Cooks in the Kitchen

Feb 16, 2017 by Boyles Asset Management in  Letters

We are often asked about the impact of operating an investment program with multiple decision makers. Even Mr. Buffett and Mr. Munger have questioned the efficacy of investment committees in the management of portfolios. We’d hesitate to put co-managers in the same category as a committee, but it is an important topic.

We are the first to admit that there are frictions in addition to the benefits of the model we have at Boyles. Boyles operates with two managers, each equally responsible for finding ideas, conducting diligence, and making decisions. We do not apportion pieces of the portfolio to either manager. Each is expected to be fully conversant about ideas under examination or in the portfolio. We’ve been operating in this manner for 10 years now. That longevity tends to help.

The biggest difficulty when it comes to such a model is that not every person similarly interprets a given set of facts or places the same weight on particular facts when analyzing an investment. This is perhaps no different from any other situation in life, and it remains true even when co-managers share an investment philosophy. It is true at Boyles. While it is rare that facts themselves are in dispute, this friction can either be a source of destructive and counterproductive strain; or what Linda Hill, a professor at Harvard University, has described positively as “creative abrasion.” After studying Pixar’s success with team-based creative development, which has led to a number of blockbuster animated movie productions, she identified three cores to the success: creative abrasion, creative agility, and creative resolution. In a 2015 TED presentation, she stated:

“Creative abrasion is about being able to create a marketplace of ideas through debate and discourse. In innovative organizations, they amplify differences, they don’t minimize them. Creative abrasion is not about brainstorming, where people suspend their judgement. No, they know how to have very heated but constructive arguments to create a portfolio of alternatives. Individuals in innovative organizations learn how to inquire, they learn how to actively listen, but guess what? They also learn how to advocate for their point of view. They understand that innovation rarely happens unless you have both diversity and conflict.

“Creative agility is about being able to test and refine that portfolio of ideas through quick pursuit, reflection, and adjustment. It’s about discovery-driven learning where you act, as opposed to plan, your way to the future. It’s about design thinking where you have that interesting combination of the scientific method and the artistic process. It’s about running a series of experiments, and not a series of pilots. Experiments are usually about learning. When you get a negative outcome, you’re still really learning something that you need to know. Pilots are often about being right. When they don’t work, someone or something is to blame.

“The final capability is creative resolution. This is about doing decision making in a way that you can actually combine even opposing ideas to reconfigure them in new combinations to produce a solution that is new and useful. When you look at innovative organizations, they never go along to get along. They don’t compromise. They don’t let one group or one individual dominate, even if it’s the boss, even if it’s the expert. Instead, they have developed a rather patient and more inclusive decision making process that allows for ‘both/and’ solutions to arise and not simply ‘either/or’ solutions.”

We believe that Professor Hill’s thoughts on creative abrasion, agility (if you substitute ideas and investments for experiments and pilots), and resolution are particularly useful when thinking about how we operate a co-manager
model. When each of the three are calibrated correctly, the team-based model can beat the single-manager model. However, for each of Hill’s concepts to work in the investment business, we believe there are a few necessary ingredients, including:

  • Cohesion of investment style
  • Open conversation about evolution of investment philosophy
  • Willingness to accept critique on ideas and diligence process
  • Trust that the other party is living up to their responsibilities
  • Open communication about interpretation of facts
  • Sufficient time operating under these conditions
  • Genuine acceptance that outcomes are joint outcomes

It is a constant process, and the relationship requires work, but in the end we believe it can lead to superior outcomes.

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This post has been excerpted from the Boyles Asset Management Q4 2016 Letter to Partners. Read another excerpt.

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Watch an excerpt of Matt Miller and Joe Koster's exclusive interview with The Manual of Ideas:

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(Watch the full conversation in The Manual of Ideas Members Area.)

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Focus on Compounding Machines

Feb 23, 2016

One of the principal changes we made to our investment strategy during the year was to prioritize searching for businesses that can double in size in the next 5 years (i.e., compound machines) instead of searching for investments that have the potential to double in value in the next 5 years (i.e., opportunistic investments).  In other words, instead of having our investment strategy be centered on buying businesses at a large discount to their underlying value we are now more interested in buying growing businesses that can double in size at a fair value.  A good analogy is we are changing from investing in diseased mature trees that should get better after treatment to investing in healthy saplings.  Don’t worry, we are not abandoning our value investing roots.  We continue to believe the price we pay for an investment is the most important factor we control and is what determines our future rate of return.

