Vulcan Value Partners commentary for the third quarter ended September 30, 2016.
- Q3 2016 hedge fund letters
- Q2 2016 hedge fund letters
We are pleased to report that all strategies produced positive results and beat one or more of their benchmarks in the third quarter. As you know, we place no weight on short-term results, good or bad, and neither should you. In fact, we have and will continue to willingly make decisions that negatively impact short-term performance when we think we can lower risk and improve our long-term returns. We encourage you to place more weight on our longer term historical results and a great deal of weight on our long-term prospects.
All five of our investment strategies have produced exceptional long-term returns. In fact, three of our five strategies are in the top 1% of their peer groups since inception, one in the top 3% and the fifth strategy in the top 12% since inception. These results are detailed in the table below.
Record low interest rates engineered by the world’s leading central banks have created an almost desperate search for yield. This monetary stimulus has caused supposedly defensive, higher dividend-yielding stocks to become dangerously overvalued. Until recently, consumer staples companies, utilities, and Real Estate Investment Trusts (REITs) have outperformed the broader market. Valuation and, in the case of utilities, quality concerns have kept us out of those areas. Recently, many of the companies in these sectors have begun to decline in price, but they remain overvalued.
For instance, Campbell Soup, a consumer staple bellwether that is on our MVP list, sold at 30 times earnings at the end of the quarter compared to a five-year average of 22 times earnings. Its earnings have declined roughly half of 1% per annum over that time period. It yields 2.6%. It trades well above our estimate of intrinsic worth. Utilities, as a group, trade at 22 times earnings and yield 3.5%. They do not produce free cash flow and are highly leveraged. Returns are regulated, and growth prospects are poor. Yet they are the second best performing segment of the market in 2016, despite a pullback in the third quarter.
REITs deserve special mention. They just became a separate sector of the S&P 500. In the 1990’s, REITs were attractively priced. While several REITs are on our MVP list, all of them are overvalued today, in our opinion. As a group, REITs’ dividend yield is 3.2%, and they trade at just under 25 times free cash flow so their free cash flow yield is approximately 4%. They are also highly leveraged. Over time, growth in rental income should approximate inflation, which the U.S. Federal Reserve is targeting at 2%. With financial leverage, REITs should be able to grow their bottom line (Funds from Operations in REIT parlance) and dividends at perhaps 4%. One other data point: Post Properties, an Atlanta based apartment REIT, recently announced that they are being acquired at roughly 26 times free cash flow, or for less than a 4% free cash flow yield. While higher quality retail and office REITs have longer leases ranging from 3 to 10 years, apartment REITs generally turn over roughly half of their units annually. So just to break even, they have to resell half of their product annually before they can grow.
So, what if Oracle, our largest position, was a REIT? How might it be valued? Oracle has over 90% customer retention. They have long-term contracts called licensing agreements that have inflation-adjusted escalators. So Oracle’s revenue structure looks a lot like higher quality REITs with long-term leases and much better than apartment REITs like Post Properties. Oracle, however, can add new services such as Cloud computing and acquire more customers without having to build new properties. In real estate terms, Oracle can grow its “occupancy” without physical constraints. We estimate that Oracle can grow its bottom line at a high upper single-digit rate for many, many years, so let us use 8% as an estimate. Moreover, unlike REITs, which are highly leveraged, Oracle has net cash on its balance sheet. So Oracle can grow twice as fast as the typical REIT without leverage. Adjusted for cash, Oracle trades at less than 11.5 times free cash flow, so its free cash flow yield is roughly 8.8%.
So, Oracle, which can grow at 8%, or twice as fast as the average REIT, sells for less than half the valuation of the average REIT and less than half the valuation paid for Post Properties. Why? Oracle only has a relatively paltry 1.6% dividend yield. REITs use most of their free cash flow to pay a dividend. Oracle uses most of its free cash flow, roughly 80% in fact, to repurchase its discounted stock. This capital allocation decision is highly beneficial to us as long-term shareholders because a dollar of dividends is only worth a dollar while a dollar of share repurchases is worth more than a dollar because Oracle’s stock is selling for less than its intrinsic worth. If the market valued Oracle’s free cash flow stream, which is higher quality and growing twice as fast as the average REIT, at the same yield as the average REIT, then Oracle’s stock price would be more than twice as high as it is currently.
Our results over the past year in particular have been held back because we refuse to buy overvalued and extremely risky parts of the market. We instead allocate capital to extremely high quality companies whose valuations are ludicrously low in comparison. As serious, long-term investors who are required to invest in equities exclusively through Vulcan Value Partners, we would not invest our money or yours any other way. We look nothing like an index, so it is reasonable to expect us to perform nothing like an index. In the short-run it can be painful. In the long-run we believe your patient capital, alongside of ours, will be amply rewarded for following our investment discipline instead of following the crowd.
