Executive Summary
v Perhaps owing to investors’ mixed feelings about and reactions to varied readings on the economy’s direction, the broad US equity market has essentially marked time thus far in 2005. We remain focused on generating above average results over multi-year frames.
v Despite this somewhat tentative investment landscape, we find the valuations and the implied opportunities in client portfolio positions to be compelling. In our opinion, several years of progress in earnings and corporate financial positions have been less than appropriately accompanied by proportionate increases in the value of client portfolios.
v Consequently, we generally increased net invested positions in client portfolios during the quarter by adding two new companies during the quarter, and selectively increasing exposure to several existing positions. Even though we trimmed select positions (based on changes in their price-to-intrinsic-value ratios) and were in the process of eliminating one entirely, client portfolios generally closed the quarter with less cash at the end of June than in March.
2Q 2005 Client Portfolio Activity
Summary
Note:
Not all Holdings listed may have been purchased, held or sold for all
client positions. New Positions Eliminated Positions Boston Scientific
Willis Group Holdings Partner Re1 1 We
began eliminating Partner Re positions in client accounts during the
second quarter, completing that process in early July. TABLE OF CONTENTS Executive Summary 1 Overview and Context 2 Portfolio Outlook 2 Portfolio Update 3-4 Portfolio Changes New Purchases Eliminated
Positions 4-9 5-8 8-9 Five Largest Holdings
Update 9-14 We Were Just Thinking… 14-15 Conclusion 15-16 Important
Information 16-18 Chart: Total Returns 2 Chart: Business
Category Allocation 3 Table: Top Ten 1,4 Table: Portfolio
Activity 1,5
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Overview And Context
“You got peanut butter on my chocolate. No, your chocolate is in my peanut butter.”
- Commercial for Reese’s Peanut Butter Cups
People sometimes view the same outcome from a decidedly different perspective, as in our memorable advertising quip above. It seems to us that the interpretation of economic news on which broad markets and CNBC junkies feed has presented similar opportunities for conflict. While the Federal Reserve moved short term rates eight times from 1.25% to 3.25% over the past year, levels of first (and second) home ownership have been reaching new highs. The per barrel price of oil has been topping nominal milestones, though the July Fourth holiday weekend nonetheless set records for number of travelers. Retail sales were slow earlier in the year, but have lately rebounded.
Perhaps owing to investors’ mixed feelings about and
reactions to mixed conditions, the broad US equity market has essentially marked time thus far in
2005. We generally avoid allowing any opinion on the overall market or macro
items to chart our investing course. We far and away prefer to consistently focus
our effort on understanding a few businesses well enough to value their
underlying prospects. While we are certainly observers of the economic
backdrop, we remain most keenly attuned to implications those conditions may
have for specific businesses and our investment strategy and focused on
generating above average results over multi-year frames.
Portfolio Outlook
Some pundits might argue that the current environment of excess competitive capital (hedge funds, private equity, etc.) has resulted in a dearth of broad price dislocations that opportunistic investors favor. We, however, continue to find a few very high quality franchises that “hit our radar screen” from a valuation standpoint. We would not characterize this environment as an across the board “buyer’s market,” but one of selective opportunity showing itself around the edges. Recent actions in client portfolios reflect our conviction in this regard.
Despite the somewhat hazy
environment and generally barely measurable returns for stocks in 2005, we remain
encouraged by some positive developments as we evaluate existing client portfolio
holdings and investigate new opportunities. In both areas, as we track
business progress and vet potential commitments, we are finding a few businesses
which possess what we view as robust growth prospects that continue to be
priced as if their progress will stagnate. The difference of opinion appears
to center around sustainability, and we expend considerable research effort in
evaluating where we think the competitive landscape indicates growth that can
have “legs” over time. The added bonus in many of these businesses is
reflected in their ability to generate excess cash and invest it at high rates
of return - dual drivers of value over time.
Just a few short years ago it was seemingly common for analysts and investors to assume that growth rates would extend to infinity. There has been something of a gradual compression in valuations over the past few years, since the deflating of the internet/tech bubble. Progress in recent years has resulted in cleaner, healthier balance sheets, good cash conversion profiles, and achievable growth prospects in select companies we are investigating. While it remains fairly selective, a number of company management teams with proven abilities to allocate capital and add value for shareholders are being under appreciated to a degree we have not seen in a few years. Generally speaking, several years of progress in earnings and corporate financial positions have not in our opinion been appropriately accompanied by proportionate increases in share prices. Though our purpose is not focused on determining “when” such discrepancies will be remedied, our experience suggests that the remedy will ultimately be in the form of reward for recognizing value in advance.