Our losses in Aéropostale prompted us to examine our historical investment record in opportunistic businesses (those that trade at a large discount to value and have low growth potential).  We learned even though some of our highest returns were from opportunistic investments, our performance was below average when we considered our losses and permanent capital losses such as with retailer Body Central.  In other words, even though we hit some homeruns we ended up playing a bad game which hurt our overall results.  The key lesson is the overall compounding of our capital was negatively impacted by our losses in the opportunistic investments.

Alternatively, when we examined our compound machine investments our worst was Strayer Education where we lost on average 30 percent of our original investment.  What explains the disparity in results from these two different investment strategies?  With opportunistic holdings we are often invested in falling knives or businesses that risk bankruptcy due to large amounts of debt, high fixed costs or turnaround situations.  In contrast, our greatest risk in compound machine investments is that we may misjudge the growth prospects of the business and potentially overpay for growth that does not materialize.  In this type of scenario we would typically only lose a portion of our investment instead of our entire investment.

We find the discipline of only seeking growing businesses to be not only a safer strategy, but a more interesting one.  We aren’t spending time worrying about whether a business will survive or get the same credit terms from a lender.  Instead, we can focus intently on finding solid management that is building great products and services.

The Growth Mindset

There are a few adjustments we are making to our overall investment process that we have successfully applied to investing in growth businesses in the past.  First, we need to focus on how we think about valuation as many of these growing businesses are either losing money or under-earning relative to their potential as they reinvest in their own growth.  This requires some adjustment in our search process as we look for businesses trading at a multiple of revenues instead of a discount to revenue or cash flows.  As a friend Alex Pichler says, “Most compound machines are found on the 52-week high list and very rarely are found on the 52-week low list.”

The key to successfully investing in growing businesses is to search for those businesses where the stock market has underestimated either how long a business can grow (durability) or how fast it can grow (rate of growth).  We have learned if we can find companies that are underestimated on both these measures, they tend to produce the best investment results.  On the other hand, we must also take care to identify where the market is overestimating these same measures.  We have learned that the stock market rewards faster growth more than durable growth, as when shoe company Crocs carried a high multiple for many years, later crashing when the faddish shoes stopped selling as well.

Second, we must be ever vigilant in understanding why the business is growing.  A key lesson from our investment in the for-profit education industry was that many schools manufactured their growth by using aggressive recruiting tactics and facilitating student loans instead of allowing natural demand to fill their classrooms.  This proved to be unsustainable growth.

Expanding Our Inventory of Ideas

During the year, another of our key priorities was to expand our inventory of ideas (our primary source for investment leads) so we can improve the odds of finding a great investment.  We believe that if we have more high quality businesses on our radar, we can make more powerful comparisons and finer distinctions among businesses.  For example, as we added businesses with high growth potential to the inventory of ideas this helped us decide to reduce positions in opportunistic stocks as we believed the growing businesses had less risk and more upside potential.

To expand this inventory of ideas, we have been conducting an in-depth search of U.S.-based company filings of publicly traded businesses in order to add new founder-led companies to our inventory.  As we qualify these founder led companies using our investment checklist we focus primarily on those businesses with growth potential.  We also examine the compensation structure, ownership, company culture indicators, and whether the business is solving legitimate customer problems.  As a result of this effort we have added over 300 new investment leads to our inventory of ideas.

[us_separator]This post has been excerpted from a letter to partners of Compound Money Fund, LP.

This document is for informational purposes only. It is intended only for the person to whom it has been delivered. This document is confidential and may not be distributed without the express consent of Time Value of Money, LP. The information contained herein is subject to change; however, we are under no obligation to amend or supplement this document. This document is not intended to constitute legal, tax, or accounting advice or investment recommendations. This document shall not constitute an offer to sell or the solicitation of an offer to buy nor shall there be any sale of a security in any jurisdiction where such offer, solicitation or sale would be unlawful prior to issuance of an offering memorandum. An investment in Compound Money Fund, LP involves a substantial amount of risk. Investments should only be made by investors who fully understand these risks and can withstand a loss of their entire investment.

