have is the benefit of time and patience. The management team has historically been best-in-class operators and while integrating a merger is not easy, things should workout in time. Recently the CEO was asked why they are not growing as fast in 2019 & 2020 and to paraphrase he said there is a time to grow and a time to be patient…this will be a time to be patient. These are the kinds of attributes we look for in the management teams we invest with. At current prices we’re being well compensated to wait and let this team perform.

Jefferies Financial (9.0% of assets)

Jefferies Financial is an investment bank and merchant bank AKA the former Leucadia. A merchant bank invests in other companies either in whole or in part. I have been watching this stock for the better part of 3 years and our patient approach was beginning to feel increasingly like a missed opportunity. Thankfully Mr. Market arrived in Q4 and we participated in a big way.

Rough math says our position at year-end equated to buying the company at a 30% discount to the stated tangible book value (the GAAP-mandated value of the assets). Note, GAAP undervalues many assets, so this is effectively a discount on a discount. If you look at a market-based valuation of the assets we own the investment bank somewhere between a 50-70% discount to its asset value. This is a conservatively-managed, low-leverage, growing bank with high levels of insider ownership. It is not a distressed bank with a toxic balance sheet. Thankfully for us it was trading a bit like one.

Realizing value in sum-of-the-parts stories can be hard. For the less familiar, a sum-of-the-parts story can be a business that has a bunch of disparate businesses that have little to do with one and other. You add up the value (hence the sum) and hopefully buy at a discount. Unless the management team is willing to sell and realize the value, it could be hard and complicated. In the famous words of all investors, this time it’s different (I hope).

Simply put, we own this because it is way too cheap and has thoughtful and talented capital allocators at the top buying back tons of stock at a significant discount to its intrinsic value. Absent a major shift in the company’s performance, the value will be realized, and we will own an increasing amount of the company. There are “hidden” assets within the merchant bank that are undervalued on the balance sheet due to GAAP accounting. Economic accounting would result in a far higher value on the balance sheet.

To be fair, the investment banking business is tough. It’s competitive, people-intensive, and somewhat dependent on the health of the economy. The price we are paying for the bank and the underlying assets provides a margin of safety. Additionally, the tone set at the top makes me proud to be a shareholder. Decency, humility and alignment are preached from the CEO and Chairman and can only serve to provide a great example to the bank employees and their portfolio companies.

Radisson Hospitality Group (24.7% of assets)

Before I get into this idea a big thank you to Brad Hathaway at Far View Capital Management and to Matt Sweeney at Laughing Water Capital Management. Brad presented this idea at ValueX Vail and I regrettably initially passed on it. Things take time to soak in with me. Thankfully, Matt is persistent and suggested I take another look. It became obvious that the proverbial “free” option was sitting out there for the taking and it became our largest position in rapid order. It was our biggest winner of 2018.

Radisson AB is the non-US hotel arm of Radisson. It was in the midst of an operational turnaround and actively being sold from one Chinese entity to the other at a bargain price (35 Swedish Kroner per share or a 20-60% discount to market). Further complicating matters, this was a stock listed in Sweden and was 70% owned by a distressed seller in China. Nobody said this was going to be simple!

Sweden happens to be a very minority-shareholder friendly country. As a minority shareholder, you cannot get squeezed or coerced into selling your stock unless a very high bar is met. Everyone gets an equal and transparent price. It became obvious that the sale was too cheap on every metric. If a higher price wasn’t offered the company would not be allowed to go private. Equally important, the share base had virtually completely turned over at 35 SEK per share which meant an increased bid (above 35) was likely needed to get the minimum necessary votes to take the company private. Even at increased prices, the economics to the buyer would go from incredibly amazing to just plain amazing.

Ultimately the bidder increased the bid by ~21% and it was our largest winner. I am disappointed in the ultimate price offered as I think significant value was left on the table. To be fair, I would put this in the high-class problems’ category.

Radisson has an excellent management team, great assets and a highly likely turnaround that’s only in its 3rd or 4th inning. If the deal closes and it is taken private, we want to express our thanks to the management team for their stewardship of the company and their willingness to communicate with their minority shareholders.

Liberty Broadband (9.0% of assets)

Liberty Broadband is the tracking stock for Liberty’s investment in Charter Communications (CHTR). We own shares in CHTR via the tracker at a ~10% discount to current market value.

There are abundant fears of cord-cutting and declining media consumption. Customers are cord-shifting and consuming increasing amounts of media and data thru alternate means (i.e. through the internet). Looking out 10 years from now it seems likely that people and businesses will be consuming more data. Charter provides the pipes to get the data to consumers and businesses and notably at much higher margins than video distribution.

When one pays their video bill, much of it is passed thru as a cost to the content providers. Think ESPN or Discovery. Those costs have continued to go up both increasing the customer’s bill but also the cost to the cable distributor (CHTR). So even though your cable bill is going up, it does not necessarily translate into more dollars for Charter. The central cost for data is laying the fiber which is akin to laying a toll-road down. Think of the data as a car driving across that newly constructed toll road. The road costs about the same whether or not anyone is driving on it. Each incremental driver increases the toll (revenues) with minimal incremental cost. When you or I call our cable company and raise our speeds much of the incremental price is pure profit to the internet provider.

Charter stands to benefit from synergies from their consolidation of 3 large cable companies. They are exiting some large-scale capital projects and should begin to harvest some of the gains of those initiatives over the coming years. They have an excellent management team who owns a ton of stock and are thoughtful capital allocators.

Linamar - (8.5% of assets)

If you want to read an inspiring story, I encourage you to read the biography of Linamar founder Frank Hasenfratz. My worst day does not compare to what he faced in Hungary during WWII. He came to Canada, penniless and built the business from the ground up. This is a reminder that in the face of adversity, we are capable of so much. Frank and current CEO Linda Hasenfratz currently own 30% of the company, though that is likely increasing…more on that later.