Portfolio Update
In our opinion, crossing the year’s halfway mark with clients’ performance generally ahead of the S&P 500 Index is a respectable outcome in a roughly breakeven market. In the category of preserving capital in tough markets, we characterize the year-to-date experience of “ahead by a nose” in the first quarter and “behind by a nose” in the second quarter. A very wise investor once described such a time period as “a lot of motion, not much movement.” In our case, we are encouraged by the “motion” of the underlying fundamentals of client portfolio companies while acknowledging the collective short-term lack of movement in their associated share prices.
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Top Ten Holdings As of June 30, 2005 |
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Company |
Primary Business |
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AFLAC |
Supplemental Health and Life Insurance |
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Berkshire Hathaway |
Insurance, Reinsurance & Capital Allocation |
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Cadbury Schweppes |
Int'l Confectionery & Beverages Manufacturer/Licensor |
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Cendant |
Travel & Real Estate |
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Comcast |
Entertainment & Information Services |
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Constellation Brands |
Wine, Beer & Spirits Production / Distribution |
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E. W. Scripps |
Entertainment & Information / Media |
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IMS Healthcare |
Pharmaceutical Market Information |
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Time Warner |
Entertainment & Information / Media |
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Zale |
Fine Jewelry Retailing |
Attribution of results is usually somewhat less than illustrative when absolute performance is of a small magnitude and the second quarter is no exception. About as many stocks gained in price as lost ground. Relative to the S&P 500’s sector scheme, client portfolios generally out-performed the Index in Consumer Staples and Industrials. On the downside, lack of exposure to Energy and Utilities and the underperformance of Consumer Discretionary and Financials detracted from client portfolios’ performance on a relative basis.
Portfolio Changes
In general, we added two new holdings to client portfolios during the quarter. Though participating in widely divergent industries, they share a common denominator in our view as businesses with good underlying economics, run by skilled professional managers pursuing shareholders’ interests and available at attractive discounts from intrinsic value. Early in the quarter we initiated positions in client portfolios in insurance broker Willis Group Holdings, a high quality, “toll-booth” business which we think has been made temporarily available at an attractive price. Despite some level of industry uncertainty related to a migrating regulatory regime, in our view the attractive economics of this classic middleman business will remain intact and available for Willis’ management to reap for shareholders. We also recently established an initial position in client portfolios in Boston Scientific, a leader in the highly profitable arena of medical devices. We note that in general, Health Care has quietly become a larger allocation in client portfolios, including a sizeable portion of the value of the conglomerate Tyco, added early this year.
We also acted on a few interesting trading opportunities in existing client portfolio companies, to varying degrees. Check the portfolio transactions portion of your June client statement package to identify any activity in these areas where we opportunistically added to portfolio exposure in a limited number of good businesses at what we view as attractive prices. Similarly, please note that we trimmed several positions, based on changes in their price-to-intrinsic-value ratios. Finally, we began eliminating Partner Re positions during the second quarter, completing that process in early July.
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Value Composite 2Q 2005 - Summary Purchase/Sale Activity Note: Not all holdings listed may have been purchased, held, or sold for all client portfolios. |
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Position (Activity) |
Investment Thesis/Reason for Sale |
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Boston Scientific (Bought) |
Leading medical device company focused on less invasive procedures to improve medical outcomes. Proven revenue growth platform and seasoned management team, with a stock priced at cyclically low expectations for productive innovation. |
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Willis Group Holdings (Bought) |
Third largest competitor in global business of brokering commercial insurance for large corporations and other sizable entities needing risk transfer. Unique opportunity for Willis to grow market share by capitalizing on damaged reputations of and required changes to past business practices of largest competitors. |
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Partner Re (Sold)1 |
Price target achieved. Our maintenance work in the insurance industry has led us to a more conservative posture based on competitive and pricing conditions. We opted to pursue booking the profits associated with the Partner Re position as its price-to-intrinsic value ratio increased and its associated margin of safety diminished, both quantitatively and qualitatively. We prefer the brokerage business model of Willis (see above) based on the differing price-to-intrinsic value relationships and current business dynamics. |
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11 We began eliminating Partner Re positions in client accounts during the second quarter, completing that process in early July. |
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New Purchases
Willis
Willis Group Holdings is a global insurance brokerage with over three hundred offices located in one hundred countries and is the third largest insurance broker in the world measured by revenues. We have followed the insurance brokerage trade for nearly two decades, and it is a good business with reasonable margins that have improved over time as the industry has consolidated. For several years, the share prices of most of the companies in this subset of insurance have traded at price-to-value ratios which we have found unattractive. That was of course until the whole industry was affected by regulatory action initiated by Elliot Spitzer, New York State’s ubiquitous Attorney General. In the ensuing fallout, industry leaders Marsh & McLennan and Aon Corporation, the two largest brokers which between them divvied up just over half of the global market in 2003, suffered damaged reputations and some level of business model disruption.
