Capital Account

February 6, 2020February 9, 2020 ~ Sullimar Capital Group ~ 3 Comments

Below will summarize takeaways from the following book: https://www.amazon.com/Capital-Account-Manager-Turbulent-1993-2002/dp/1587991802. The post will be “living” and will be updated/elongated as soon as possible.

Chapter One Takeaways:

A key component of Marathon’s investment theory is based on the inverse correlation between profitability and levels of competition. Capital Account at 45. Their thinking goes something like this: if competition declines, then future profitability is likely to increase, which should result in higher stock market values. Id. Often, investment analysts miss how competition (the supply side) drives profitability and shareholder returns. Id at 47.

If, during the course of a business cycle, the competitive environment of an industry changes dramatically, then we can expect peak to trough profits to change correspondingly. Id. at 48. The actions of management are extremely important as well. When a mature company operates from a smaller asset base (ie: ROIC improves), it can boost shareholder value even if cyclically adjusted profits stay the same. Id.

What might determine the direction of normalized profits? “The first important factor is the change in competition between one cycle and another. This needs to be tempered by an assessment of the firm’s position in the corporate life cycle and whether its product life cycles are lengthening or shortening. The latter is particularly important because shortening product lives are rarely caught by reported earnings. Indeed, the appearance of rising profits from a new product may be offset by a shorter product life.” Id.

In order to get clues into management behavior, look to proxies and incentives. As far as valuation in concerned, be mindful of market value to replacement costs. (NOTE – Market value to replacement costs applies to most companies. However, the types of companies Bruce Greenwald refers to as franchise companies are likely untethered from replacement costs. In those instances, an investor should think more about yield on cost than replacement values). Long periods of companies trading at discounts to replacement cost tends to result in profitability improving. Id. at 49. This is because sustained low valuations exert downward pressure on capital spending. Id. Eventually, some form of underinvestment leads to product shortages and improved profitability. Id. (NOTE – Be mindful to analyze this on a geographic basis. For instance, the US steel industry could be rational but foreign companies could expand production and ruin the benefits of US rationality).

Conversely, when companies are valued in the stock market at premiums to replacement costs there is a strong incentive to increase capital spending. Id. at 50. This is a form of multiple arbitrage where the company can spend $1 and have it valued at far more than $1. “All too often this encourages undisciplined expansion, which in turn leads to excess capacity and falling profitability. Id. Generally speaking, industry capex to depreciation is a decent clue for determining whether an industry is over or under investing. Id.

Be mindful of the impact asset lives can have on capital cycle analysis. For instance, paper processing plants have longer lives than semiconductor fab facilities. Id. at 57. Therefore, it can take a longer time for capital cycle analysis to flow through the paper processing industry. Id. It’s equally important to study the extent to which new technologies can wreak havoc on capital cycle analysis. Id. In today’s terms, be mindful of potentially disruptive technologies and how quickly they can enter the market.

Chapter 2 Takeaways

“When we examine a company as a prospective investment, we analyse both the industry in which it operates from a capital cycle perspective and make an assessment of the individual firm’s management. We attempt to judge whether the sector is attractive, whether our prospective portfolio company is positioned favorably within its sector and what are the likely returns a company will earn from reinvesting its profits. Since by definition half of all companies must be reinvesting at below average returns, they should ideally be retrenching. However, by our estimate, around 90 per cent of firms continue to invest for growth, regardless of their profitability.” Id. at 65.

Although not news, remember to be mindful of growth for growth’s sake. Moreover, pay some attention to where the company is located. In Chapter 2.3, Marathon highlights France (in 1994) as a country housing corporations with particularly egregious corporate structures and incentives. Perhaps today’s version is the energy MLP industry in Texas.

Throughout Chapter 2, Marathon argues that management compensation via long term options is a good thing. At least up to a point. In short, options compensation, while not a one for one incentive structure, does focus management on share price. Thus, management teams are more willing to make reasonable capital allocation decisions.

With respect to buybacks, Marathon argues a number of conditions should be met:

The company must be able to afford the buyback without putting itself in jeopardy. Watch leverage and liquidity.
Buybacks are most suitable for businesses that are mature and generating plenty of cash.
Generally it’s the adoption of new performance measurement systems, rather than share repurchases themselves, that benefit investors.
Be very wary of buybacks that drive EPS targets. According to Marathon, buying in shares to improve ROIC or another rational investment metric is a far superior capital allocation decision than driving EPS.
Share repurchases should be done below intrinsic value. Above intrinsic value repurchases are no better than cash dividends.
Consistent share repurchases instill discipline.

Chapter 3 Takeaways

The more things change, the more they stay the same. Much like today, the 1990s saw extreme outperformance in the “growth” segment of the stock market.

In 1998 Marathon wrote:

“Enthusiasm for highly profitable businesses has been a striking characteristic of the stock market over the last few years. Yet in theory there is no reason why growth stocks should outperform value shares, since the market is capable of adjusting share prices to reflect each individual companies’ prospects. In other words, as the share price should reflect the net present value of the cash flow a business is likely to generate over its life cycle, it matters little whether this is a modest amount, in the case of a steel company, for example, or a much greater amount, say in the case of Coca Cola.” Id. at 87-88.