Broadcast Television: Cord Cutting vs. Cord Shaving

Feb 20, 2016

We were more active selling equities than buying in the second half of the year, selling shares in a number of long-term (Yahoo, Softbank, and Cott) as well as short-term (Videocon) holdings.

[pullquote align=”right” cite=”” link=”” color=”” class=”” size=””]We sold Yahoo because we lost confidence in the leadership of Marissa Mayer and her ability to extract value from the core Yahoo business.[/pullquote]

We sold Yahoo because we lost confidence in the leadership of Marissa Mayer and her ability to extract value from the core Yahoo business. Our Yahoo thesis was premised upon the Market’s misappraisal of Yahoo’s ownership stake in Alibaba. Alibaba’s IPO last year highlighted the value of its business and drove Yahoo shares higher. Over a 3.5 year holding period we realized an annualized gain of 37%.

We did not do as well on our investment in Softbank, losing 29% over a period of 17 months. Softbank has four primary stores of value, Alibaba, Sprint, Yahoo Japan and a domestic telecom business along with hundreds of portfolio companies thrown in for free. We are of the view that Sprint is permanently impaired. We do not think the company possesses sufficient liquidity to survive the price war in monthly phone service. Meanwhile, Softbank’s domestic telecom business has not fared much better, losing 35% of its subscribers last year due to aggressive pricing by competitors and the loss of exclusivity with Apple phones.

We are still confident in Alibaba’s prospects but with Softbank’s component parts bleeding value we thought the wisdom of investing in Alibaba through Softbank no longer made sense.

We invested in Cott Corporation because we though the market was not ascribing adequate value to the company’s transformational acquisition of DS Services’ water distribution business. Shares rerated higher with Wall Street willing to pay a higher multiple for a higher quality business. We realized a gain of 58% in a little over a year.

We wrote about Videocon in our 2015 June letter and anticipated holding shares for years to come due to Videocon’s attractive position in India’s high growth satellite television industry. Two things became apparent to us in relatively short order with Videocon; one, management was too promotional for our tastes and two, the economics of the Indian satellite television business were not nearly as attractive as we had envisioned. For example, while we thought average revenue per user (ARPUs) would trend higher over time due to consolidation, we realized that pervasive piracy in India was likely to keep pricing sub-optimal for some time to come. We lost 22% in six months on our position.

Selling is an underappreciated art in investing. Much verbiage has been spilled on buying but little on selling. While it is painful to lock in a loss and be publicly wrong about an investment, we endeavor to invest with the absence of ego. As John Maynard Keynes once quipped, “When the facts change, I change my mind.”

Story Time

“The power of anecdote is so great that it has a momentum in and of itself. No matter how boring the facts are, you feel inherently as if you are on a train that has a destination.” Ira Glass – This American Life

One of the most significant challenges in investing is keeping simple narratives at bay. The human brain is hard wired to embrace narrative. Story telling is a central feature of the human condition and enables us to sustain culture, illuminate truths and bind us together in common cause. When our brains are bombarded with signals, stories create patterns of the noise and surface meaning.

While stories help us make sense of the world, the allure of narrative interpretation leaves us vulnerable to taking mental shortcuts. Risk management expert, Nassim Taleb referred to this notion as the “Narrative Fallacy.”

“Explanations bind facts together. They make them all the more easily remembered; they help them make more sense. Where this propensity can go wrong is when it increases our impression of understanding.” – Nassim Taleb – The Black Swan

[pullquote align=”right” cite=”” link=”” color=”” class=”” size=””]Traditional television is dead.[/pullquote]

Let me tell you a story. Traditional television is dead. Streaming options, such as Netflix, Amazon Prime, and Hulu will make traditional broadcast television obsolete. Cord cutting will make appointment television a relic from a bygone era, as relevant as a radio fireside chat.

The supremacy of streaming television services over broadcast networks is a seductive narrative. We can all agree that the unparalleled choice of streaming, coupled with commercial free viewing, has sealed the fate of broadcast television. But what if the rush to frame a narrative around the future of television obscures important facts?

An examination of television consumption habits supports a different view than conventional wisdom. For example, television viewing has remained stable with the average person watching 5:14 hours of TV per day in 2014, relative to 4:24 hours in 2010, according to media ratings firm Nielsen. What’s more, television viewing dominates media consumption by more than two to one, with adults spending 16 hours of their weekly leisure time on smart phones, tablets and computers, compared to 37 hours watching television.

