Trapeze Asset Management 2Q18 Letter: The Quality Quandary

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Trapeze Asset Management commentary for the second quarter ended June 30, 2018; titled, “The Quality Quandary.”

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As value investors, we are always on the lookout for bargains—stocks or bonds that are trading at prices below our estimate of Fair Market Value (FMV). Both research and common sense dictate that the greater the discrepancy between price and FMV, the better—it provides a higher possible margin of safety and implied upside. However, securities are often detached from their FMVs because the business is suffering, leaving investors to figure out whether the issues at hand will be minor and temporary or debilitating and permanent.

Buying the most statistically undervalued companies can be quite lucrative but can also expose investors to deteriorating businesses—some are clearly cheap for a reason. On the other end of the spectrum, the highest quality businesses tend to be fully priced—some unduly, due to their popularity—so high quality investment opportunities can be scarce. Hence, the quality quandary.

Investors generally fall into two camps. Value investors usually dwell in the bargain basement bin. In the other camp, which comprises most investors, are growth or momentum investors, who tend to gloss over valuation work as they prize business metrics over all else. Our philosophy requires both—a high quality business at an attractive valuation. Simply stated but not easily executed, because it requires additional analysis to determine a company’s lasting competitive advantages and the patience to await a price sufficiently below our FMV estimate to justify a potential outsized rate of return.

Curtailing Losses

Our own philosophy has evolved. In years past, we emphasized the more undervalued opportunities, still preferring good businesses but valuation was a key driver. In emphasizing undervaluation, we held some less predictable businesses. Our migration toward higher quality businesses was motivated by our desire to have fewer clunkers—to lower the number of losers and to shrink the size of the losses.

We aim for more winners than losers. Who wouldn’t? And, to maximize the gains from our winners while minimizing the losses from our losers. But, again, simple to say, harder to achieve.

The better the business, the more predictable are its earnings. The more predictable the earnings, the easier it is to estimate the value with relative confidence. Companies that are less susceptible to competitive threats, with higher returns on capital, and, efficient balance sheets are usually the steady growers. Therefore, these companies are more likely to have consistently rising FMVs. While certain companies trade at low valuation multiples, appearing undervalued, and can provide tremendous upside should the business improve, the risk of erring in our analysis, we believe, is substantially increased when the business has less predictability. That’s the reason we often invest in companies trading at 20% discounts to our FMV appraisals, rather than those trading at perhaps larger discounts, as high quality companies typically don’t detach too far from intrinsic value.

In between unanalyzable companies—the impossible ones to predict—and the highly predictable ones, lie most businesses, a wide swath for whose trajectory is less certain. These companies often have too many moving parts, too many competitors, are too levered—both financially and operationally (from high fixed cost structures)—and therefore are overly vulnerable to sudden changes in the landscape (i.e., new entrants, falling demand, higher interest rates, or regulatory changes). For these reasons we find ourselves mostly passing over opportunities which are potentially high reward but equally, if not more so, high risk.

Even though, in the last few years, the markets have been much less volatile, there are still enough instances where the shares of high quality companies fall to at least a 20% discount, allowing us to build a diversified portfolio. Usually, a 20% discount is as good as it gets for high quality companies. Only at the depths of bear markets, when everything’s on sale, can one normally find superb companies at larger discounts.

Bigger is Better

By no means should this imply that we will not make mistakes. Investing requires assumptions about the future prospects of companies, an activity which is fraught with errors in judgment. Even more reason for trying to stack the odds in our favour. And with large cap companies, the likelihood of their staying power or ongoing success is bolstered by size itself—whether driven by cost advantages, dominant networks (not easily replicable distribution channels or user bases), or key intangible assets (e.g., brands or patents). As important, if we are able to determine we are wrong in our analysis, especially if something has come out of the blue, then we can sell at a moment’s notice and move on to the next opportunity. And the types of companies we are seeking should offer a smoother ride as larger, high quality companies tend to have smaller gyrations.

Blemished or Rotten to the Core?