Later in the year they revisited their growth vs. value observations:

“We have felt that price-earnings mutliples of 50x earnings might be a little rich for firms whose profits might be overstated and whose main investment strategy is acquisition of their own shares, regardless of price. Furthermore, the high levels of current profitability, from which further enhancements are already discounted, increases our concern…Shares defined by Wall Street as growth stocks have a high probability of failure. Over the last 33 years, only 19% of growth stocks have maintained that elevated status for a decade or more. For most of this period, growth stocks were not as highly rated or as profitable as they are today.” Id. at 91.

They go on to analyze whether growth stocks can grow into current valuations and propose the following decision tree:

In the decision tree above the business model is riskiest at the top of the tree. Id at 93. Importantly, companies with long runways and low risk growth paths are worth a higher multiple than those lacking those characteristics. However, just as oaks don’t grow to the sky, multiples eventually reflect unrealistic expectations. The investor’s job is to avoid the pitfall of believing hype at exactly the wrong time. Watch out for leading indicators of falling profitability, industry expansion, lower returns on capital, and accounting gimmicks that keep earnings elevated. These are all warning signs and demanding valuations require few warning signs.

Interestingly, Marathon bucks conventional wisdom saying they operate under the philosophy that the range of investment outcomes is characterized by “fat tails.” Id at 99. Most market participants assume there is a normal distribution of returns. Marathon, however, argues shares spend relatively little time at “fair value.” Id. Instead, shares spend lengthy periods of overvaluation followed by lengthy periods of undervaluation. Id.

That thesis carries important conclusions. First, it implies short term mean reversion is not likely. Id. Second, it implies extreme periods of misvaluation are not short lived and/or rare. Id.

Given what’s going on within the market, it’s interesting to revisit Marathon’s thoughts in the late 1990s. A couple excerpts:

“We believe the capitulation of the investment community [to chase high flying shares]…will have economic consequences long after the current trend is reversed. This is because valuations affect behavior. For instance, among firms in the value universe which fail to earn their cost of capital even the most diehard optimists in senior management now accept that asset expansion destroys value.” Id at 103-104.

On investor’s behaviors: “The high valuation of growth stocks might leave investors dangerously exposed should growth disappoint at any time. This has induced investors to buy shares in companies they believe will maintain growth. In the last few years, as growth slowed, the list of potential growth companies has narrowed considerably…Growth now has a scarcity premium attached to it.” Id. at 106.“

The more things change, the more they stay the same…

Chapter 5 Takeaways

Chapter 4 didn’t have much. So, here’s chapter 5.

In 1994 Marathon saw the market capitalization of telecom stocks as a signal that competition would likely enter the market. Moreover, Europe was deregulating many telecom markets and transitioning from state run to private enterprise telecom companies. Signals included the following:

“Equity market valuations [of telecom companies] have sky-rocketed. The market capitalization of the telecoms service sector in Europe now…represent[s] 13 per cent of the MSCI Europe Index. Compare this with the modest 2 to 3 percent of national income spent on telecom services in the major European economies. The challenge for investors in such a rapidly changing an complex industry is to understand the assumptions underpinning current valuations and identify those companies with sustainable competitive advantages...That the market values of telecoms firms are currently at a huge premium relative to invested capital reflects an expectation that the prices [economic profits will remain] long into the future.” Id. at 130.

They shared this image of industries beginning deregulation.

That framework appears applicable to industries in the midst of disruption as well. Such as media distribution in 2020.

An important quote to remember: “The laws of the capital cycle are such that in a [competitive] environment, the price of goods and services will drop to the marginal cost of production and even below for a while.’ Id. at 129. This is extremely important to remember. There must be a very good reason if underwriting deviates from this thesis. Don’t find “moats” where none exist if you want to protect capital for the long run.

On network effects: “Many segments of the telecom market [in 1999] display network effects, i.e., the value that a customer derives from a product or service is dependent on how many other customers also use the product. For the network operator, the more businesses a network connects to, the greater the value of being plugged into it. There are also more subtle network effects: advertising is attracted by high levels of subscription, which funds investment in improving quality to attract more subscribers, thereby completing the virtuous circle. However, the first mover advantage will probably be sustainable only when customer turnover is low.” Id. at 134. It’s important to remember that being first, in and of itself, is not a durable advantage. Companies and management teams must combine that with customer lockin.

Throughout the chapter Marathon demonstrates a strong understanding of competitive advantages. Where those advantages begin and end, to whom the real customer relationship belongs to, and whether the growth spend that telecoms underwent in the 1990s would prove economic. The firm also consistently focused on share turnover as an indication of whether a company like Level 3 had long term oriented shareholders (they didn’t and turnover was quite high).