Broadcast content remains a mainstay of America’s living rooms, with most families loath to give up appointment viewing of sports programming, or big event programming such as the Academy awards. While ratings for cable programming have declined precipitously, ratings for local news increased 5% last year according to Nielsen. Compare this to cable news with viewership down 8%.

Not only are viewers not fleeing, advertisers continue to see television as the preferred medium to reach consumers with local television ad revenue up 7% year over year in 2015. Perhaps this is because broadcast television is available in 100% of households whereas cable advertising is only available to subscribers

In short, while broadcast television is a mature industry, it is not in terminal decline. Naturally, our anti-consensus view prompted exploration of the broadcasting space, which led us to Sinclair Broadcasting (SBGI).

Sinclair Broadcasting — The Revolution Will Be Televised

Sinclair has been a leading consolidator of local television over the past few years. The company’s network television stations reach 39% of American living rooms with 172 stations in 81 markets. Sinclair’s geographic reach gives the company sizable economies of scale in everything from producing news content to negotiating retransmission fees. Sinclair is the leading affiliate for both ABC and FOX stations and among the largest NBC and CBS affiliates.

Cord Cutting vs. Cord Shaving

The media narrative on television suggests consumers are cord cutting – replacing cable TV packages with a broadband connection and a streaming service. While cord cutting is indeed a risk, we are far from a tipping point. According to Nielsen, pay TV subscribers only dipped 0.1% in 2015 from the year prior. This is far from the dramatic decline portrayed by the media. We surmise that rather than cord cutting, viewers are electing to cord shave – reduce cable TV content packages to a “skinny bundle” of must have content. The economics of cord shaving make sense since consumers still need a broadband connection to consume over the top (OTT) content such as Amazon Prime or Netflix.

[pullquote align=”right” cite=”” link=”” color=”” class=”” size=””]Perhaps paradoxically, cord shaving has highlighted the value of broadcast television rather than minimized its relevance.[/pullquote]

Perhaps paradoxically, cord shaving has highlighted the value of broadcast television rather than minimized its relevance. Instead of paying for hundreds of arcane channels with niche content, consumers are free to choose only the channels most important to them. Viewers are happy to part with Man vs. Food but reluctant to give up local sports programming, news and primetime shows. An acceleration in skinny bundle adoption is likely to concentrate value into a smaller number of content providers. Current skinny bundle offerings highlight the core position of broadcast television with six of the seven skinny bundle offerings containing local network television channels.

Our variant perception rests upon the premise that increasing adoption of skinny bundles is a net positive for broadcast television rather than a negative. Commentary from Sinclair’s 2015 second quarter conference call helps signpost this trend:

“It’s important to differentiate that we are not a cable network. I believe that we are and will continue to be a part of every skinny bundle. ….I like our chances in the skinny bundle because that means we have fewer competitors on the dial.”

As cord shaving gains momentum, broadcasting networks’ ad inventory will become even more valuable by virtue of reduced supply of alternative television advertising outlets. This should enhance the economics of broadcast network companies such as Sinclair.

Retransmission Fees Have De-risked Broadcast Television Business Models

One of the most significant shifts in the economics of television broadcasting over the past five years has been the growth of retransmission fees. Retransmission fees represent the compensation paid to television broadcasters from cable and satellite providers in exchange for the right to carry local channels. The last few years have seen explosive growth in retransmission fees with aggregate retransmission payments rising from $0.5 billion in 2008 to $6.3B last year. Despite the growth, there is still significant potential for station operators to increase retransmission fees as legacy contracts come up for renewal. Sinclair is particularly well-positioned to ramp retransmission fees with approximately 75% of its cable/satellite subscriber base up for renewal this year.

Media research firm SNL Kagan projects retransmission fees will jump by two thirds over the next five years to $10.3 billion. The case for continued growth in retransmission fees is strong with data showing that broadcast television remains significantly under-monetized. For example, while broadcast television accounts for 40% of television viewership it only accounts for 10% of affiliate fees suggesting there is ample room to raise fees.