We have always liked the analogy between shopping for fruit and value investing. It’s our job to determine whether a business has sold off because of a minor blemish, one that could be cut out with a paring knife, or whether it’s rotten to the core. We are looking for opportunities where there was a short-term disappointment, industry concerns, or news flow that sparks uncertainty which unduly depresses a company’s share price. And, we do find ourselves passing over businesses all the time because they might be spoiling—they aren’t undervalued or are overly vulnerable, for example, to competition, cyclicality, government regulation, or a single customer.

If we do buy a position and it turns out that we erred in our analysis, then we must be prepared to alter our opinion and press on. This is the most difficult part of investing. Admitting you’re wrong is never easy—just ask our significant others. Taking a loss, with other people’s money, makes it even harder. But we need to constantly remind ourselves that small losses are preferred to large losses and that we can always find other opportunities where our conviction is higher.

How do Commodity Stocks Fit In?

Periodically we have found ourselves enamoured with Gold or Oil. By definition, in general, these are not industries that have competitive advantages. As they teach us in Econ 101, the companies in commodity industries are price takers, not price makers. We justify our holdings in these areas, though, in a few ways. We only intend to make purchases when our analysis provides compelling evidence of a potential bull market in the underlying commodity. And, we won’t indiscriminately invest in any businesses exposed to commodities. Nickel, copper or zinc are extraordinarily cyclical and extremely difficult commodities to even attempt to predict. Gold and oil, on the other hand, have demand curves with much more stability. As we’ve noted many times before, the demand for oil lessens in a recession but, other than the '08 Great Recession, it does not normally suffer an outright decline. Importantly, within these sectors we also seek out high quality companies (low cost, well financed operators, with high growth prospects in stable jurisdictions), again in an attempt to mitigate downside risk. Furthermore, we find comfort in holding companies backed by hard assets, especially in times of rising inflationary expectations.

Our Own Competitive Advantages

Some are convinced that to generate returns above the market an investor must possess an informational advantage. For example, with small cap stocks, especially where there's no analyst coverage, the off-the-radar status of a company can provide an investor, who has studied the company in-depth, with information to calculate FMVs. This fills the void where others may simply be ignoring these situations altogether which can lead to a significant uptick when more participants catch on. Over the years, we have enjoyed many of these investment opportunities—though it can be extremely frustrating waiting for the market to recognize these situations. And in those investments where we were wrong, it took quite some time to extricate ourselves from positions, sometimes incurring significant losses.

Our much more meaningful advantage, we believe, is our analytical one. In our view, our approach has many of its own competitive advantages. First and foremost, as noted above, is buying quality at a value price. Most investors don’t even calculate FMVs. They might use shortcuts and invest based on relative multiples, focus solely on the business, or simply buy ETFs to access the returns of overall markets or sectors. By pegging a value through completing a discounted-cash-flow analysis, we have a reference point for the potential magnitude of the discount and for when to sell. And we are comforted by the high quality companies we own, by their recognizable brands, dominant market shares, high returns on invested capital, solid balance sheets and proficient management teams.

Having a global opportunity set to find holdings should also be an advantage. Many investors still have a considerable home bias, even though a wider basket to choose from and the accompanying diversification should benefit one’s portfolio.

Our proprietary tools should also set us apart. TVMTM allows us to screen for high quality opportunities that may be trading at a discount to FMV. TRACTM provides us with buy and sell points—providing alerts on when to enter or exit apposition in an effort to maximize gains and initiate stop losses. And our macro tools—TECTM and TRIMTM—designed to alert us to the next recession and subsequent market panic, enhance our ability to hedge (where authorized by client accounts) against market declines when these alerts are triggered.

Steady State

U.S. GDP growth was revised up to 4.2% for the second quarter, the fastest rate in several years. And while short-term interest rates had been rising, long-term rates have recently fallen back somewhat as growth and inflationary expectations have moderated. The excesses that might require quelling don’t appear to be anywhere near levels of concern. Inflation, which has ranged between 1% and 2.5% for the last 20 years, has lifted but just back to the Fed’s 2% target (the July core PCE at 2%, with the broad deflator slightly higher). Interestingly, core goods prices were down year-over-year in July for the 69th straight monthly annual decline. Unemployment levels continue to improve and wage pressures have been evident with private sector wage and salary growth over 5% in the last 6 quarters. Consumer confidence is near all-time highs—which could be a negative—it’s usually an indication of overconfidence. High debt levels should be a major concern—U.S. student debt (over $1.5 trillion), credit card borrowings (over $1 trillion), auto loans (particularly sub-prime), corporate debt (formerly a bright spot in the last recession) now at the highest level in over 50 years relative to EBITDA for S&P 500 companies, and high-yield corporate borrowing (especially relative to low default rates)—all unnerving.