On over indebtedness creating opportunity: “Just as during the technology bubble the ability to raise cheap capital led to ludicrously overvalued companies, the viscous cycle in the debt markets (in May 2002) is creating the opposite phenomenon. Many indebted companies now have share prices that are significantly below our assessment of a ‘clean balance sheet’ valuation. As the price of debt falls in tandem with the market value of the equity, the likelihood of debt-for-equity swaps rises to the point where distressed debt can often be viewed as equity in waiting. While traditionally, the upside for debt securities has been limited to face value, under the debt-for-equity swap model, distressed debt is beginning to look more like equity, both with regard to risk and potential rewards.” Id. at 147. Note – Remember that carnage creates opportunity and look across the capital structure for potential opportunities.

In June 2002 Marathon was following the tech and telecom industry closely. They tend to like situations where shares are trading below replacement cost because management teams have the option to purchase shares rather than spend on capex. They also look for firms in an industry buying debt back at discounts to par because that is another example of capital buying a part of the business in cheaply. However, the industry remained too fragmented for Marathon’s liking and they decided to watch and wait for consolidation.

Chapter 6 Takeaways

On why IPOs tend to be poor investments: Id at 157.

First, new issued tend to be concentrated in fashionable sectors where a great deal of money has already been made.
Second, insiders only sell at attractive valuations. Since shares tend to trade around intrinsic value in cyclical fashion, they are likely to be undervalued in the future if they are overvalued today.
Third, investment banks are paid handsomely to sell a good story.
Fourth, the company knows a lot more than the equity buyers.

“Despite the favourable reception accorded new flotations in 1995, it would be foolhardy to adopt anything other than a skeptical approach to new issues. We continue to prefer a policy of investing where the supply of equity is shrinking rather than rising, as such a situation is more likely to be consistent with reasonable valuations. Unfortunately, this means our portfolios will be disproportionately invested in the mundane rather than the glamorous. Over the long run, this may be no bad thing.” Id. at 159.

On investment banks and bankers: “An understanding of ‘how the game works’ provides us with an edge over the competition. We believe investment banks exploit weak CEOs; that fads and fashions are hyped to drive deals; that the power of investment banks is sustained by an industry cartel; that skulduggery is rampant; and that banks’ research encourages momentum strategies which produce ultimately futile stock trading.” Id. at 166. Note, that was written in 2000 and some things may have changed. Overall, the incentives identified are more likely to endure than not.

Chapter 7 Takeaways

Marathon is extremely good at focusing on incentives. In discussing economic value added (EVA) as a concept they question whether the incentives are actually counter to long term growth. Id. at 184. They are also extremely focused on looking at what is going to happen, not what happened. For instance:

“Proponents of EVA-type systems agree that it is not the level of profitability that’s most important but the direction in which it is heading. For this reason, we continue to believe that the best investment opportunities lie among companies in the value universe. Not only is it easier to improve corporate profitability from a low level, but expectations for value stocks are now extremely pessimistic, especially compared with so-called growth companies. The new corporate metrics (such as EVA) will surely be applied in the value universe…[which could prove quite profitable for investors].” Id. at 186.

On share repurchases: “Contrary to the widespread belief that highly-profitable and highly-valued businesses have all the opportunities, when it comes to share repurchases it is among the lowly valued business where returns are potentially highest. An out-of-favor company pays a low price for its shares (compared to assets and cash flow), and the size of its buyback can be meaningful relative to the number of shares in circulation. The opposite case is the case for the “nifty fifty” companies whose shares may be trading above intrinsic value. For these companies, the typical share repurchase is so small, relative to market capitalization, that it is largely offset by dilution from share options issued to employees. In some sectors, especially technology, share repurchases are only a drop in the ocean compared to the number of options outstanding.” Id. at 190. That was written in 1999 and remains true today. Tomorrow’s headlines are history’s stories.

They go on to say: “The future returns from repurchasing shares, seventeen years into the greatest bull market of all time, are likely to disappoint shareholders. In our view, the money would be better spent on doubling the research budget, or preferably on special dividends to shareholders…The looking glass world of buybacks is largely ignored by the investment community. At a recent company presentation, analysts bombarded Merck’s management with questions about the R&D pipeline, but none asked about the considerably larger sum being spent on share repurchase. If we capitalized as an investment the cost of company buybacks, then assets at Merck would rise by nearly 40% and return on capital decline proportionally. In our opinion, this represents a truer picture of the trend in returns at the company.”

On turnarounds: Look for businesses that have hit a temporary bump, but did so following big investments in R&D and/or marketing. Those businesses likely have good things going on under the surface.

Beta is Risk

August 10, 2019August 13, 2019 ~ Sullimar Capital Group ~ Leave a comment

Yes, you read the headline correctly. The academics got it right. Sort of…

Public market investing rewards those who can identify assets trading at discounts to what they will be worth in the future. But what about the time in between initial purchase and the future? That’s where Beta comes in.

Beta, for those that don’t know, is the measure of a stock’s movement compared to the market. So, if a stock has a Beta of 1.25 a stock holder should expect to see 1.25x the volatility (good or bad) of the market. That volatility can cause some pretty costly errors.

