Global Return Asset Management 2015 Letter: Verizon & Spectrum Analysis

Global Return Asset Management annual letter for the year ended December 31, 2015, titled, “2015 Full Year Results.”

Dear Friends,

For the full year 2015, after fees and expenses, we generated a 1.56% return while maintaining, on average, 25.31% of assets in Cash.

Throughout 2015 it was difficult to find securities to purchase, but rising stock prices enabled us to sell 13 positions. Our 2015 activities:

The first section of our letter discusses our Cash Balance, which on December 31st was 29.40%. Following, I describe how our ideal client will judge us. The final section is an examination of the shakeout occurring within the Cable TV and Wireless Industries and how I’m viewing a perspective investment in Verizon Wireless.

Please contact me if you have any question or would like to discuss my investment strategy or risk management principles.

Respectfully,

Elliot Trexler

Global Return Asset Management – Why I Kept So Much Cash

“The future ain’t what it used to be,” Yogi Berra.

That’s what I was thinking as we entered Q3 2014 and it’s reflected in our rising Cash Balance.

Here’s an excerpt from our Q3 2014 letter:

Last month, China’s central bank injected over $81 billion dollars into the country’s top five banks. The Chinese central bank provided this liquidity amid data indicating that the economy (which is the second biggest in the world) is faltering. There was a time when this negative data was noteworthy or the markets would decline. However, Alibaba, a company headquartered in China, went public in what turned out to be the largest initial public offering in history. Simultaneously, the S&P 500 went on to make new highs.

This reminds me of when two hedge funds at Bear Stearns collapsed after their subprime mortgage bets soured, yet the S&P 500 marched on and made new highs within three months. I wonder what the perception was of the investors who were buying stocks at that time.

I had no idea when the Chinese markets would sober-up but to me the data was clear – it was time to start getting defensive. I’m not a market-timer but I do like to plan…

Throughout 2015 I wasted a lot of time trying to justify why I had so much Cash. It wasn’t until late August that my bullies stopped harassing me.3 In early November my mettle was briefly tested but that lasted as long as my walk to the subway, about four minutes.

Purchasing stock in the stock market is analogous to purchasing a piece of fruit in the grocery. When I go to the store I don’t meander around looking for stuff to buy, I just evaluate the fruit I’m considering and either buy it or not based upon its price and quality. But I’m also a thrifty value shopper so sometimes I’ll wait to buy my fruit if data indicates that the entire store should be going on sale.4 I make no attempt to guess when the store will go on sale or by how much but I’m willing to patiently wait for a discount while I’ll endure the bullying.

Put bluntly, my job is to allocate capital to companies that will increase my purchasing power and if I can’t find opportunities that I think will do this then I’m not going to take any risks. As stock prices decline so too will our Cash Balance. In fact, this is when our Cash is most productive – I can buy more stock with less money. It should not be ironic that declining prices offer reduced risk and increased returns, which, after all, is what every investor wants.

Judge Me Please

I’ve officially broken Wall Street’s #1 Rule. No, I didn’t act on insider information. What I did was tell a prospective client that he shouldn’t invest his money with me. I know – a terrible breach. How could I allow such an atrocious lapse of judgement occur?

Let’s call this prospective client Bob. Bob is a wealthy guy who retired in his early fifties but remains active with his many investments. Bob doesn’t live in Las Vegas but he spends a lot of time there gambling. He used to get my monthly and quarterly letters and was impressed by our performance so he called to discuss an allocation.

Bob asked a few questions about several positions but didn’t appreciate the long-term value they offered. Instead, Bob thought I should sell them because it would help my monthly and quarterly returns (after all, the market was going down so I should lock-in my profits, so he suggested). As the conversation evolved, it became apparent Bob’s personality is more like a trader; he wants to frequently buy-and-sell stocks to goose the returns; but I’m not equipped for this.

Yes, I outperformed the S&P 500 and my peers. And yes, I accomplished this while our Cash Balance was a drag on returns. So now I’m going break Wall Street’s #2 Rule: I ask you to not focus on this year’s out-performance. (Gasp!)

I told Bob I should be judged on the compounded annual growth rate (CAGR) I generate. Focusing on one quarter or even one year’s results is a disservice to you and Global Return. To explain why, I’m going to rely on Peter Lynch and his investment track record.

Who wouldn’t love to have Lynch’s track record? For thirteen years, this legendary manager of the Magellan Fund at Fidelity Investments generated an annual rate of return of 29%; he has cemented his reputations as one of Wall Street’s greatest.