As this industry turmoil was unfolding late last year, we developed a renewed interest in these businesses and undertook a full review of the entire value chain in commercial insurance to determine the impact on existing insurance holdings as well as to investigate afresh the degree to which stock price movements and shifting business conditions were creating price-to-value opportunities. We surmised that the changes would advantage some players and that all of the value of that likely shift had not been properly accounted for in stock price adjustments across the industry. Willis became our choice largely based on a culture and structure that is suited to capitalizing on the realignment that is even now taking place.
We respect the management team that is in place to manage through this unique opportunity. CEO Joe Plumeri’s background at CitiGroup and predecessor firms points to an enthusiastic sales culture backed by strong compliance systems used to dealing with regulatory scrutiny. In our view his management background is suited to deal with the changes that take place as the insurance brokerage business model adjusts to a regulatory environment similar to those of other financial services segments. Eliott Spitzer worked his way to insurance only after taking on brokerage research departments and mutual fund day trading miscreants, suggesting last October that the insurance industry needed more transparency and better practices. Notably, while Willis also signed a settlement agreement with Mr. Spitzer after the initial investigations, the company was not sued by his office, nor was it made to apologize. In fact, Willis was explicitly praised for its proactive response to the contingent commissions issue that raised the New York Attorney General’s hackles in the first place. (We reviewed the Attorney General complaints and agreements from Aon, Marsh & McLennan and Willis, including in Willis’ case the supporting documents in a pleading filed by the Minnesota Attorney General. Our analysis of the various documents indicates a clear difference in the business practices of Marsh & McLennan and Aon and that of Willis, providing confidence that they are in a position to continue to increase market share.)
We believe that both underwriters and purchasers of insurance will retain a significant dependency on the insurance broker to provide information that allows risk to be properly priced from the perspective of both parties. However, because of the dislocations caused by the investigations and associated fallout, large blocks of insurance business that have not migrated in some time will likely be bid out competitively for insurance brokerage services. We believe that the market share shift will occur over the next few years as clients change or increase the number of insurance brokers they use because: 1) they believe they were misled by their brokers of record, 2) their account team moves to another firm, and 3) risk managers decide that increasing the number of brokers used will result in a better overall performance for their risk transfer portfolio. Willis, at mid single digits market share of an estimated $30 billion market, only has to gain a few points of share in order to generate significant positive change in its intrinsic value. Since 2001, the company has achieved organic growth rates respectably above industry peers, suggesting it was gaining market share prior to the Spitzer investigation.
Our review suggests that whole teams of insurance professionals with rich contacts in many different industries and valuable knowledge about their clients are willing to shift professional affiliation in the hopes of escaping the damaged reputations of the tarnished competitors, thus improving their future prospects. Based on our analysis of the industry, we view Willis as the only competitor to Marsh & McLennan and Aon that possesses available scale necessary to take advantage of these dislocations. Because Willis has built a sales culture and compliance system that anticipates a more rigorous and complex regulatory environment, as well as more transparent pricing to clients, it is our view that Willis is the most logical place for many of the employees (and their clients) who might prefer an alternative to the industry’s two “400 lb. gorillas.” Other insurance brokers will also likely be able to take some of the talent that is seeking a new professional home, though evidence indicates that other competitors are less suited to the global infrastructure that will allow them to win a significant share of large accounts.
We would and do expect some near-term pressure on Willis’ profit margins as they assimilate the upfront compensation expenses in advance of insurance going out to bid and being re-placed. But as a smaller yet formidable competitor with a significant market share gap from the two damaged industry leaders, Willis does not have to move very much market share in order to be very successful for their shareholders. As the next few years’ financial picture develops, we would expect even marginal acquisitions of professional insurance broker teams and new business wins to result in attractive value accretion for Willis shareholders over time.
Consistent with our ongoing analysis of the insurance industry, we also expect pricing to offset some of the volume pickup, since commissions for insurance brokers are, largely, a percentage of what we expect will be declining premium prices for individual risk placements. However, we also note that while unit pricing may be in for a cyclical decline, there has been a trend of growth in the gross amount of insured dollars over time, as the perception of risks to be mitigated shifts (one might call it a tax on litigation and legal extension of liability). In our opinion, this confluence of circumstances is directly responsible for the opportunity to purchase shares of this good business with good management at a recently attractive price for client portfolios.