Many, if not most, people have the capability to pick businesses that make sensible investments. Many, if not most, people have the ability to decide a sensible price to pay for an asset. Few people, however, have the ability to consistently see how assets are trading and remain rational. Moreover, the faster the prices move, the less rational people are. Why?

Upside volatility in stocks people don’t own causes FOMO (fear of missing out). This can lead to investors chasing stocks that run at exactly the wrong time. Downside volatility in stocks people own cases the flight response nature ingrained in our psyches. This can lead to people bailing on stocks they own at exactly the wrong time. Joel Greenblatt summarized public investing well when he said he gets paid more to have a strong stomach than for his analytical ability. See http://cfany.gallery.video/fullconference/detail/video/6053271135001/joel-greenblatt—keynote-presentation:-ben-graham-vi at 17:20 and 21:00ish.

So yes, Beta is risk. To the investor’s behavior. Beta, however, is not investment risk. Nor is it business risk. Thus, the academics got it right. Sort of…

Buybacks: An Inside View

June 18, 2019June 19, 2019 ~ Sullimar Capital Group ~ 1 Comment

Delta bought $1Bn+ of their own shares in February 2019. In doing so, Delta accelerated management’s planned capital return to shareholders. My first thought was “Delta thinks its stock is cheap.” Today, I view the move as smart capital allocation with potential upside.

Delta funded the transaction with a seasonal working capital debt facility. Usually a company has to pay an upfront fee to obtain a new debt facility. Let’s assume the upfront fee was ~37.5bps given Delta’s credit profile and ongoing bank relationships. Like all debt facilities, there’s an associated interest expense with the facility. These facilities are usually priced in relation to LIBOR. For this discussion, I assumed Delta has to pay LIBOR + 150bps. That said, I suspect the cost is closer to LIBOR + 75bps or LIBOR + 100bps. Either way, the example yields the same conclusion.

Assuming Delta obtained the facility in January, the cost of the facility looks something like this:

Note – the repayment assumptions accelerate during the summer because that is peak travel season.
Note also – Delta’s 2020 bonds yield slightly more than 2.60% to maturity. The facility above assumes a 4.15% interest rate. Thus, I suspect these calculations prove overly punitive to Delta’s ultimate interest expense.

As shown above, Delta incurred an incremental interest expense of roughly $13.8mm. What did Delta gain?

Delta’s dividend savings during the period almost exceeded the cost of the facility. On an annualized basis, the dividend savings exceed the assumed facility cost by 138%. Obviously, this math can get taken to an extreme because the company can retire more shares as it borrows more money. That said, this is a great example of how an investment grade balance sheet enables a company to play offense when opportunities present themselves.

Delta’s decision carries some risk. If the summer travel season is poor then Delta may not be able to pay the facility off as quickly as I assume. In that case, the facility costs will exceed my projections. Nevertheless, the company could manage an additional billion dollars of debt, if necessary (it had $1.9Bn of cash as of 3/31/19).

Importantly, despite any temptations, management didn’t get too carried away on the facility size. Accordingly, Delta made a low risk, potentially high reward bet. Those are exactly the kinds of bets I want my management teams making.

NOTE: Delta increased their dividend from $1.24/sh/yr to $1.40/sh/yr following the repurchase. This reduced the annualized savings from retiring the February shares from $24.3mm to $2.2mm. Personally, I would prefer for them to retire the shares and pay special dividends rather than raising the promised dividend. That said, I understand management’s decision and remain pleased with the corporate finance decisions.

ROIC And Returns

February 26, 2019March 6, 2019 ~ Sullimar Capital Group ~ Leave a comment

Warren Buffett discussed his Kraft Heinz mistake with Becky Quick. While he still views Kraft Heinz as a wonderful business, he paid too much. Here is a screenshot of the transcript:

Source: https://www.cnbc.com/2019/02/25/full-transcript-billionaire-investor-warren-buffett-speaks-with-cnbcs-becky-quick-on-squawk-box-today.html

Investors often say that overtime your returns will converge with the business’ returns. As Buffett mentions above, that is simply not true. What is true, however, is your returns converge with the underlying business when you purchase a business and it grows substantially following your purchase. The higher the entry price, the more the business has to grow in order to provide the owner with the business’ underlying economics.

The reason is simple. As an owner/partner, you earn your proportionate economics on the earnings a business generates. However, each partner has a different entry price based on a different earnings base (depending on when they purchased shares and/or LP interests). Therefore, each owner/partner is entitled only to his/her purchase yield on the base he/she acquired. Following the purchase, however, an owner’s economics on the incremental earnings base mirrors the underlying economics of the business.

Kraft cannot grow the earnings base Buffett paid for. Thus, he is stuck (for now) earning $6Bn on his $100Bn purchase price. His economics will only improve if KHC (1) repurchases shares when they yield more than 6% on the enterprise (he is effectively averaging down in that transaction), (2) grows again and is able to earn more than $6Bn pretax without needing to raise additional equity, or (3) successfully executes an accretive acquisition.

As the greatest of all time shows, price is extremely important on slow growing businesses. More importantly, he provides some clarity on an often misunderstood investing idea.