Investors will always remember Lynch’s remarkable returns but they won’t remember, in his own words, “In those 13 years, 10 times it [the portfolio] declined over 10%.”5 Ten declines over 10% in 13 years sounds like a lot of declining.

A 29% annual return equates to about 2.20% per month for the entire length of time Lynch led Magellan. Despite these impressive gains, here’s what did not happen – Investors in the Magellan Fund did not open their account statement month-after-month to discover their account appreciated 2.20% from the prior month. Instead, their returns bounced around like a fish-out-of-water.

Any investor who made an allocation to the Magellan Fund based on a monthly or even one year return probably also made a withdraw based on a monthly or one year return. The odds of an investor consistently making money with this in-and-out strategy are infinitely against them.

Knowing this, and after our lengthy conversation, it was apparent that Bob and I wouldn’t be good partners.

Global Return Asset Management – The Assumptions Underlying Monthly Returns

I’m no Peter Lynch, but judging me on my long-term results will prove more beneficial. My CAGR represents the effectiveness of my investment process. If an investor won’t evaluate me on my CAGR we’re not going to be good partners because my security selection and investment process, risk management principles, portfolio management and even my psychological makeup are all designed for long-term performance.

What perplexes me is why people spend an inordinate amount of time analyzing monthly returns. I’m not talking about perusing for anomalies. I’m talking about spending hours running tests on my returns that are supposed to provide some insight.

Whether they realize it or not, these practitioners believe many assumptions. Some of which include:

1. Stocks and the markets in which they trade will act the same way in the future
2. The portfolio manager’s returns are based on skill, only; no luck was involved
3. The future will offer the same investment opportunities available in the past

Wall Streeters cringe at the notion they’re gamblers but conducting these bizarre monthly analyses is akin to what happens at the Roulette Table. We’d all agree that each roll is an independent event, that no prior roll has any impact on the outcome. We don’t assume this, we know it.

But let’s hypothesize we’re all at the Monte Carlo Resort and Casino in Las Vegas (pun intended). If we were standing at the Roulette Table and saw the ball land on Red 30 consecutive times most people would place big bets on Black. They’d tell themselves, “It has to land on black! It has to!”

The knowledge that every roll is an independent event is completely discarded by the assumption that the ball must land on Black. This same things happens with these monthly return analyses, people know:

1. Stocks and the markets in which they trade will not act the same way in the future; that
2. Portfolio managers are the beneficiaries of good and bad luck; and
3. The future won’t offer the same investment opportunities

Yet, by placing so much value in monthly returns and these return analyses, their actions indicate that they hold the above listed assumptions; like the person who bets big on Black at the Roulette Table while knowing each roll is an independent event.

Investors would benefit more by learning how a portfolio manager’s investment process generates his or her CAGR and this is how I should be judged.

Back on Cash: What Am I Going to Do with this Cash?

Find investments!

Actually, that’s not the case. Much like I don’t meander around a grocery store looking for stuff to buy, I don’t sift through the stock market looking for investments.

Most people look for securities to invest into so they can earn a return. But this is the wrong perception to have because investing is the act of purchasing risk and it’s the act of purchasing risk that generates a return. Shifting our perspective to acknowledge that we are “purchasing risk” to generate a return radically alters our perception of a security.

Behavioral psychology states that people will find what they’re looking for. If when analyzing a security someone is looking for reasons it will generate a return they’ll find those reasons. Unfortunately, once the investor has found “facts” to validate buying the security, he often doesn’t consider much other information; he thinks he has the answer. Furthermore, looking for risk is challenging, so people don’t like doing it, much more fun can be had fantasizing about returns.

Conversely, if we’re looking for risk, we’ll find it. Looking for risk is challenging because it’s latent and often buried within a company’s operations or industry dynamic, rarely is it found on a financial statement (Would anyone ever lose money investing if risk was listed on a financial statement?). Furthermore, because risk is latent, identifying it requires critical thinking beyond financial statement analysis and first-level thinking.

The easiest place to find risk is in a company’s operations and its industry dynamics. This is where I start my analysis, at the industry-level so I have a broad understanding of its dynamics and its competitors. Once I’ve identified an industry’s and security’s risk, I can answer whether or not the security possesses a risk/reward ratio sufficient to justify purchasing it. The interesting thing about a company’s profits (the “reward” part of the ratio) is that much of it derives from its industry’s dynamics.

Profitable Industries Attract Competition

Capitalism 101 demonstrates that profitable industries attract competition which leads to a decline in revenue and net income among industry participants. Until industry stability is achieved, which is the result of a shakeout, capitalism’s competitive forces will influence where and by how much a company allocates capital. Unfortunately, this generally drives a company’s return on invested capital towards its cost of capital; or worse, below its cost of capital.