Linamar is a Canadian industrial company best known for their automotive supply business. This perception is why we own the company at a 12-15% free-cash-yield. Many auto suppliers are trading at very low multiples to both free-cash and overall enterprise value. Why is that? Specifically, why do people not like Linamar?

1) Peak-Auto: the last time auto sales dropped they dropped off a cliff, so experience creates anxiety to get ahead of the next slowdown

2) Electric Vehicles: Linamar makes internal combustion engines (ICE) – the future is all electric

3) Trump and Congress: Can they get a new NAFTA deal ratified or is it going to be a NAFTA/Brexit -like situation?

It’s hard to find bargains when there is optimism. What if autos plateau instead of nosediving? What if sans-Electric vehicle subsidies ICE engines don’t disappear for a while? What if the Art of the Deal makes magic happen with Canada and Mexico? At these prices we don’t need to believe in these outcomes, we just need to believe it is possible.

In the words of the late Billy Mays: But wait, there’s more!

Auto supply only comprises ~60% of their operating income and stands to become less meaningful to them as they expand into industrial verticals that are higher margin and growing.

A big hang-up I had with the company was a lack of meaningful share buybacks despite an obviously depressed stock price. It produces a lot of cash and they could meaningfully shrink the share count without incurring increased leverage. We and others communicated this over the years to the company. I was pleased to see a recent announcement authorizing management to buy back up to 10% of the publicly owned stock. We applaud this decision and are thrilled to see a willingness to capitalize on market short-termism.

Approximate attribution for 2018:

Below are the central contributors to the Fund’s 2018 performance. The left chart shows the % of our total PNL broken down by investment type. The right chart shows the contributions in %. For example, equity longs contributed 58% of our total profit for the year. Additionally, our assets appreciated BY 5.5% from Radisson Hospitality.

Black Bear Value Partners

Average quarterly exposure for 2018:

We maintained a balanced exposure throughout 2018 with ~10-15% in net cash. Our short position grew from ~26% in Q1 to ~69% in Q4. Keep in mind our short is shown at an aggregate value. It is NOT how much capital we have at risk since we express the views in options. For example, we may have a short that is 50% but only 5% of our capital is at risk. Our exposure entering 2019 can be found on page 1.

Black Bear Value Partners

Shorts

We have talked a lot on our credit short idea which is quite asymmetric. In Roman times, the architects of an arch stood beneath said structure when the supports were removed. This created complete alignment. If the arch was structured improperly they got flattened like a pancake. Eating your own cooking doesn’t guarantee a great meal but definitely reduces the odds of indigestion. It would be interesting to know how many of these credit ETF products are owned by the senior management who propagate their suitability to investors.

We are short a variety of credit ETF’s both thru options and outright. In summary it seems like:

A) There’s a lot more debt issued in the market

B) Spreads are tight/rates are low

C) Expectations for defaults are low because that’s been the most recent experience

D) The rules governing these structures are lacking

In a nutshell – there’s been a lot of money sloshing around in the system. I think it was Howard Marks who said, “too much money chasing too few deals”. As usual, he says it better and with fewer words.
Some have asked for a prediction on the timing and my confidence in a blow-up in credit. To be clear, I am not predicting this is imminent as I have no idea.

What is clear is the payoff is asymmetric and those on the other side need to be precisely right to make a little money. We stand to make a lot by being imprecisely right. In the meantime, we don’t risk very much.

It is generally hard to buy insurance on your home when smoke is coming out of the windows. In December, a couple of market smoke alarms went off and things went off the rails. So far in 2019, most have returned to Pleasantville. I will leave to you to decide what could happen if we entered any prolonged period of negative expectations. I don’t have the answers, but we have some highly asymmetric investments if this comes to pass.

Cash

Adjusted for incoming capital on January 1st we had approximately 15% of our assets in cash/T-bills. While I think it’s good for us to have some cash available, we do not target a cash balance. If opportunities are available, we buy. In the absence of new ideas, we hold cash.

The Shifting Tides in Value Investing

It feels like we are about to enter (or are in) a value investor renaissance. People are giving up, quitting at just about the time things are starting to get interesting.

“Value” has been out of favor for a while now and fatigue is creeping in. Swimming with the current is a lot easier than going upstream, yet that is what is required when trying to find a variant view. It can be tiresome if the goal is group acceptance. Thankfully, popularity at cocktail parties has never been my focus (or strong suit) and I am most comfortable going against the grain.

If you love what you do, and your goals are long-term in nature, it can be quite fun and rewarding. If your goals are a quick buck and instant gratification it can be quite frustrating.

Over the course of my career I have studied the behaviors of how and why people are successful, especially in sports and business. Kobe Bryant still wakes up at 5AM for a morning workout continuing a staple of his career. Many fans and competitors marvel over his in-game performances but few see the lonely and sometimes monotonous pursuit of excellence. It’s a pursuit of passion and intense love of the game coupled with competitive fire. You must put the daily repetitions in if you want peak-performance during the toughest moments. We will continue to put the reps in and work both smart and hard so that we can perform during the inevitable tough times. I’m as excited as I have ever been and am glad we are on this journey together.

General partnership business

Lastly, a big thank you to our partners/service providers. I count BTIG (prime broker), Opus Fund Services (fund administrator) EisnerAmper (tax/audit) and Kleinberg, Kaplan (attorney) as partners in our business and thank them for their help in 2018.

I anticipate timely K-1’s and no need for any extensions from Black Bear.

Thank you for your trust and support. I wish you and your families a happy and healthy 2019.

Black Bear Value Partners, LP

This article first appeared on ValueWalk Premium