Note: This discussion assumes Buffett purchased Kraft with 100% equity. That’s not factually accurate. Financing decisions can change the specifics of the discussion above, but the points made above are accurate for teaching purposes.

CPG and Capital Theory

January 28, 2019January 31, 2019 ~ Sullimar Capital Group ~ Leave a comment

The book Capital Returns is too good to summarize. The book itself is a summary of Marathon Asset Management’s investor letters from 2002-2015. The intellectual flexibility that firm demonstrates is inspiring.

One key takeaway is analyzing industries through a capital cycle theory lens. The capital cycle can be described as follows:

High returns on capital lead to competition entering an industry.
The new competition increases the amount of assets chasing the same dollars of profit.
More assets fighting over the same profit dollars reduces margins.
Reduced margins decentivize entrants, drive out competition, and enable the surviving companies to begin increasing margins.
Repeat

Accordingly, firms and sectors with the lowest asset growth tend to outperform. The phenomenon is called the asset-growth anomaly. See https://www.aqr.com/Insights/Research/Journal-Article/Investing-in-the-Asset-Growth-Anomaly-Across-the-Globe for a solid paper on the topic. That theory is a major reason I like the beer industry so much despite the rise of craft entrants. Globally, I still perceive the industry to be very rational and I view brewpubs more as restaurant competition rather than brewer competition. That said, it’s impossible to view more assets chasing beer sales dollars as bullish for Big Beer. But I digress…

A lot of traditional consumer brands discuss disruption. Why? Historically, traditional large brands leaned on retail distribution channels, dominated shelf space everywhere, scaled production and distribution to enhance margins, and pushed their messages out via advertising. See https://www.forbes.com/sites/antoinegara/2018/04/30/jorge-paulo-lemann-says-era-of-disruption-in-consumer-brands-caught-3g-capital-by-surprise/#2607284d1f9b. Today, the internet eliminated traditional advertising and distribution barriers. Therefore, it is easier to have launch a new brand.

Moreover, consumers are willing to trust brands quickly. Therefore, the brand equity that used to serve as a consumer short cut has eroded. That said, social media influencers and internet marketing are not very discerning. Time will tell whether brand equity makes a comeback. Watch the documentaries on the Fyre Festival on Netflix or Hulu to determine whether you think its plausible that consumers begin to crave the certainty of Big Brands again.

Regardless, barriers to entry are clearly lower than they used to be.
The perception of viability attracts assets to the industry. When new assets chase returns faster than industry profit pools grow, total profit declines. Importantly, Mr. Market knows that. So it’s worth looking to see how entities are priced given the facts. Kraft Heinz is a traditional CPG company impacted by these trends; though mostly because of consumer’s willingness to trust private label brands. Its valuation relative to history looks like:

I’m not extremely excited about those multiples because a 16x EV/EBIT equates to less than a 5% unlevered (EV/NOPAT assuming no interest expense) cash flow yield on a firm that isn’t growing. Moreover, competition remains strong and private label attacking market share is likely to continue. Personally, I’d like to see Kraft Heinz offer a return on equity north of 12% (PE of ~8.3x) before I got excited given the facts as I understand them.

But, I will continue to watch “melting ice cubes” because when facts and/or results change they can offer very attractive risk/rewards. More importantly, no one else likes to own them. Historically speaking, out of favor companies outperform the most loved companies. Though this last “bull run” makes me wonder whether that rule changed. Time will tell.

The Merits of Writing

January 10, 2019January 12, 2019 ~ Sullimar Capital Group ~ Leave a comment

First and foremost, SCG is not an investment advisor and does not recommend buying shares in AB InBev. The investment discussed below has substantial risk and should only be considered after lengthy due diligence. That said, I recently purchased shares of AB InBev @ $68.37/sh. Therefore, readers should presume I am promoting my own position when I am talking about AB InBev going forward.

I recently presented an investment in AB InBev to a group I belong to, The Manual of Ideas, as my “Best Idea of 2019.” That was my first presentation to the group. Thus, I took career/reputation risk discussing this investment. Moreover, it’s an investment with a credible bear thesis so I have a reasonably high chance of looking “obviously foolish.” As if that weren’t emotionally taxing enough, yesterday I saw some numbers released that created some “fast thinking” panic. Bud and Bud Light both apparently saw U.S. volume declines in excess of 6%. See https://adage.com/article/special-report-super-bowl/ab-inbev-reveals-super-bowl-ad-plans/316173/?mod=djemCMOToday.

My first reaction to the story was “Great, it took exactly one day for my ‘Best Idea of 2019’ to blow up.” Then I started to do some math and write.

To begin, I have a high degree of confidence the cited numbers relate to AB InBev’s U.S. business. The U.S. market accounts for ~31% of sales attributable to AB InBev (AB InBev only owns ~62% of AmBev but consolidates 100% of the entity’s sales). In 2016 Bud and Bud Light accounted for ~60% of AB InBev’s U.S. volumes. Presumably this percentage declined as brands like Stella and Michelob grew their percentage share in AB InBev’s portfolio. But, let’s assume 60% is the correct number and volume production equates to sales.