Boston Scientific
Boston Scientific (“BSX”) is a medical device company that develops, manufactures and distributes products that typically use minimally invasive designs in order to improve the medical outcome of therapeutic procedures. The company has consistently applied technology advances to various therapy areas and compiled an impressive track record of marketing medical devices to the benefit of both patients and its shareholders. A good example is their leading product, the cardiac stent, a small wire mesh “scaffolding” that is inserted into clogged blood vessels via a catheter. For suitable patients, the procedure is extremely popular with cardiac caregivers as an alternative to open heart surgery. The stent business has become a blockbuster success and has come to dominate BSX’s financial results over the past year and a half. (Cardiac stents are in a market with patent protection and only one current competitor, Johnson & Johnson.) Both the number of units and pricing have increased over time as product enhancements in the form of a drug coating designed to improve efficacy have allowed the company to increase profit margins for this business line to enviable levels. (Global pricing is somewhat lower than in the U.S., but still posts stratospheric profit margins.)
We have followed the medical device industry and this company specifically for some time, noting its similarities and differences from the other major health care therapy solutions category, pharmaceuticals. Because of their high profit margins, device companies rarely trade at valuations we find compelling. Boston Scientific shares have recently traded at valuations more on par with pharmaceuticals companies while its business prospects are more attractive, in our opinion. We believe the efficacy of products is easier to discern, the competitive landscape more forgiving, and the path to cash flow more predictable than the current profile of R&D productivity from major drug companies. Aditionally, there are a limited number of paths to the customer in the medical device area, and Boston Scientific has a compelling strength in the relationships of its sales force with the physicians who make the choice of device.
The economics of the stent business have driven the extraordinary financial performance in the company’s recent past, and it seems, based on a significant contraction in its earnings multiple to recent levels, that market participants are skeptical of their opportunity for an encore. In fact, it seems likely to us that client accounts have the opportunity to own this great business because the market is currently valuing it as a “one trick pony,” single-product company. While drug eluting stents are certainly the company’s leading product line, Boston Scientific importantly holds leading market share in products representing roughly 90% of its remaining sales outside of stents. Non-stent businesses represent over half of revenues, and offer significant growth opportunities in multiple product categories. The company maintains leading positions in various therapy areas such as cardiac closure, endoscopy, and electrical stimulation on a worldwide basis. In our view, the cash generated courtesy of 60% operating margins in stents will continue to be reinvested to drive attractive revenue and cash flow growth.
We allow that a breakout product with “stentorian” financial characteristics akin to their current blockbuster is somewhat unlikely to emerge and remains difficult to predict even in the event. Nonetheless, the company has demonstrated success in its internal R&D efforts, as well as through selective acquisitions of novel technologies to either extend its position in existing product lines or gain leading market shares in new device markets. Their reputation, market, and well-trained direct sales force have created something of a distribution advantage across various therapy lines which makes them a logical acquirer for entrepreneurs with great ideas but limited paths to market.
Boston Scientific is guided by an experienced, savvy management team in possession of an enviably liquid financial situation and a demonstrated commitment to reinvesting in high return growth opportunities. We believe that even assuming a sizable decline in its stent market position, investors are too significantly discounting the company’s ability to continue to grow. In contrast, we expect that their "hybrid" internal and external R&D approach will generate meaningful free cash flow going forward, creating substantial additional value on top of their 25 years of successful innovation. At recent stock prices, we think there is an attractive discount from Boston Scientific’s conservatively estimated intrinsic value (even after allowing for market share erosion and price declines in stents, less aggressive timelines for pipeline products to emerge, etc.).
Positions Eliminated [1]
Partner Re
In conjunction with maintenance research and investigation for new purchases (see Willis), we have been involved in an ongoing evaluation of the entire insurance value chain. Placing that current review of various industry players into long context in insurance, and after canvassing our network of industry contacts, we currently see the insurance pricing cycle entering the more challenging part of its curve. Analysis of industry data and discussions with market participants on both sides of the transactions indicate that pricing power and discipline (as well as the unseen but extremely important “terms and conditions”) has begun to dissipate after a few years of a “hard market” for commercial coverage.