In the discussion that follows, we generally define material contributors and detractors as companies having a greater than 1% impact on the portfolio.
Vulcan Value Partners Large Cap Review
We purchased six new positions in the third quarter and exited five positions.
There was one material contributor and no material detractors to performance in the third quarter.
New purchases included McKesson, AmerisourceBergen, UnitedHealth Group, Qorvo, Skyworks, and Verizon.
McKesson and AmerisourceBergen are both drug distributors. They participate in an oligopolistic industry with high barriers to entry. Route density and scale are very important in the drug distribution business, making it uneconomical to challenge the incumbents. In addition, regulatory hurdles are high because they transport controlled substances. UnitedHealth Group is the largest health insurer in the United States. In addition, it owns Optum, a rapidly growing healthcare information services company. We do not believe the market appreciates and adequately values Optum within UnitedHealth Group. Qorvo and Skyworks make radio frequency filters (RF), power amplifiers, and mixed signal semiconductors. These chipsets are critical components in modern cell phones. As telecommunications technology continues to evolve from 2G to 3G to 4G and soon to 5G, bands continue to proliferate, and data usage grows exponentially. Their products are a small part of the cost of a cell phone, but the phone will not function without them. They operate in a global oligopoly. Only a handful of companies can produce these increasingly complex chipsets at scale. Switching costs are high and risky. As an example, think about the financial and reputational damage to Samsung from the Galaxy 7 battery debacle— and batteries are commoditized while RF chipsets are not. All of these newly purchased companies have strong balance sheets and produce high levels of free cash flow.
Sells included Aberdeen, Dover, LVMH, Checkpoint Software and Verizon. Aberdeen was a mistake. We define a potential mistake as a company whose value drops or does not grow within two years of purchase. When we identify a potential mistake, we re-evaluate our investment case. Depending on the cause of the value decline, we might continue to hold it or we may have made a mistake, in which case we sell. Whether we have a gain or loss in the stock is irrelevant to our investment decision. All that matters to us is price compared to value and value stability. We decided to sell Aberdeen because its value was less stable than we modeled when we purchased it. What did we miss? Aberdeen produces ample free cash flow and has a very strong balance sheet. Aberdeen has exposure to emerging markets, which we quantified. Several years ago, Aberdeen correctly closed many of its investment strategies, which we also quantified. Aberdeen had a meaningful percentage of its assets under management (AUM) from Sovereign Wealth Funds, a source of capital that we thought would be stable. However, it turned out to be highly unstable when commodity prices, including the price of oil, declined from peaks over the past two years. This additional pressure on AUM led to revenue and profit declines that were greater than we anticipated. Following our investment discipline, we sold our position and redeployed capital to companies that we believe have more stable values and more attractive price to value ratios. We hate to make mistakes, but we try to learn from them so that we minimize the number of mistakes that we do make.
We have owned Louis Vuitton a number of times over the past several years. Once again, it was a successful investment for us. We sold it to reallocate capital to more discounted names.
Check Point was also a successful investment for us. We held it for nearly four years. Over that time period its value grew nicely, and its price compounded at rates in the mid-teens. As price and value converged, our margin of safety narrowed, and we sold Check Point to reallocate capital into more discounted names.
We have owned Dover for several years, purchasing it well before oil prices turned down. Our investment discipline of demanding a margin of safety in terms of value over price served us well with Dover. Dover is a diversified industrial company that has a large pump business selling to the energy sector. With oil prices down and drilling activity declining, Dover’s pump business profitability declined as well. This negative was offset by free cash flow production and better results from other parts of Dover’s businesses so that Dover’s value was flat over our holding period. Dover’s price rose, and we made a decent return as price and value converged. We sold Dover to allocate capital to more discounted companies with growing values. We insist on a margin of safety to protect us from events that we cannot predict. Doing so resulted in an opportunity cost as opposed to a capital loss at Dover.
Verizon was both a purchase and a sell in the third quarter. It was a profitable investment for us. We sold it to reallocate capital into much more discounted companies that became available to us after we purchased Verizon, and its stock price increased while its value was flat.
State Street was up nearly 30% in the third quarter. In our judgment, there was no material news or event to cause State Street’s stock to rise so much. However, it was one of our most discounted companies earlier this year when we were adding to our position in the company. We can never predict the timing of when prices will rise or fall, but we can take advantage of price volatility when we own companies with stable values, such as State Street.
Oracle is our largest position, and our logic for making it so is discussed in the introduction. Please refer to the introduction for details.
Vulcan Value Partners Small Cap Review
We did not purchased any new positions in the third quarter and exited three positions.