If 60% of 31% of sales are fading at 6.6% the result is a 1.2% decline in total sales. That sales decline doesn’t account for the offset in growing brands such as Stella Artois and Michelob Ultra. That’s actually not that bad. My projected returns rely on U.S. sales declining at 2% per year. See below.

Do I wish Bud and Bud Light were growing in the U.S.? Yes. But I knew they weren’t. The 6.6% number scared me emotionally. But once I got rational and “thought slow” I realized I had accounted for that possibility via a conservative underwriting. That said, rapid volume declines could put my margin assumptions under pressure but as of now I think those margin assumptions are reasonable. Time will tell.

Without writing I probably couldn’t be so rational about the results because of how badly I want this idea to work. The presentation induced emotion that otherwise might not have been there. Thankfully, writing has me thinking slow. This investment may not work. But at least the investment’s success or failure won’t be caused by my emotional reaction.

What Should AB InBev Do About Bud and Bud Light?

The investment thesis in AB InBev is not a U.S. focused thesis. That said, the U.S. business is important for AB InBev’s debt repayment. Therefore, data points such as Bud and Bud Light falling 6+% y-o-y are concerning.

I’d like to see more resources diverted towards the craft beer portfolio, Stella Artois, and Michelob Ultra. Those brands are growing nicely. See https://www.bizjournals.com/birmingham/news/2018/10/01/here-are-the-top-20-best-selling-beer-brands-in.html. The recent repackaging in the “Taste of Belgium” 12 pack (Stella, Leffe, and Hoegarden in one 12 pack) is a good packaging innovation. While Bud Light remains important, I don’t believe marketing will solve the consumption trends in that brand; it’s more about milking the cow rather than driving growth.

Longer term, I’d like to see the company figure out how to activate the craft beer portfolio they’ve acquired. Perhaps they should borrow a page from Starbucks and create the beer equivalent of Starbucks Roasteries. A group of really awesome beer shrines in urban environments could be a decent way to remain corporate but also authentic to beer lovers.

Most importantly, AB InBev should focus on emerging markets. The relative scale advantages AB InBev enjoys matter immensely in those economies. Expanding the beer category and offering consumers a reasonably cheap alcoholic beverage solution offers true growth potential in EM. Furthermore, any and all potential distribution advantages should be solidified over the next 3-5 years. Those investments would generate solid ROIC for years to come.

After paying down debt and widening the emerging market moat AB InBev should probably diversify further away from beer. This would be natural as the company already bottles and distributes Pepsi and Gatorade in LatAm. Whether the diversification efforts lead to non drug related beverages or marijuana related beverages remains to be seen. For the near future, let’s work with the portfolio we have and pay down debt. Acquisitions can wait.

Disclosure: Long AB InBev

Cash Flow is King, But Sometimes it Isn’t

November 26, 2018November 28, 2018 ~ Sullimar Capital Group ~ Leave a comment

In my younger years I was too focused on hard and fast rules. Rule 1 was cash flow is king. Rule 2 was buy cheap. If a company wasn’t generating meaningful cash it fundamentally wasn’t worth investing in. I wouldn’t even consider Rule 2. After all, a company is worth the cash it generates in the future; discounted to today’s values. Below is a model that illustrates this concept. Each cash flow has a 10% discount rate applied to it.

You can see how much weight the early cash flows have to the calculation. Which is to say that $100 generated in “Year 1” is worth $90.91 in today’s dollars while the $100 generated in “Year 10” is only worth $38.55 in today’s dollars. Therefore, the cash flows at the end of a 10 year model need to be substantially larger than the near term cash flows in order to be worth the same amount in today’s dollars. This impact is exacerbated when near term cash flows are negative.

That has always been a hurdle for me because I lack the confidence to accurately foresee cash flows 10 years from now. Furthermore, the required growth in cash flows caused greater uncertainty and doubt. A negative consequence of that mental barrier/bias is I almost always missed out on growth companies because they tend to use cash while they grow. Thus, current cash flows in growth companies are not representative of mature cash flows. A recent presentation by Aswath Damodoran illustrated this point with this slide:

Source: https://www.youtube.com/watch?v=c20_S-QgvsA&t=2s

Damodoran highlights the cash needs of companies in different life cycles very well in that slide. In my experience, a lot of money can be made investing during the high growth part of the life cycle (assuming you pay a reasonable price). I believe the reason stems from the fact that the future is still uncertain so it’s still possible to have investing edge (Note: the dispersion of future cash flows in growth companies arguably means there is more risk associated with investing in them).

Most people can reasonably forecast the future of Coke. Forecasting LaCroix’ future is more difficult. Furthermore, Coke’s valuation very driven by existing cash flow rather than future cash flow. Thus, it’s less likely to be materially mispriced because everyone is looking at the same information in the same way. This makes buying Coke very cheap very difficult and probably limited to severe market corrections. Waiting for those opportunities probably isn’t the best investing strategy because holding cash and waiting for a crash can cause behavioral mistakes.