But we won’t likely see a major impact until the market anticipates the economy is beginning to deteriorate. The markets have reacted negatively for a handful of days at a time recently, due to geopolitical situations when concerns about trade wars, Turkish currency issues or Venezuela’s hyperinflation made headlines. But these issues don’t yet appear to be contagious.

Other than the U.S. stock markets, year-to-date virtually everything else is flat to down—bonds, international stocks and commodities in general. Stock market valuations in the U.S. are full but not excessive and those indexes continue to power ahead. The underlying fundamentals continue to be quite positive, keeping the market elevated. Q2 produced the highest number of positive earnings surprises in some time. Since other non-U.S. markets have either pulled back or gone sideways, it’s left many of those stock markets attractively valued.

The index of Leading Economic Indicators remains healthy and our own TEC™, our economic composite, is not flashing negatively as it awaits an inversion of the yield curve (where short-term rates—90-day T-bills—rise above 10-year bond rates) and a softening in other economic statistics, which appears a ways off. Some emerging markets have declined; however, our market momentum indicator (TRIM™) is still only alerting to a handful of bear markets globally. Though there are cautionary flags, like rising debt levels, inflation and interest rates, as well as a flattening yield curve, we are still confident in being fully invested because a near-term global recession seems unlikely.

Our Strategy

With the selloff in a few names and sectors recently, we have been able to become fully invested. While volatility has been low and large cap bargains scarce, we have found enough quality companies—those with favourable earnings outlooks trading at wide enough discounts to our estimates of their FMVs. We continue to add large cap positions to our All Cap portfolios and look to add more when our current smaller cap positions are sold once they rise close to our FMVs.

We have been able to add companies from various sectors—each company having sold off for specific reasons which we believe will prove temporary. We continue to have an overweighting in resources via our oil & gas and gold positions. We expect a rebound in gold prices as bearishness is near record highs. Gold should also be a decent hedge against rising global inflation and debt levels. We expect oil prices to firm as well. Inventories continue to drop and the market deficit, which has persisted for the last few quarters, should get worse as inventories decline. The only other noteworthy sector exposure now is from the three Chinese companies we have recently purchased—all dominant franchises which are discussed below.

Our Portfolios

The following descriptions of the significant holdings in our managed accounts are intended only to explain the reasons that we have made, and continue to hold, these investments in the accounts we manage for you and are not intended as advice or recommendations with respect to purchasing, selling or holding the securities described. Below we discuss each of our new holdings and updates on key holdings if there have been material developments.

All Cap Portfolios and Recent Developments for Key Holdings

Our All Cap portfolios combine selections from our large cap strategy (Global Insight) with our best small and medium cap ideas. We generally prefer large cap companies for their superior liquidity and lower volatility. Importantly, they tend to recover back to their fair values much faster than smaller stocks, so they can be traded more frequently for enhanced returns. However, our small cap positions are cheaper, trading far below our fair value estimates; therefore, our All Cap portfolios currently hold a meaningful position in small caps.

Most of our small cap company holdings trade well below our estimate of their respective FMVs. These are smaller, less liquid holdings which are potentially more volatile; however, we continue to hold these positions because we find their risk/reward profiles favourable.

All Cap Portfolio Changes

In the last few months we bought several new large cap positions (summarized in the Global Insight section below) including Stanley Black & Decker, Dollar Tree, Molson Coors Brewing, Mitsubishi Chemical Holdings, Alibaba Group Holding, Baidu, Naspers, and NXP Semiconductors. We sold TJX Companies, the balance of our Kirkland Lake Gold and most of our Wesdome Gold Mines as they ran up to TRAC™ ceilings, near our FMV estimates. We sold Daimler, Oracle, and Siemens when each broke down through a TRAC™ floor. And we eliminated CIBC and Riocan REIT to make room for more undervalued positions we preferred.