There were two material contributors and no material detractors to performance in the third quarter.
We sold Curtis-Wright, Nu Skin Enterprises, and Trade Me Group.
Curtis-Wright was an excellent investment for us. We held it for almost four years. Over that time the company grew its value at a low double-digit rate, and the stock price compounded at over 20% per annum as price and value converged. We sold Curtis-Wright because it rose to our estimate of fair value so that we no longer had a margin of safety.
Nu Skin was a disappointing investment for us, but following our investment discipline enabled us to minimize our loss by sizing our position according to Nu Skin’s price to value ratio. We demand a margin of safety in terms of value over price to protect capital and minimize risk. Events happen in business that no one can predict, sometimes to the good and sometimes to the bad. Insisting on a margin of safety minimizes the damage that unforecastable negative events can cause. In Nu Skin’s case, the company suspended operations in China, its largest market, due to regulatory concerns that proved to be exaggerated. Nu Skin has resumed operations in China, but the disruption hurt Nu Skin’s value. We sold Nu Skin close to our estimate of its reduced value. Our loss was less than half of what it would have been if we had not followed our investment discipline.
Trade Me Group was a very good investment for us with a nearly 32% gain in the roughly six months that we held it. Unfortunately, price rose much faster than value, and we sold it at our estimate of fair value. While we are pleased with the gain, we would have preferred to hold it longer and enjoy the compounding of the company’s value as we did with Curtis-Wright.
Virtus gained over 38% during the third quarter. Virtus remains attractively priced even after its gain this quarter. We wrote the following about Virtus in our first quarter letter:
“Virtus was our only material detractor with a 33% decline in the first quarter. Virtus has a number of investment strategies, some managed in-house and some sub-advised. One of them is a highly successful emerging markets strategy sub-advised by Vontobel Asset Management. During the quarter, Vontobel announced that the lead manager of its investment team for emerging markets was leaving the company. It is probable that Vontobel will experience net outflows for some period of time. Vontobel is a well-respected manager with a deep bench of professionals and the emerging markets strategy has always been managed by a team. While we are disappointed by this news, we enjoy a substantial margin of safety. Roughly two thirds of Virtus’s market cap is in cash and securities. Assigning no value to Vontobel whatsoever, the market is valuing Virtus’s remaining assets under management of approximately $35 billion at approximately $200 million.”
Following our investment discipline, we increased our stake in Virtus at absurdly low valuations in the first quarter. The company also responded to its deep discount by launching a tender offer for its stock. We applaud management for its excellent capital allocation decision which increased our estimate of Virtus’s value per share.
Sotheby’s gained nearly 39% during the third quarter. Sotheby’s management team is doing an excellent job operationally and in terms of allocating capital. The market is belatedly recognizing Sotheby’s improved performance which is transpiring against the backdrop of a relatively weak art market.
Fossil was not a material detractor or contributor this quarter, but we get a lot of questions about it so we thought it would be a good idea to update you. We think we are right about Fossil, but we will be the first to tell you that we are human and make mistakes. Fossil has committed substantial resources to expand into smart watches and wearables. We think they are making good decisions that will benefit long-term shareholders but these decisions have hurt short-term results. We should see evidence of their success or lack thereof this Christmas selling season. If Fossil executes well, our investment case is intact. If they do not execute, then we have made a mistake. So, the critical aspect of our analysis is our assessment of the people running the company. Management, led by Kosta Kartsotis, retains our confidence. Kosta has been the long serving CEO, and during his tenure, he has turned Fossil into a leading lifestyle branded watch company. In hindsight, he and Fossil were too cautious and moved too slowly into smart watches. As investments in wearables have weighed on results, Kosta has not taken a salary or bonus for the last three years. He is the largest private owner of Fossil’s stock. Actions speak louder than words, and we are impressed with the leadership Kosta has shown.
One more company deserves special mention. SAI Global, an Australian based standards and assurance company, was up over 34% in the third quarter. We are a forced seller as it is being acquired by Baring Private Equity Asia at a price very close to our estimate of fair value.
Our intent is to be fully invested, but cash levels are rising as a number of companies we own are reaching fair value and we are unable to find enough qualifying investments to replace the ones we are selling. We follow our investment discipline and size positions according to discount. There are few discounted businesses in the Small Cap market that meet our quality criteria. Cash is a residual decision, and we are normally fully invested. The last time cash levels were this high was 2007. We urge you not to allocate additional funds to Small Cap at this time. If you have alternatives that are more attractively priced, we suggest you reduce your allocation to our Small Cap program. There will be a day when we will urge you to add to your Small Cap position with us. In the meantime, we would prefer for you to preserve your capital.
See the full PDF below.