I’ve learned from my mistakes and now try to look at a business or investment at the time of maturity. I would not summarily dismiss purchasing a building during the construction phase while it was not earning maximum rent and was consuming cash while contractors completed renovations/build out. Buying a business is no different.

Making money investing is a difficult pursuit. Nuance and flexibility are rewarded much more than hard rules and style conviction. As I’ve let go of my style as a “value” investor looking for cheap cash generation I’ve begun to see opportunity in buying smaller firms at growth inflection points. The key is determining which part of the life cycle a firm is in and analyzing that particular situation accordingly.

The Importance Of Entry Price

November 21, 2018February 23, 2019 ~ Sullimar Capital Group ~ Leave a comment

When is an investor most likely to permanently lose money? When he/she enters an investment. Therefore, investors should be extremely cautious before entering an investment. In theory this sounds nice, but in practice the fear of missing out (FOMO) can cause investors to buy too early.

Some basic math shows the risk of buying at elevated prices. I recently looked at Adobe Systems Inc. I haven’t done enough work on the company to have informed opinion about the success of their recent acquisitions and whether management is capable. That said, I am used to their Adobe branded products because I use them frequently. Therefore, I understand Adobe’s core product is fairly integral to a business setting and they are priced on a subscription basis.

Wall Street loves subscriptions because they tend to reduce churn and increase revenue certainty. Consumers tend to renew subscriptions (sometimes without even realizing it), tend to not request their money back once billed, and cannot defer purchases because a company simply bills their credit cards. Therefore the existing revenue streams of subscription companies are very likely to continue. Furthermore, price increases tend to be easier to pass on to consumers since there is less sticker shock (many consumers don’t even check their subscription bills).

Another thing Wall Street loves is software companies. Why? Because once a software company gets traction with customers there is minimal incremental capital to signing up the next customer. Therefore, most of the additional revenue becomes cash flow to the business. Thus, once a software firm achieves a minimum viable scale each additional customer becomes immensely valuable (assuming the cost to acquire that customer is less than the lifetime value of the customer).

Adobe is subscription based and has hit scale. Therefore, Wall Street loves it. I decided to take a look because there has been a sell off in tech stocks lately. Below is a very simple back of the envelope model I built.

I built the model assuming that Adobe continued trading at roughly 30.2x free cash flow. I decided to increase Adobe’s buyback ratio over time and allowed for free cash flow growth in excess of GDP growth. These are reasonable assumptions because Adobe probably won’t need all the cash it generates and should be able to raise prices.

This seems reasonable so far, but the results rest on the assumption that Adobe will continue to trade at 30.2x free cash flow. Is that reasonable? Perhaps. The current yield on 30 year treasury bonds is roughly 3.4%. The current yield on Adobe is 3.3% (1/30.2; the inverse of the free cash flow multiple). So, investors are willing to accept slight less free cash flow yield than risk free bonds today because they deem Adobe’s growth and earning certainty worthy of that bet. It’s important to stress that Adobe currently trades at a lower cash flow yield than risk free assets.

Interest rates have been depressed for a long time now. I have no idea whether they will continue to stay at these levels or not. But, its reasonable to ask what happens if rates revert to their long term average of ~4.5%. For purposes of this illustration lets assume that happens over the next 3 years. The investment result is below (assuming Adobe trades at a similar yield to 30 year bonds).

In the example above the business performs exactly as it does in the first scenario. However, the multiple contraction decreases a shareholder’s 5 year return from 35.3% to 9.0%. In that scenario, a shareholder would earn less than 2% per year. That return is certain to reduce a shareholder’s purchasing power over time.

Therefore, identifying a business worthy of investment is a necessary but insufficient condition to becoming a good investor. Tradeoffs must always be made. Bad businesses will sell at extraordinarily cheap prices at times. They may be worth buying. Conversely, good businesses selling at extraordinarily high prices may not be worth the risk of wealth destruction. Reasonable minds can differ about which companies to buy and sell. But price and risk must be a critical part of the discussion.

The Same Investment Mistakes Occur Everywhere In Life: The Too Hard Pile

November 13, 2018November 13, 2018 ~ Sullimar Capital Group ~ Leave a comment

The more I look at different “deals” the more I get convinced everyone is looking at the same stuff in different wrappers. My first home purchase was located at the corner of Division and Clybourn in Chicago. It was a very cool property with an incredible view of Chicago. In fact, it probably had the best views of the city I’ve seen.

Why was I able afford it? Because it had a massive downside. The home was located near Cabrini Green. See https://en.wikipedia.org/wiki/Cabrini%E2%80%93Green_Homes

I was betting on Cabrini Green coming down and the neighborhood drastically changing. I figured even if I paid a little too much for the property the neighborhood would change so much that the price I paid would look like a bargain.

So why was this “investment” unsuccessful? For starters, the global financial crises came and development completely stopped. I probably should have known the housing market was phony when I could get a loan as a law student and provide no documentation. But, at the time I wasn’t able to think the way I do now. So let’s put the greater housing market in the “outside of my control bucket” for now.