Specialty Foods Group has sold its business to Indiana Packers (a Mitsubishi subsidiary). Closing is expected in the next few weeks, followed by a return of capital to stakeholders of most of the proceeds. Another much smaller portion is expected to be returned in early '19 and a minor additional holdback amount should follow around March '20. The distributable proceeds are expected to exceed our current holding value.

Global Insight (Large Cap) Portfolios and Recent Developments for Key Holdings

Global Insight represents our large cap model (typically with market caps over $5 billion at the time of purchase but may include those in the $2-5 billion range) where portfolios are managed Long/Short or Long only. A complete description of the Global Insight Model is available on our website. Our target for our large cap positions is more than a 20% return per year over a 2-year period, though many may rise toward our FMV estimates sooner should the market react to more quickly narrow their undervaluations. Or, some may be eliminated if they decline and breach TRAC™ floors. At about 73 cents-on-the-dollar versus our FMV estimates, our Global Insight holdings appear to be cheaper, in aggregate, than the overall market.

Global Insight (Large Cap) Portfolio Changes

In the last few months we bought several new positions including Stanley Black & Decker, Dollar Tree, Molson Coors Brewing, Mitsubishi Chemical Holdings, Alibaba Group Holding, Baidu, Naspers, Grupo Aeroportuario del Sureste, Hewlett-Packard Enterprises, and NXP Semiconductors. We sold Husky Energy and TJX Companies as they ran up to TRAC™ ceilings, close to our FMV estimates. We sold Porsche Automotive, Daimler, BMW, Oracle and Siemens when each broke down through a TRAC™ floor. And we eliminated CIBC and Riocan REIT to make room for more undervalued positions we preferred.

Stanley Black & Decker owns a portfolio of global tool and storage solutions brands. Key brands include Stanley, DeWalt, Black + Decker, Bostitch, and CRAFTSMAN. Commanding nearly 16% of the global tools and storage market, Stanley Black & Decker is nearly double the size of the next largest player (Bosch). This highly fragmented market is ripe for consolidation. Asia, representing nearly 10% of global tool demand, represents a growth opportunity either via continued organic growth (currently at mid-double digits) or via acquisitions. The recently acquired CRAFSTMAN brand, with its subsequent exclusive distribution partnership with Lowe’s, is an example of how smart acquisitions can drive growth. On Lowe’s Q2 earnings conference call, management attributed CRAFTSMAN tools with driving double-digit comparable growth and market share gains. We see commodity inflation headwinds being offset by price increases and cost cutting measures. Even with what we believe is conservative growth and margin assumptions we derive a valuation estimate of $167.

It was the best of times, it was the worst of times. Dollar Tree is the tale of two companies. On the one hand, the Dollar Tree branded stores have been posting strong mid-single digit growth in comparable same-store sales. On the other hand, the Family Dollar banner has struggled to achieve positive comps. Representing nearly half of total revenue, Family Dollar is a major drag on overall financial results. In Q1, the Dollar Tree segment’s operating income was 11.9% compared to just 3.9% for Family Dollar. Dollar Tree has been working diligently to turn around Family Dollar since acquiring it in '14. We believe management is making significant progress. Family Dollar stores are being renovated. Those stores are showing promising results but have yet to make a dent, as only hundreds of stores have been renovated, leaving over 8,000 locations to be revitalized. Dollar Tree’s current share price does not reflect management’s turnaround plans—and eventual trajectory back to double digit pre-tax margins. Alternatively, the Family Dollar banner could be sold, returning Dollar Tree back to a high growth, highly profitable retailer. Using current operating metrics we derive an FMV estimate of over $100.

Investors embraced Molson Coors Brewing’s '15 purchase of Anheuser-Busch InBev’s 58% stake in its MillerCoors joint venture, bidding Molson’s share price to an all-time high of $110 in '16. Currently trading around $66, exuberance has been quickly replaced by extreme pessimism. Investor attention has shifted towards flagging U.S. beer consumption trends, higher costs due to tariffs, and the potential threat of marijuana as an alternative to alcoholic beverages. Management is actively addressing all three areas. To reignite demand, Molson is reinvesting in its portfolio. Rising costs from tariffs (which we believe to be temporary) are being met by a plan expected to deliver over $200 million in cost savings in '18 and $600 million between '17 and '19. On the marijuana front, we expect this to be a growth driver, not a threat. Its recently formed joint venture with Hydropothecary will explore weed-based beverage opportunities. Our FMV estimate is $93.