Moreover, it is our view that changes in the business model and competitive landscape for commercial insurance, in the form of capital competition and "easy money," provide the opportunity to amplify the downside affects of future cycles. When price opportunities improve, usually in the wake of a sizable catastrophic event, existing industry players are on the hook for paying claims, but reap less of the subsequent price increases because of the speed at which new players emerge to leapfrog them and cut into the profits they might otherwise earn to rebuild. We have watched this dynamic develop over many years, though it has accelerated to almost absurd extremes in the current wash of liquidity available from hedge funds and other nimble conduits for investment capital.
Based on our assessment of these shifts in the business reality for all industry participants, coupled with an increasing price-to-intrinsic value ratio and consequent diminished margin of safety, we opted to pursue booking profits associated with the Partner Re position. It remains a high quality business in our view, with a solid management team, which we were able to purchase at an attractive price in a different environment when we first established clients’ positions nearly five years ago. At that time, we felt that insurance pricing was heading in the right direction, and that Partner Re had some clear structural business elements available for its able management team to leverage to improve the value of the business over time.
Much of that thesis has worked out as expected, though the pricing environment is now less attractive and the “low hanging fruit” of business model adjustments at Partner Re has been harvested. Finally, the relationship of stock price to intrinsic value is the primary fulcrum around which our level of investment interest and capital allocation enthusiasm rotates, and we acted accordingly as that ratio shifted over the course of Partner Re ownership in client portfolios. A different stock price as a starting point might lead us to different conclusions, subject to facts and circumstances of the business at that time.
Five Largest Holdings Update
AFLAC
AFLAC returns to the top of the top ten holdings ranks courtesy of both its stock price performance and our marginal increase of its weighting through new purchases during the quarter. We haven’t addressed the company in writing in some time, so we’ll spend a bit of extra space as a review.
We first bought AFLAC for client portfolios in 1993 and clients have generally owned the stock for most of the period since, with brief exceptions related to valuation rather than fundamentals. AFLAC sells insurance products designed to help consumers pay out-of-pocket expenses associated with illnesses or injuries. Typical expenses include co-payments and deductibles as well as non-medical expenses. AFLAC dominates the supplemental health insurance market in Japan, where it is the low cost producer for its products and pays the highest commissions in the industry.
Though at the industry level, insurance is highly competitive, AFLAC’s niche of cancer insurance in Japan was historically insulated from competition for so long that it created a huge competitive moat that its management has continued to exploit right up to the present day. We also believe that the structural shifts in healthcare policy and demographic changes occurring in Japan are making AFLAC’s products even more meaningful on a current basis. For example, in Japan, demand for general supplemental health insurance products is expected to continue to grow as co-payments increase as a result of increasing burdens on that country’s national health insurance system. In addition, AFLAC expects that banks will be allowed to sell is products beginning in 2007, potentially opening up a meaningful new distribution channel. We also suspect the company to benefit as insurance price increases -required to restore the health of the industry in Japan- flow through to even better profit margins over the next several years.
As we have come to know (and love) it, the basic plan at AFLAC is to execute three strategies:
q Broaden products - AFLAC added two new products in Japan recently and has continuously diversified its business mix through steady innovation. It flagship cancer product represented over 40% of new premium sales in 2002, a figure that has declined to the low twenty percent range recently as AFLAC has cultivated new revenue sources.
q Operate efficiently - AFLAC’s operating expense ratio in Japan is under 20% (and they have worked to make steady improvements over time) as their entire there operation is engineered to take advantage of their low priced, high unit volume niche.
q Expand distribution - the potential bank distribution mentioned above is the latest possibility; past executions to expand include a successful relationship with Dai Ichi Life.
Domestically, AFLAC’s sales of supplemental health products, supported by its branding program (the AFLAC duck), are expected to expand growth to a range of 5-10% for an extended period of time. AFLAC’s management has made a number of operational improvements and changes to address growing pains as a result of very high growth rates in U. S. sales organization in prior years. We anticipate that the markets in the U.S. and Japan will produce meaningful cash flow growth at AFLAC, continuing to reward shareholders even from recent purchase prices. We generally increased AFLAC positions in client portfolios in late April.
Berkshire Hathaway
Berkshire’s shares traded down slightly during the second quarter, though we believe that solid operating results at the company are currently being obscured by “noise” and investor anxiety surrounding the investigation of the insurance industry by various regulatory bodies. With its stock recently trading within percentage points above mid-1998 prices despite a much improved business profile since that time, it seems clear to us that the market’s inability to periodically mis-value the company persists.