More importantly, I was the dumb money. I should have done more research to figure out whether the neighborhood changing was a realistic expectation. Once I moved into the home I learned that my alderman and the alderman for the low income housing across the street were different people. That means they were serving different masters. Therefore, they had different incentives.

Those incentives are massively important in a city like Chicago. Alderman have a ton of power. That was a fact that I could have known but didn’t even think to look into.

Which leads me to comment on the most important piece of advice Warren Buffett has ever given: create a too hard pile. I am fairly confident in my ability to see a home in an existing neighborhood and determine whether that home is a reasonable value. What I am not comfortable with is my ability to determine (1) which neighborhoods will gentrify and (2) the rate they will do so. Therefore, an investment that requires gentrification by a certain date should be “too hard.”

For the longest time I thought Buffett said things were “too hard” when he couldn’t really understand them. But, can’t Buffett understand almost any business concept? Yes. So how do 90% of the things he looks at end up in his “too hard” pile? Because their success is too difficult to determine.

At the moment I believe the common stock of General Electric is incredibly cheap. In fact, I think it’s quite possibly the deal of a lifetime. Yet, Buffett isn’t buying. Why? I believe there are issues within the entity he thinks are “too hard.” I suspect he looks at some of the business lines and views turning them around in a similar vein to how I should have viewed the potential gentrification of my first neighborhood.

Remember, there is no requirement to play a game you don’t understand and/or want to get involved in. No is a perfectly fine answer. Get in the habit of saying this is “too hard.” It will help your results over the long term.

The Evolution of a “Value” Investor

November 10, 2018November 11, 2018 ~ Sullimar Capital Group ~ Leave a comment

I have a tendency to need to make my own mistakes. I wish I could learn from others more quickly, but it seems as though personal experience is my only reliable teacher. So, it is with some hesitancy that I have to admit that only recently have I understood the growth investor’s mindset.

I initially got interested in investing when my grandmother’s friend, John Runnette, sent me The Intelligent Investor, The Battle for the Soul of Capitalism, and Common Sense on Mutual Funds. Mr. Runnette must have had a sick sense of humor because 2 of those books are written by John Bogle, who founded Vanguard. The other, written by Benjamin Graham, is the layman’s version of Warren Buffett’s bible.

My personal experience left me thinking there is no way markets are rational. I lived through the 1999-2001 period and John sent me those books in 2009. Thus, I was in the middle of watching the second gut wrenching crash in a decade. Therefore, the idea of a market portfolio was inherently unacceptable to me because I “knew” that was a silly idea. Surely, the “enterprising investor” as Graham described him/her could outperform those silly indexers. Right? Well, it turns out this is a very difficult game.

My dad likes to say “I knew all the answers and then the questions changed.” That is how I am beginning to feel about investing. That said, the fundamental tenant of viewing a stock as a part ownership interest in a business AND paying a reasonable price for that interest will never go away. What I’ve learned over time, however, is the previous sentence is far more nuanced than it may appear.

What is a reasonable price to pay? The answer to this question depends on a number of factors, but the most important components are whether the business (1) is growing or shrinking and (2) requires additional investment to grow or shrink? Please see the post on The Importance of ROIC and Growth for more information.

A business that is both growing and doesn’t require additional investment should grow in value over time. In fact, that growth is likely exponential assuming the ability to grow continues over time. Therefore, you can pay a lot more for the existing business because the growth in value will probably bail you out. In the long term, if you identify a company like this early enough in its lifecycle then its hard to see a scenario where you will lose much money (especially if you repeat this process a number of times).

I have made serious errors is investing in companies that are in decline but they are selling at “discounts” to my estimate of what they are currently worth. The problem with these situations is the business value is eroding over time and the value can decline below your entry price. While I believe there is merit to the strategy of buying these kind of companies (see Tobais Carlisle’s book Deep Value), I think the only suitable approach is through an ETF (the cost effective option; Toby is releasing the ETFs with ticker symbols ZIG and ZAG shortly) or very diversified portfolio. This is because the stratefy depends on mean reversion and requires a large number of bets to work. Any one “cheap” business losing its value can go to $0.

It took me a very long time to realize that cheap relative to today’s value is not the only definition of value investing. Further, it took me a long time to realize that cheap relative to today’s value tends to realize investment results via an investment “rerating” or increasing in market value. This creates a problem because there are many times those investments don’t have too much organic growth (though they can). Therefore, when the investment increases to an investor’s estimate of its true value that investor needs to sell and find the next idea. The downsides of that approach are the investor (1) pays capital gains and (2) has to find the next idea.

Therefore, an investor can find him/herself with too much cash relative to what they would prefer. Having too much cash may not sound like a problem. In practice, however, having cash can create the feeling of needing to deploy it. That feeling has led me to make mistakes (this is a common problem).

All of this is to say that my approach is now to attempt to limit my investible universe to companies that have long growth paths in front of them and don’t require much incremental capital to grow. I will always be attracted to “underpriced” situations but hope to spend much more time looking for great businesses that can grow and trade at reasonable prices. Easier said than done…