Therefore, paradoxically, the relationship between a company’s profitability and its industry is both causal and correlated. To be clear, the industry does not determine a company’s profitability, but it has a direct impact. We’ll use the Cable TV and Wireless Industries as an example.

The Cable TV Industry has accepted it must find, or create, mobile delivery channels to distribute its content to viewers. Advancements in wireless technology, the dawning of cord-cutting and the unrelenting adoption of mobile phones have given the Wireless Industry the competitive advantage with customers.9 And profitability flows from competitive advantages. In other words, profitability is flowing away from one industry and into another.10 To remain profitable, companies once in the Cable TV Industry must enter the Wireless Industry.

Meanwhile because the Wireless Industry has new competitors and knows profitability will be challenged, its constituents are adapting. Wireless companies are transforming their business models from being a networks for calls and texts, to being a network and distributor for calls, texts, data, video, digital media content, entertainment and full-time connectivity (personally, socially and professionally).

With this understanding, should I increase our investment in Verizon Wireless?

Key Statistics

• 47% of Americans are wireless-only
• 110% of Americans have active wireless accounts (that’s not a typo read the footnote)
• Video makes up 55% of all mobile traffic and is expected to increase 10x by 2019
• 3,600,000 texts are sent every minute

Who in the United States hasn’t looked at their mobile phone at least three times within the first three hours of waking-up? Mobile phones are a utility – like water and electricity – that we use in our everyday lives. Increasingly, our daily routines are being directed to and managed by our mobile phones, so the winners of this shakeout will be the companies consumers most rely on for their daily routines.

Competitors in the Cable TV and Wireless Industries are positioning themselves for the future and a series of mergers has blurred the lines (pun intended) between the two industries.

Global Return Asset Management – 2015 Activity

• February 2015 – Dish Network outbids Verizon spending $13.3 billion on wireless spectrum
• May 2015 – Charter Communications buys Time Warner and Bright House Networks (pending)
• June 2015 – Dish Network and T-Mobile discuss merger (terminated)
• June 2015 – Verizon buys AOL
• July 2015 – AT&T buys DirectTV
• September 2015 – Verizon CEO states “ongoing discussions” of an arrangement with Dish Network
• October 2015 – Comcast CEO confirms agreement with Verizon and Sprint to use their networks

Among Cable TV competitors, Comcast is entering the mobile phone market. The company is positioning itself to offer customers the quad-bundle (internet, TV, home phone and mobile service); something AT&T can offer thanks to its purchase of DirectTV. Comcast is also installing free wifi hotspots in core markets where it has subscribers. These hotspots double as mini-cell towers for laptops and mobile phones to tap into and the company has signed agreements with Verizon and Sprint to use their networks as a backup to these hotspots. Meanwhile, Dish Network spent $13.3 billion dollars, outbidding Verizon, to purchase wireless spectrum. Within six months Verizon and Dish Network began “discussions” on how the two can work together. It appears that Dish Network’s strategy was to outbid the wireless companies to ensure a seat at the table (i.e. establish relevance in the wireless industry).

In the Wireless Industry, the fiercest competitions are between Verizon and AT&T and Sprint and T-Mobile. Verizon and AT&T are the behemoths every company must contend with; at least for now, they’re the gatekeepers of the mobile device world. Both companies have reshaped their business models to compete with new industry dynamics.

AT&T has diversified away from the U.S. wireless business, which now comprises only 22% of revenue. The DirecTV acquisition provided AT&T an entry into at-home wireline television, wireless entertainment and wireless mobile video content. The company also offers its services in Mexico and throughout Latin America.

Conversely, Verizon is doubling-down on the U.S. wireless industry and has declared its intentions of being a mobile first company. To achieve this, over the last 12 months Verizon has sold several assets, including its at-home wireline phone and Fios businesses and invested nearly $30 billion dollars into its wireless infrastructure. This includes spending $10.4 billion buying additional spectrum to ensure it has sufficient capacity for mobile calls, texts, data, video, digital media content, entertainment and full-time connectivity.

Meanwhile, T-Mobile (the little-company-that-could) has overtaken Sprint in a fierce battle to become the 3rd largest carrier in the U.S. T-Mobile is led by outspoken, creative and very effective CEO John Legere, who is a force for change within the industry.15 The company’s business model, customer service plans and marketing strategy of being the “Uncarrier” has effectively recruited new customers directly from Verizon and AT&T (or as John calls them, “Dumb and Dumber”).