The investigation (begun last fall) of insurance industry practices by New York Attorney General Elliot Spitzer and the sometimes inflammatory rhetoric surrounding it has unsettled insurance investors. The focus has thus far primarily fallen on “finite (re)insurance” and whether or not the buyers of such insurance appropriately accounted for and disclosed such transactions. Berkshire was spotlighted for a reinsurance transaction in the year 2000 with AIG. As a result, two Gen Re executives have pleaded guilty and were subsequently terminated by Gen Re. We have reviewed a recent civil complaint filled by the SEC discussing the charges and are aware of the potential of additional executives at Gen Re being named.
We have also placed any information we gathered in the context of our understanding of the total picture of Berkshire’s business profile as well as Mr. Buffett’s long history of integrity. We continue to believe it extremely unlikely that Mr. Buffett was involved in any unlawful or even potentially unlawful action. Moreover, the potential economic impact of the resolution of issues surrounding transactions which have been publicly identified thus far will not, in our view, be significant to Berkshire. Ultimately, in our opinion, nothing about how these regulatory matters are ultimately settled would in our view have any ability to damage Berkshire’s business model.
Berkshire’s profitability profile is doing just fine, though that is being overlooked largely we think due to the short term headline risk associated with the insurance challenges. The operating businesses at Berkshire now represent half of the company’s intrinsic value by our estimates, and the value created over time by these operating companies has made Berkshire less insurance centric than in the past. This may be one of the best opportunities for shareholders to recognize value when and as other investors come to appreciate this dynamic. Despite the recent swirl of events in the insurance businesses, Berkshire retains valuable insurance franchises, discipline, competitive advantages and a solid source of low cost capital in that aspect of its business model. The excess capital at Berkshire is “worth,” on its face, roughly $44 billion. What the deployment of those billions may turn into over time is the critical question for Berkshire shareholders. Because Berkshire continues to produce additional cash at low cost, has a vast opportunity set for reinvestment, and houses highly skilled capital allocators among its senior management ranks and board of directors, we like the possibilities. The company remains, in our opinion, poorly understood and commensurately undervalued.
Cendant
Cendant operates a business model that is, for the most part, focused on collecting fees from long-term contracts and relationships as well as operating various ancillary services related to travel and real estate. Over the past 12 months, management has repositioned the businesses in which Cendant participates by exiting non-core businesses and using the proceeds to acquire additional assets in its two core market segments. Specifically, Cendant, through a combination of spin-offs, IPOs, and outright sales, will by the end of this year have exited the mortgage, tax preparation, and marketing services businesses. The proceeds from these actions have been allocated to the acquisitions of travel assets including Orbitz in the U. S., and Gulliver’s and ebookers in the UK.
While we support management’s initiatives, we recognize that the result has been a somewhat complex financial picture, as recent results are increasingly less comparable and therefore harder for analysts to compare. On occasion, we have found that such circumstances can present attractive opportunities when the underlying businesses are compelling enough to wade through the shift. We have been comfortable tracking the progress Cendant has made in improving its balance sheet and returning capital to shareholders via dividend and share repurchases. As the company works its way through an important transition - and they still have a few parts to go to complete it - we think the long term value of their remaining assets will become clearer. But we suspect the lumpiness has weighed on the stock price some as many investors prefer a wait-and-see approach.
We believe these actions manifest the company’s continued effort to use its capital efficiently and focus on the core strengths of its travel and real estate related, fee-based business model. The company is delivering on the objectives that its management team committed to several years ago: balance sheet and business rationalization working towards modest organic growth from its underlying businesses generating significant free cash flow. Even after recent acquisitions, in its core travel and real estate markets, Cendant will be left with more than $1 billion of excess cash, in addition to a target of roughly $2 billion of cash flow from operations for 2005. As long as that cash continues to be allocated to a combination of stock repurchase, dividends, and reasonable related-business acquisitions, we would anticipate significant additional value creation and hopefully recognition at Cendant over years to come.
Constellation Brands
Constellation’s stock price continued to perform well during the second quarter. In our view, akin to Sherlock Holmes’ “dog that didn’t bark,” the news for Constellation during the second quarter was what didn’t happen rather than what did. In the continuing consolidation of the spirits business, the liquor assets of UK-based Allied Domeq were up for grabs, with Constellation bidding in conjunction with other industry players and private equity backing to divvy up the assets. Because of the potential size of the deal and concerns over the price to be paid, Constellation’s share price was actually weak until it became clear that they would not emerge as the winner.