We were attracted to Tokyo-based Mitsubishi Chemical Holdings industry leading return on equity and laser focus on free-cash-flow generation. Disappointing Q3 results drove the stock to just 6x EV/EBITDA and well below our FMV estimate of ¥1,300. Strong demand from China and tight environmental regulations should keep MMA (used for acrylic glass) prices firm. Total synergies from the merger of its three consolidated subsidiaries—Mitsubishi Chemical, Mitsubishi Plastics, and Mitsubishi Rayon—are expected to be ¥50 billion. We also applaud the company’s recent move to tie executive compensation to return on equity, free cash flow, and share price performance.

While the Yen has held reasonably steady lately, the Chinese Yuan has been falling. Though the concern about declining growth rates in China is ever-present, the trade war would seem to be the blame for the Yuan’s fall, perhaps even orchestrated by the Chinese government to enhance the country’s competitive position. This exacerbated declines in the share prices of some key dominant Chinese companies that had already been correcting post material run-ups, allowing us to establish positions in three companies, all of whom, in our view, possess durable competitive advantages and were trading at material discounts to our FMV estimates.

Alibaba Group Holding is one of China’s largest e-commerce (C2C, B2C, B2B) companies with dominance in fintech, logistics, cloud computing, media, and online to offline services, all of which form a massive digital ecosystem of consumers and businesses around its technology platform. Alibaba generates the bulk of its revenue from ads and fees—it’s a virtual toll booth on Chinese internet consumption, online payments, content consumption, logistics, and trade. The domestic e-commerce marketplaces are monetizing at rates below international peers, and should increasingly bridge the gap with stronger mobile monetization, unrestrained ad bidding, value-added services, and pricing power. Alibaba’s pan-Southeast Asian e-commerce marketplace, cloud platform, and video-on-demand (VoD) services are growing rapidly in an investment phase but currently undermonetizing, with margins expected to inflect meaningfully going forward as these segments mature. Meanwhile, spending to grow into these and other areas reduced margins in the latest quarter, though revenue growth continued at a rapid pace. We believe the runway for growth is long. Our estimate of the sum-of-the-parts valuation is over $300, substantially above the share price.

Baidu is China’s dominant search engine Internet company that also owns a leading VoD platform and a meaningful stake in the largest Chinese online travel agency. Core revenue growth has accelerated at the search and news feed businesses as AI-powered initiatives drove strong traffic and led to better monetization. Their VoD platform is investing heavily into content and their more than 400 million user base continues to shift towards subscriptions for an ad-free experience. Baidu’s developments around conversational AI, autonomous driving, and their deep learning platform offer an attractive free option. Growth is supported by secular tailwinds in ad mix shifting online, growing internet penetration, and a booming middle class. Here too, our $360 sum-of-the-parts valuation estimate is well above the share price.

Naspers, which we have owned previously, is the largest company in South Africa. It has been selling off as its core asset, Tencent Holdings, another one of China’s dominant online behemoths, has been correcting. Tencent is the leader in online payments, mobile gaming, online advertising, and, instant messaging, including WeChat—the most popular app in China. A combination of a declining Yuan and government imposed delays on new online games has rattled investors. Though almost all of Naspers’ value stems from Tencent, the company also controls dominant multi-billion dollar businesses in online classifieds, VoD, and other growing areas. The company appears intent on closing the gap between its share price and the underlying value. Our FMV estimate is $63.

Grupo Aeroportuario del Sureste is one of the largest airport holding companies in Mexico, with a collection of regional-monopoly airports in the country’s Southeast tourist destinations, Puerto Rico, and Colombia. The company is increasingly changing its sales mix towards higher margin commercial revenue which is driving margin expansion, in addition to operating leverage from greater traffic in a country where flights per capita are meaningfully lower than North American counterparts. Cancun recently expanded capacity to support incremental growth, and the integration of the recently acquired Colombian group should provide additional value to the company as management improves operational efficiencies at these historically mismanaged airports. Our FMV estimate is at $250.