I own a small amount of Verizon Communications but with new industry competitors and the prospect for declining returns, at least in the near future, is this an industry I want to invest more money into?

At its current price and with a competitive battle heating up, I’m not interested in buying more Verizon stock. But I’m going to maintain our position for two reasons.

First, a company’s profitability is directly linked to its competitive advantages. Though Verizon is facing stiffer competition it has incredible competitive advantages, I just want confirmation they’ll withstand the shakeout before investing more capital.

Verizon has many competitive advantages, a few include:

• 105 million retail connections,16 or about 1 in 3 people in the United States. Further, 98% of Americans live within Verizon’s coverage.
• Over the last five years, Verizon has invested $90 billion dollars in its wireless and fiber network infrastructure – that’s a lot of infrastructure for any competitor to challenge.
• Verizon’s purchase of AOL and recent launch of go90 could be industry game-changers.

As impressive as these advantages are many risks still exits. Some examples are:

• Revenue is threatened. Three direct competitors exist and several more are entering the market. This prevents Verizon from raising prices (so sales growth isn’t likely) and existing sales will be challenged.
• Stickiness of customers. Switching providers has never been easier; you can keep your mobile number and transfer all your data in 10 minutes. Verizon and Sprint are offering up to $650 dollars to new customers who switch and AT&T is offering $100 dollars.
• Industry stability and new products. In a stable industry it’s rare that one company possesses a product or service that is markedly superior over its competitor’s products or services. But with new entrants bringing a myriad of diverse assets with them, it’s difficult to know what new products or services might differentiate each competitor.

The second reason for maintaining the position? We’re in a low-return, low-growth environment and Verizon has a long-term history of paying a dividend.

Here are the salient points of our original investment:

• Purchased in 2012 at $39.50 per share.
• Dividends received equal 21.3% of our original investment. Said differently, in four years nearly a quarter of our investment has been reimbursed.
• Dividends received were reinvested to purchase more shares, which has increased our share ownership by 13.6%.
• Because I haven’t invested any money beyond the original investment (yet our share ownership has increased) our price-per-share has decreased; this has increased our yield-on-investment from 5.14% to 6.49% (a 26.3% increase).

Let’s assume that when the $128 dividend payment was received Verizon’s stock price was $40/share; meaning the dividend was able to buy 3.20 shares. These additional 3.20 shares may not sound like much, but it’s a 1.26% increase in share ownership (and it’s only the first quarter). How much did I invest for these new shares? $0.00 dollars. Meaning our original price-per-share decreased to $39.01, and since we’re still receiving a $2.03 dividend, our yield-on-investment has increased to 5.20%.

Here’s how this plays out:

But here’s where the real magic of compounding kicks-in. In 2013 Verizon increased its annual dividend to $2.09 per share:

In this environment, where am I going to get a 5.82% yield from a company like Verizon Wireless and have the possibility of additional upside?

Notice that as Verizon’s stock price increases the dividend received isn’t able to buy as many shares. This implies that for long-term shareholders it’s preferable that the stock price not increase so they’re able to accumulate more shares from dividend payments.

Assuming Verizon is a formidable company able to grow its market share, revenue and cash flow, it’s easy to see the value of owning a dividend paying company in a low-return, low-growth environment.

Valuation

Earlier I stated that once I’m able to identify an industry’s and stock’s risk, I can answer whether or not it possesses a risk/reward ratio sufficient to justify purchasing it. At present, I can’t affirmatively answer three important questions required for a realistic valuation:

1. What are the risks worth?
2. Is Verizon’s business model defendable against existing or potential business models?
3. Who can deliver the most content to consumers with the cheapest cost structure?

At Verizon’s current price, I don’t want to invest more capital for a front row seat to watch who wins this battle. I’d rather wait for the shakeout and have confirmation of who the winners are before investing more. (Can you imagine standing at the Roulette Table and placing your bet after the ball has landed?)

If Verizon is able to withstand the shakeout, I intend on increasing the size of our position. That said, if the right price presents itself before the shakeout finalizes, and nothing negative has developed, I’ll add to the position. In the meantime, my biggest concern is that yield-craving investors will bid up the stock’s price.

Conclusion

As stock prices decline, my list of potential investments will grow longer, our Cash Balance will decline and the sentiment of my letters will change to bullishness. I yearn for declining prices because this is when our Cash is most productive – I can buy more stock with less money. It should not be ironic that declining prices offer reduced risk and increased returns, which, after all, is what every investor wants.

Please contact me if you would like to discuss my investment strategy or risk management principles.

Respectfully, Elliot Trexler