We have maintained that Constellation’s success can be largely traced to a management team possessed of discipline in its approach to executing at the operating level AND in allocating capital. Discipline is one of those words that’s easy to say and hard to do. It’s even harder to prove, since in some cases, it takes negative assurance to verify it. That is to say, in order to be truly sure of discipline in acquisition strategy, it takes watching someone walk away from the bargaining table rather than stretch and over commit to bad terms, for the sake of building an empire. We have grown confidence, borne of experience, that any deal Constellation’s team was comfortable with would have had reasonable opportunities for good economics. We are now equally comfortable that the discipline they have applied over time led them to know when to walk away.
Our efforts to regularly incorporate new information about the intrinsic value of portfolio businesses – as opposed to taking cues about value from the stock market – have been a rewarding exercise during clients’ holding period for Constellation. Because we investigated and understood several ways that its management team has taken steps to make the business larger, more diverse and most importantly more valuable, we have been comfortable maintaining a sizable position in client portfolios despite continued appreciation in Constellation’s stock price. On that front, our maintenance research on the integration and rationalization of the Mondavi acquisition continue to inspire confidence. An impressive culture and motivation systems are ingrained at Constellation, and in our view they are executing to make a good business better. They clearly have an advantaged platform and are in a sweet spot for growth of industry, and the company’s stock still trades at a discount to our estimate of intrinsic value.
EW Scripps
Scripps’ stock was in the middle of the pack for the second quarter, barely budging from March to June. The company announced that it was acquiring an online shopping service, Shopzilla, a transaction they closed in late June for $525 million. We view the move as a progression in Scripps’ defined path of diversifying their mix across various media categories. Founded in newspapers, the management team has historically - and profitably – moved into television and cable networks, video shopping and now directly onto the internet. Scripps has a history of starting valuable media assets from scratch (HGTV) as well as acquiring them (Food Network). We have developed confidence in their process for properly vetting the proposed return on capital outcomes associated with internal or external development of different avenues to achieve their asset objectives.
Operationally and financially, Scripps has continued to execute, earning good results from is signature HGTV and Food Network properties and traditional assets. The company continues to make progress with developing networks Fine Living, DIY Network (do-it-yourself), and Great American Country (GAC), expecting them to collectively begin contributing to the network segment profitability after several years of nurturing them. They continue to invest in the Shop At Home network, which is growing revenue but requires investment to implement the electronic commerce vision of its management.
By operating across a broad range of media, Scripps hopes to be able to capture viewer-ship and advertising dollars that migrate to those other media over time. They have executed the reallocation of capital phenomenally well in the case of their cable networks in the past, making investments on which its shareholders are still dining out today. Recall that unlike many other networks, Scripps’ develops and owns the original programming used on its networks and is still in the early stages of leveraging this content into other forms of distribution, in particular video on demand and the internet.
Scripps may be able to use some technology tools from Shopzilla on the other web sites that are more closely related to their cable networks’ content. However, in our view the Shopzilla transaction represents more of a new platform entry, as opposed to the Shop At Home deal, which is designed to work more closely with existing assets. We expect Scripps to solidify their existing asset offerings and earn good results doing so in the interim. At the same time, as the cable and satellite distributors make the transition to all digital channels, capacity may decline as a barrier to entry. Therefore, Shopzilla looks to us like Scripps’ management planting some fresh seeds for the next leg of the company’s evolution. We remain interested to see where Scripps’ management can take its collection of compelling content and are intrigued by their recent moves to cast that net even wider.
We Were Just Thinking
Speaking in less than scientific terms, we think it would be a fair assessment to suggest that there has been a massive shift of assets into hedge funds and related alternative investment categories that share a fair amount of borrowing as a common denominator. In one regard their popularity is unsurprising, since the overall category appears to have logged relatively good, and more importantly steady recent investment returns, particularly in light of the stock market’s volatility since the 2000s were inaugurated. Investors have always been attracted to things that have done well recently, seeking specific return goals that may or may not be justified by the prospective underlying economics of what that marketplace has to offer.
Somewhat to our surprise, the investment landscape is looking more and more bifurcated along a spectrum we might term “cash / ‘negative cash’.” It seems that many of the most rewarding – and rewarded – categories of investment over the past few years have essentially involved the “negative” use of cash, i.e., borrowing money to enhance the financial result. Hedge funds are generally users of leverage in various forms, from straight up borrowing to short positions (borrowed shares) to various complex derivative instruments. We note and stipulate than many sophisticated professional investors have used hedge fund vehicles with great success over long time periods. Whether that success can be translated to a broader populace of investors and a much larger pool of capital and participants/sponsors remains an open question.