The Best Democracy Money Can Buy

Political advertising is a significant contributor to broadcaster revenues but varies with the election calendar. While political advertising has always been an important contributor to television station owners’ revenues, the Supreme Court’s Citizens United ruling in 2010 opened the flood gates. The decision removed limits on political spending by corporations and unions resulting in a windfall for local TV stations.

Political ad spending in 2016 is poised to shatter records. Wells Fargo projects $6 billion in spending, a 16% increase over the 2012 election. With television spending on the election through August of last year up 900% compared to the same period in 2012, we think Wells Fargo’s estimate will be handily topped. The gusher of spending will disproportionately benefit TV stations, which have typically captured 66% of political spending according to Wells Fargo. Sinclair should be a prime beneficiary of increased political spending with stations in 21 state capitals and ten swing states.

Spectrum Provides an Imminent Catalyst

Sinclair’s spectrum assets should provide additional lift to the shares and help provide downside protection. The company believes it can monetize $2 billion worth of spectrum in the Federal Communications Commission’s March 2016 auction. The numbers stem from a station by station independent analysis conducted by investment bank Greenhill. Potential values could be much higher. In 2012, Wells Fargo estimated that Sinclair could sell $3 billion worth of spectrum assets without compromising cash flow. Sinclair has stated that selling $2 billion worth of spectrum will only result in a 3% impact to broadcast cash flow.

There is of course no guarantee that Sinclair realizes $2 billion from its sale of excess spectrum, but if estimates prove correct, the impact on shares would be significant equating to 69% of Sinclair’s current market cap.

Compelling Valuation

Sinclair’s valuation is compelling. The company has guided to an average of $4.55 in free cash flow per year over the next two years equivalent to a 14.9% free cash flow yield. (Due to the spike in political ad revenues during elections it is best to analyze broadcasters on a two year basis) This is more appropriate for a business in run-off. We think a 10% FCF yield is sufficiently punitive for a business in flux, yielding a share price of $45+. Success in the spectrum auction could tack on another 30-50% to share gains.

[pullquote align=”right” cite=”” link=”” color=”” class=”” size=””]Sinclair is an example of how the best investments are found where no one else is looking.[/pullquote]

While the official narrative says otherwise, broadcast television is not going away any time soon. The shift toward skinny bundles makes broadcast channels more relevant, not less. The acceleration of retransmission fees, industry consolidation and increased political spend have made the broadcast business much more predictable. While we find Sinclair shares attractive for the underlying economics of the broadcast television industry, we like the fact that the FCC spectrum auction will provide a near-term catalyst to realizing value.

Sinclair is an example of how the best investments are found where no one else is looking. After all, we can only find mispriced securities if we face limited competition from fellow buyers. Yale’s Chief Investment Officer, David Swensen, referred to such investments as “uncomfortably idiosyncratic positions.” Such a position can make one uncomfortable, but if there is one thing we have learned in over a decade of investing, it’s that “many great investments start with discomfort.” – Howard Marks

The above post has been excerpted from a letter to partners of Coho Capital Management.

Best Real Estate Company in the World an Amazing Bargain

Feb 20, 2016

[pullquote align=”right” cite=”” link=”” color=”” class=”” size=””]When a stock that we own declines, we re-analyze our investment thesis and ask ourselves if it is still valid. Did something fundamental change for the company? Did we make a mistake?[/pullquote]

When a stock that we own declines, we re-analyze our investment thesis and ask ourselves if it is still valid. Did something fundamental change for the company? Did we make a mistake? We have just completed a full review and re-examination of every company in our portfolio. Our conclusion is that our portfolio companies are in great shape, are growing value over time, and are trading at huge discounts to their intrinsic economic values.

We are amazed at the bargains that Mr. Market is offering us. Howard Hughes Corp, arguably the best real-estate company in the world, trading at 50% of net-asset value. Citibank and Bank of America, two pillars of global finance that have made great improvements since the financial crisis of 2008, both trading around 50% of book value. Our basket of Korean Preference shares – all good, profitable, dividend paying business – trading at an average 55% price discount to their (already cheap) respective common shares. Israel Discount Bank, after making strong progress on its multi-year turnaround plan, trading for 50% of book value. Samsung Electronics, a global leader in consumer electronics, trading at 4-year lows and a 2 times EV to EBITDA price multiple. We are eagerly buying more of many of the companies that we own.

The above commentary has been excerpted from a letter to clients of Emerging Value Capital Management.

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