Things That Don’t Make Sense

Feb 15, 2017 by Boyles Asset Management in  Letters

“One of the key things to investing, and I think this is a life truism, is to be aware when you hear a voice in your head that says, and you usually squint your eyes or you’ll hear someone say the following words: ‘That doesn’t make sense.’ And that’s always a sign of something really powerful.” –Adam Robinson (in an interview on “The Tim Ferriss Show”)

To many people more confident about how the future will unfold than we are, 2016 may go down as a year that didn’t make much sense. The majority of so-called “experts” were wrong on things such as Brexit and the U.S. election, and wrong on how Mr. Market would respond to the results that occurred. For our part, we try not to rely too much on prediction, and instead focus our efforts on individual stock selection among businesses that can survive whatever the future has in store, at prices that give us some margin for error in case we are wrong. But the powerful lesson from studying the phrase “that doesn’t make sense” rests in the fact that it often means one of two things: 1) One’s current view of how a certain part of the world works is wrong, and it will make sense once that view is corrected (and in hindsight); or 2) There is something much bigger going on, which one does not yet understand.

The example that Robinson used to illustrate the second point had to do with real estate investor Sam Zell noticing where Starbucks locations were opening up, and using that data point as the spark that led Zell to see the bigger force of China’s construction boom when it was still in its early stages. While we weren’t able to locate enough information to tell that story in more detail, there is another story, still in progress, that also illustrates the point: the rise of the internet, and its effect on non-internet businesses.

During the internet bubble of the late 1990s, many investors, especially in the value crowd, found themselves looking at valuations that didn’t make sense. And they were correct about the value of many of those businesses. But the bubble went on for a long time, and for many, when it seemed like valuations were as far detached from reality as they possibly could become, they just continued becoming further detached. As investors and students of how the world works, we want to see things as they are, and learn the proper lessons from the things we study. And often that means asking ourselves a second, related question—especially when we catch ourselves thinking that something doesn’t make sense. Nobel Prize-winning psychologist Danny Kahneman often asks himself this question. As described by Michael Lewis in his latest book, The Undoing Project, “…when Danny heard an illogical argument, he asked, What might that be true of?

And to an investor focused on value investing in the late 1990s, there were plenty of illogical arguments to be found, whether it was a focus on eyeballs (webpage views) over profits, or any other metric that left one reminded of the story about a business losing money on every sale, but making it up on volume. In the internet bubble, there was more than one answer to the Kahneman question above, which aims at getting at the underlying truth of the topic at hand. One answer was psychological. Berkshire Hathaway Vice Chairman Charlie Munger has said that on several occasions, Warren Buffett has made the point that “It’s not greed that drives the world, but envy.” And envy played a big part, as people hated seeing their neighbors getting rich, and the urge to participate grew too unbearable to ignore for a large swath of people. (Munger also makes the point that envy and jealousy made two out of the Ten Commandments. That’s probably a good sign that their power shouldn’t be underestimated.)

But the internet and the way it would change business models in the future was an incredibly powerful force that people were either right to get excited about, or right to be worried about if their profits depended on a business model that could be disrupted. During the bubble, investors and the prices they were willing to pay for that future became detached from reality. But the forces pushing change continued unabated, as Moore’s Law continued to drive down the cost of computing, thus driving the cost of internet distribution closer and closer to zero.

Bill Gates, in his 1995 book The Road Ahead, wrote, “We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten.” And that overestimation of the short-term and underestimation of the long-term is what happened, and continues to happen, with the internet. When married with a good product, some of the businesses that ended up gathering the most eyeballs were able to reap the rewards of network effects and the winner-take-all nature of the internet to become some of the most valuable businesses in the world today. Google, which in its early days in 1998 offered to sell itself for $1 million; and Facebook, which wasn’t even launched until 2004, have completely upended the advertising industry, and are two of the most valuable (and plenty profitable) businesses in the world today.

And there’s Amazon.com, which was front and center during the bubble. It was trying to upend an industry much larger than that of advertising. Ironically, an investor would have actually earned a reasonable return even buying it at its peaks during the height of the bubble from 1999 to early 2000, although the hype and price then would have been hard for a value investor to justify. But while those were still the beginning days of retail on the internet, the numerous department and mall store closings announced during the last few months are prime examples of the power that the internet can wield, and as the accompanying chart from visualcapitalist.com shows, the shift in customer attention has also shifted market values during the last decade.

We bring all of this up to stress the importance of the internet and technology to almost all businesses. While the changes during the last 20 years have been massive, there is still much to come and much to think about, both from an opportunity perspective as well as a risk-management perspective. As technologist Kevin Kelly wrote in his most recent book, The Inevitable, “In terms of the internet, nothing has happened yet! The internet is still at the beginning of its beginning.” While we don’t expect to be considering the purchase of any of the major technology companies mentioned above—absent another 2008-like market decline—there are profitable businesses that will benefit from the tailwind technology will provide. Indeed, some of them are run by management teams we admire that have carved out smaller, growing niches; we’d love to own them at a fair price. We were able to make investments in two of them during the early 2016 market decline: one in decent size (BrainJuicer) and one (Tucows) in which, when it was raining gold, we unfortunately brought our thimble.

““Big opportunities come infrequently. When it’s raining gold, reach for a bucket, not a thimble.”
–Warren Buffett, 2009 Letter to Shareholders

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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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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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