Q3 2019 Letters

The Fund returned -7.60% for the third quarter 2019. This compares to returns of 1.73% for the S&P and 0.77% for the Russell 2000. While underperformance is never fun, it is a requirement if we want to generate outsized (and differentiated) returns over the standard benchmarks.

The price paid for long-term outperformance will be short-term underperformance. We will zig when the market zags. Sometimes to our benefit, other times to our detriment. In the seven quarters tracking the Fund we’ve lagged the S&P thrice, or 43% of the time. This should be expected. Nearly all our holdings are outside a major index.

Since we’ve started these letters (Q1 2018), the Fund’s cumulative return is 17.30% (8.65% annual average). During that same time frame, the S&P’s cumulative returns is 13.41% (6.70% annual average). A small 2% annual outperformance doesn’t appear to be significant at first glance. But we must remember the power of compounding. A hypothetical $10,000 invested at the above-mentioned average annual returns reinforces this idea. These aren’t actual returns but a hypothetical extrapolation to show the power of compounding:

Viewed through a longer-term framework (5, 10, 20 and 30 year time frames), a small 2% outperformance makes a big difference.

Of course, we’re not satisfied with 2% outperformance. We would prefer a wider margin. Yet we will not devalue our underwriting standards in an attempt to chase short-term returns. We continue to invest in businesses with little-to-no debt, generate healthy free cash flow, return capital to shareholders and increase intrinsic value.

Expectations Is What Matters

Michael Mauboussin is one of the best investment thinkers of our time. His white papers, books and podcasts are treasure troves of knowledge. I make an effort to read, listen or watch at least one Mauboussin piece of content each month.

Last month I listened to Tobias Carlisle’s interview with Mauboussin on The Acquirer’s Podcast. During the interview, Mauboussin discussed his book Expectations Investing and what a stock price really means. The central thesis on Expectations Investing is found in Chapter 1 of Mauboussin’s book:

“Stock prices express the collective expectations of investors, and changes in these expectations determine your investment success.”

Low priced stocks represent low, collective expectations. In contrast, high-priced stocks represent high, collective expectations among investors. This doesn’t mean the low-priced stocks are “cheap” and the high-priced stocks “expensive”. Rather prices express embedded expectations about the future from the collection of market participants.

How can we take advantage of expectations? First, we can look at stocks that have the lowest embedded expectations. These are stocks usually trading around their 52-week or all-time lows. Second, we can hypothesize a variant perception about a company that isn’t currently embedded in the stock price.

The great part about investing in low expectation stocks is that we don’t need a lot of positivity for us to achieve outsized returns. For example, if a stock is trading around all-time lows because the collective expectations is bankruptcy, all we need is the company to not go bankrupt. If that happens, we’d be handsomely rewarded as the collective readjusts their expectations of the stock.

Portfolio Updates

Not much changed during the quarter with regards to the portfolio. There were two changes we made. First, we exited our short position in Under Armour (UAA) for a profit. Second, we entered into a new position that is an immediate top-five holding, Fox Corporation (FOX).

Under Armour, Inc. (UAA): High Unrealistic Expectations 

Shorting is like practicing jiu-jitsu. I don’t do it often. But when I do, I’m glad to come out alive. In our case, “alive” means booking profits. The short on UAA proved profitable as we exited around $18/share. Given the news surrounding Kevin Plank’s departure and pending securities fraud investigation, I want to reiterate our initial short thesis. Here’s our thesis back from the Q2 letter:

“The short thesis for UAA is simple. Here’s a business that’s reported -3% sales growth in their “best” market (the US) for the last three consecutive quarters but trades at 60x 2019 earnings and 21x 2019 EBITDA. Bolstered by robust 12% international growth, total sales growth is a meager 1% through 2H 2019.

I don’t see a world in which it makes sense to pay 60x earnings for sub 5% top-line growth, let alone 1%. In fact, the company’s failed to break 5% revenue growth over the last two years — yet still commands a 60x multiple. Have I mentioned the company is in the retail space?”

Let’s look at our short through an expectations lens.

At the time we went short, the stock price presented very high embedded expectations about the future (60x earnings). We thought these expectations weren’t feasible and the future would look much different (in a bad way) than the past. The CEO departure and subsequent securities fraud investigation weren’t part of our thesis. Unfortunately we weren’t smart enough to hold on until those events.

Fox Corporation (FOX): Low Expectations with Great Assets

FOX was spun-off from 21st Century Fox in March of 2019. The company began its journey as a public company at around $40/share. Due to spin-off selling dynamics, the stock dropped ~25% to below $30/share. We thought the share drop represented a low expectations opportunity to purchase a high quality business, run by incentivized management generating substantial free cash flow.

There are things not to like about FOX. The Murdochs pay themselves hefty compensation packages (most of which through stock rewards). There’s also some share class structure that prevent shareholders from engaging in activism with Rupert Murdoch owning most of the voting-power Class B shares. And we can’t forget the cord-cutting bonanza that’s sent most cable stocks plummeting (I’m looking at you, CBS).

FOX relies on real-time, live news and sporting events. These events aren’t as susceptible to streaming services that rely on “save and watch later” mentalities. These are events you want to watch live. While advertising impressions have declined for pre-programmed shows, live-event advertising remains strong.

At the time of our purchase (around $30/share) the market valued the company’s cable business — arguably the best cable business in the world — at 9x EBITDA. 9x EBITDA for FOX’s cable assets is attractive enough on its own merit. Yet FOX offered more. The company also owns 28 TV stations across the United States.

These TV stations generate over $430M in annual EBITDA. But, at $30/share, the market valued all 28 TV stations at $0. So 9x EBITDA bought you the cable business, giving you 28 cash-flowing TV stations for free. Plus, FOX’s cable assets are more resistant to the cord-cutting/streaming service.

Unlike most spin-offs, FOX isn’t saddled with loads of debt. They have $19B in current assets ($3B of liquid cash) and only $6B in borrowings. Most of that debt isn’t due until after 2029. The company also generates close to $2.4B in annual FCF. That translated to a 13% FCF yield at the time we entered our position.

In terms of capital allocation, FOX makes an effort to return capital to shareholders through dividends (1.38%) and buybacks. Our investment in FOX reminds us of one of my favorite Joel Greenblatt quotes:

“My largest positions aren’t in the stocks that I think I’ll make the most money. They’re in the stocks where I don’t think I’ll lose money.” 

Our purchase price (11x current earnings), strong balance sheet ($3B in cash vs. $6B in LT debt), healthy cash flow ($2.4B) and incentivized management give us confidence that our odds of losing money with FOX are low.

Turning a Corner

My goal with the blog (and these letters) is to develop a track record so that one day — God willing — I can start my own small, private investment partnership. A large step in that direction is putting my money where my mouth is. Over the course of tracking the portfolio I’ve used a paper trading account. Yet starting January 1, 2020 I’ll be reporting figures in a real money account.

I am confident that over the long-term our value investing strategy will generate outsized returns compared to broader indices. I don’t want to reinvent the wheel. These last (almost) two years have been my attempt at showing the power of searching (and investing) in overlooked, off-the-beaten-path corners of the markets.

The strategy works best with smaller amounts of capital. For that reason, I have no desire to manage billions, or even hundreds of millions. A small, private investment partnership capped at $25M is more than enough to implement our strategy.

Future Outlook

The Fund owns great businesses that are growing in intrinsic value. While Mr. Market may not agree with our view of long-term value in the short-term, over time we’re confident the weighing- machine will tilt in our favor.

I look forward to writing to you in January. If I don’t hear from you, we hope you have a tremendous Holiday season.