In 2015, HP Inc.’s then CEO, Meg Whitman, announced an ambitious plan to split the company into two units: HP, comprised of consumer PC and the printing businesses, and Hewlett-Packard Enterprises (HPE), focused on enterprise hardware, software, and services. Since the split, HPE has itself experienced a radical transformation, spinning out its software business to Micro Focus and reorienting business strategy around cloud computing, AI, machine learning, and the Internet-of-Things. Now that the dust has settled, we believe HPE is poised to capitalize on its strong portfolio of solutions for these high growth markets. As margins expand, we see free cash flow hitting $2 billion by 2020. Our FMV estimate is $19.

Qualcomm’s two year pursuit of NXP Semiconductors came to an end in July after Chinese regulators decided not to grant regulatory approval for the combination. The proposed merger was approved in eight key jurisdictions but escalating political tensions between China and the United States over free trade and intellectual property laws took precedent over what should have been a straightforward approval process. NXP now trades at just over $90, materially below Qualcomm’s final $127.50 bid. A 2-year information vacuum and concerns about the deal’s impact on management’s focus pushed many investors to the sidelines. The reality, we believe, is that NXP is stronger now than it was when Qualcomm first approached the company. NXP is the leader in Identification/Payments (bank cards, mobile NFC), number one in Automotive (in-vehicle networking, secure car, safety, entertainment) and the leader in RF power transistors. NXP’s 11,000 engineers around the world have generated 9,000 issued and pending patents. One upshot of the failed merger is a $2 billion break fee that will be used toward debt repayment and a $5 billion share buyback program. With the buy back and strong demand for its critical components, we see close to $10 of EPS by 2020. Our FMV estimate is $110.

Income Holdings

After rising, the 10-year U.S. government bond yield has dipped a bit to just 2.9%. High-yield corporate bonds now yield about 6.3%. At 340bps the spread between the two is historically narrow versus a more normal 500 bps over the last 20 years. Therefore, it appears likely that high-yield bond yields have further to rise. In our view, government rates and investment grade bonds are not yielding enough given potential risks.

In fact, as rates have risen, the last couple of years have delivered the worst returns for U.S. government bonds since the '80s. While rates could fall somewhat in the near-term because speculators are currently heavily betting on even higher rates, the trajectory over time is likely higher due to quantitative tightening and the outlook for higher inflation. The 10-year treasury yield, based on history, should rise towards 4%, given the prevailing economic growth rates.

We continue to hold a number of undervalued income positions and collect outsized interest income on these positions. Our income holdings have an average current annual yield (income we receive as a percent of current market value of income securities held) of about 9%. Though there is risk from higher interest rates, which would compete with our holdings, and specific business and credit risk for our corporate positions—bonds, REITs, preferred shares and income funds. In the last few months, we sold Artis REIT after it triggered a sell signal in our TRAC™ work. And we added the Just Energy 6.75% Convertible debentures due 3/31/23 whose yield to maturity of 8.6%, at the time of purchase, we believed was too high considering our estimate of the asset value of the company in excess of $1.7 billion versus total debt of about $470 million.

Specialty Foods Group has sold its business, the details of which are noted in our All Cap Portfolio section above.

Quality and Value

In our approach, quality and value are intertwined. Good opportunities to us are those that are trading at sufficient discounts to our FMV estimates while possessing well above average business attributes.

Our goal is to be fully invested in a diversified basket of these undervalued quality companies. And to sell positions when they rise toward those FMVs, slip below our TRAC™ floors, or when our view of the fundamentals changes materially for the worse.

If our outlook for the overall economy or stock market turns negative, we intend to raise cash and/or short the market (where authorized by accounts), in order to protect our accounts. During bear markets, investors often throw the baby out with the bathwater and even the highest quality companies can be grossly mispriced.

Holding quality companies also helps with our sleep patterns. It’s certainly easier to maintain conviction for companies, especially through corporate adversities, when holdings possess competitive advantages and consistently growing earnings streams. It’s said that you can’t have your cake and eat it too. Nevertheless, we will continue spending our time screening, analyzing, and patiently awaiting investments that are both undervalued and high quality.

Herbert Abramson and Randall Abramson, CFA

September 7, 2018

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