One glaring example of our purported cash / negative cash dichotomy might be found in comparing client portfolios’ largest holding, Berkshire Hathaway, with these increasingly popular vehicles. As we predicted over the past few years in our separate write-ups on Berkshire, Cash Happens and Mega Real Bucks, the company has begun to amass a sizable cash position generated from a diverse collection of operating businesses, recently amounting to roughly $44 billion dollars. Berkshire’s share price on the other hand has gone nowhere, and many investors fret that Mr. Buffett cannot conceivably find enough opportunities to reinvest that massive cash hoard. Meanwhile, literally thousands of savvy financial types with sophisticated computer models and/or track records and resumes from major Wall Street firms are hanging out shingles as hedge fund managers, and investors are throwing money at them. Here our exaggeration is limited. One of the first things most of these funds do is to contact former Wall Street associates to help multiply the capital they raise, often by some integer multiple.
Like many things in life leverage can be rewarding when exercised prudently. For example, all of the companies in client portfolios make some use of debt within their capital structures. Financial leverage amplifies results on the upside because once its capital cost is covered, appreciation or cash flow above that service cost accrues to the borrower. The unequal but opposite reaction that is the price of the bargain is that adverse outcomes are also amplified. Whether or not cash flows in some form (income or realized gains) materialize, the lender will need to be repaid a fixed and inescapable (except through default) obligation. We have noticed that when certain risks do not manifest themselves for long enough, human nature allows people to convince themselves that the risk has been removed rather than lying dormant. When Shakespeare observed that “borrowing dulls the edge of husbandry,” he forgot to throw in “not to mention the senses.”
In some ways, this is the signature element of financial markets circa mid-2005: producing cash is viewed as somewhat problematic, but getting it from someone else in the form of credit lines and various derivative counter party borrowing arrangements is not. And yet somehow this diverse pool of investors is reasonably expected to unearth enough profitable investment opportunities to reward all of the return requirements of their growing clientele, while an uninformed constituency clamors for a dividend because Berkshire has “too much cash.” Note that at the industry level, it is estimated hedge funds are closing on a trillion dollars in invested capital, or more than twenty times Berkshire’s cash - before adding on the borrowing capacity and the risk of severe loss it introduces (even if that risk remains hidden for a time).
Oh, and one last thing, let’s not forget the friction associated with transacting and gaining access to the promised return patterns. The entry price is typically one percent of capital plus twenty percent of the profits, and another layer of fees that shares the same “pay me twice” structure for smaller investors accessing through “funds-of-hedge-funds,” a term that would be comic if it weren’t tragic. They pool the capital, and then generally borrow (not produce cash, but borrow, i.e., create obligations which must be paid back) heavily leveraging up several times and marching down the path of heads they win tails you lose investing. Some of these will sprinkle in debt at multiple levels, i.e., both the underlying hedge funds themselves and the fund-of-funds “sponsor.” Webster’s defines hedge as “a means of protection or defense, as against financial loss.” This is protection?
In contrast, let’s use Berkshire Hathaway as a comparable again. (Berkshire is just one example; there are other client portfolio companies with what we view as great business profiles, which are producing cash and are likely to continue to do so for some time to come.) Its shares are available for purchase in the open market five days a week for probably $12.95 commission at a discount broker, and selling in our view at a sizable discount from the intrinsic value of its businesses. It provides access to arguably the world’s greatest investor, with decades at the helm for his salary of $100,000 annually, no stock options to dilute you. There is little debt on the balance sheet relative to its assets, and its management team maintains an avowed aversion to borrowing backed up by decades of behavior to prove they mean it. It produces rather than consumes or borrows real cash from its operations at a rate that would shame Rumpelstiltskin.
Cash and “negative cash.” Guess which of the two available alternatives people have been choosing in spades? Maybe the investments that use up all their cash and then go borrow a bunch more will avoid ending badly, but count us dubious. Of course that’s just our opinion.
Conclusion
We remain actively engaged in analyzing information that is timely and relevant to the future prospects of a few quality companies suitable for client portfolios. The environment for us to ply our trade in our view has grown somewhat more attractive as businesses progress while market prices remain largely inert.
As we noted in our recent client letter, we enhanced the firm’s website at www.oakvalue.com, including information about the Oak Value philosophy, research process, and our people, as well as copies of current and prior portfolio commentaries. We hope you will take some time to review the site and welcome your feedback and suggestions. We thank you for your continued interest and partnership and welcome your questions and comments.
Oak Value Capital Management, Inc. Investment Committee
David R. Carr, Jr. Larry D. Coats, Jr. Matthew F. Sauer
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[1] We began eliminating Partner Re positions in client accounts during the second quarter, completing that process in early July.