LBW Commentary Q4 2016
How LBW See’s It When speaking with prospects, clients, or anyone who will listen, about LBW’s investment framework we may begin the conversation talking about one of the forefathers of value investing, Benjamin Graham. Graham wrote a book titled “The Intelligent Investor: The Definitive Book on Value Investing” and in that book, he brought to light the concept of “Mr. Market”. Who is “Mr. Market”? It is probably best described by Graham himself: “Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.”
In essence, Graham is explaining that the market price for a publicly traded company is not always indicative of its actual value. The reasoning behind this is that a company’s value in no way can fluctuate as much as its daily price movements. In fact, the average company’s stock price can see as high as a 50% difference from their 52-week highs and lows. This concept, as simple and intuitive as it may seem, at times is difficult to grasp, and when concepts seem to be elusive, it helps to have real-life examples to connect them. For this addition of “How LBW See’s It” we wanted to do a review of the markets’ actions in 2016. The year 2016 provided multiple real-life examples which can help us solidify Graham’s “Mr. Market” concept. However, before we dive into the market’s events of 2016, we need to define “Mr. Market”. For this writing, “Mr. Market” will represent the Dow Jones Industrial Average (Dow). Now that “Mr. Market” is squared away, let’s examine his reaction to 2016’s different market events. December 31st, 2015 – January 8th, 2016 During this time frame “Mr. Market” dropped over 1,000 points, equating to a decrease of -6.19%. This was “Mr. Market’s” worst-ever five-day start to a year. Why the gloomy attitude? To quote LBW’s Q1 edition of “How LBW See’s It”: “The swing was caused by the usual suspects: the continuing commodity rout, the strengthening U. S. dollar, the unpredictable Federal Reserve’s (“Fed”) interest rate moves, and continuing fears of a global slowdown”. February 11th, 2016 “Mr. Market” continued to be pessimistic about commodity pricing, the strength of the U.S. dollar, and the Fed’s unpredictability and on February 11th “Mr. Market” hit his 2016 low. From December 31st, 2015 to February 11th, 2016 “Mr. Market” dropped approximately -10%, which can be classified as a market correction. March 17th, 2016 It only took 24 trading days for “Mr. Market” to erase his 2016 losses and move into positive territory. Why the change of heart? Being headquartered in Wisconsin, we assume it was due to good weather. June 23rd, 2016 – July 8th, 2016 During this short time frame “Mr. Market” dropped approximately -5% (June 23rd, 2016 to June 27th, 2016). However, within eight trading days he recovered and ended this time-frame up approximately 0.75%. What was the reason for “Mr. Market’s” bi-polar behavior? Well, on June 23rd, 2016 the U.K. voted to exit the European Union (E.U.); this event may be better known to you as BREXIT. Our guess is that “Mr. Market” wasn’t sure of the effect BREXIT may have had on his holdings. November 8th, 2016 What is interesting about this date, other than it was the day the United States elected its next President, was the fluctuation “Mr. Market” had during after-hours trading. As the votes from the election were being counted “Mr. Market” dropped approximately -4%. However, by the close of November 9th, 2016 “Mr. Market” had fully recovered his after-hours decline. December 30th, 2016 At the close of December 30th, 2016, the last trading day for 2016, “Mr. Market” had appreciated by approximately 16.5%. As you can see “Mr. Market” was temperamental in 2016. One day he believed the world was coming to an end and the next, it was prosperity for all. His price fluctuations were incredible. For example, he started the year off by declining approximately -10%, but finished the year up 16.5%. Why was “Mr. Market” so volatile? We aren’t always sure, but we believe it could be attributed to a confluence of macroeconomic factors, and honestly, we don’t necessarily care. A more important question that should be raised is: during the BREXIT time-frame described above, do you think the value of the companies that comprised “Mr. Market” decreased approximately -5% in the span of 10 trading days? Our answer - NO! This is exactly Graham’s point – the daily market price of a publicly traded company is not always indicative of its actual value. Again, the concept of “Mr. Market” is not always easy to apply, but it is a thought process we use when making investment decisions. When performing research, we take macroeconomic factors into consideration, but we do not allow them to dictate our investment decisions. Our job is to understand a business, value it, wait for “Mr. Market” to sell it to us at a discount, hold it, and then sell it back to “Mr. Market” at its fair value. This type of investment framework is a long-term approach and takes patience. In 2016 we took advantage of “Mr. Market’s” temperamental mood and we intend to do the same in 2017. Nathaniel’s Beautiful Mind Mutual Fund Spotlight The Cook & Bynum Fund (COBYX) started trading on July 1, 2009, but the firm, Cook & Bynum Capital Management, has been around since 2001. It started with managing Separate Managed Accounts (SMAs) and eventually a started a private partnership in 2007. As the portfolio managers, Richard Cook and Dowe Bynum, began to deliver stellar returns in its partnership, their limited partners began to ask if Cook & Bynum could create a vehicle that their family members might be able to invest in (due to private partnership regulations). Hence, The Cook & Bynum Fund was born. COBYX is a highly concentrated mutual fund that as of 2016’s third quarter has a total of seven equity holdings of which three are foreign, and comprise 60.8% of the portfolio. You do the math – that means they have a cash balance of 39.2%! This is exactly the type of fund we want to invest in because they view cash as a position and will wait to properly deploy it until they see a great investment opportunity selling at a significant discount to its value. While they have underperformed their benchmark, the “S&P 500 Plus Dividends” since inception by ~6.37% (as of 12/31/2016: COBYX = 8.58%, “S&P 500 Plus Dividends” = 14.94%), they have done so with a cash balance range of 23.4-48.1%! Now one could argue that they missed out on all of those returns by having such high cash balances, and should have been fully invested, but we would respectfully disagree. From our point-of-view, they are doing their job by delivering decent returns at minimal risk to their shareholders while positioning themselves to pounce when opportunity knocks. What I’ve Learned We have learned a great deal since LBW has opened its doors. We recently concluded our annual meeting in which we discussed our initial goals when we started the firm. It was interesting to see what we had and had not accomplished and the various reasons why and why not. In all, we met most of the goals, and were quite satisfied with the ones we did achieve. We also discussed what we had learned in our respective areas of expertise. Upon reflection, we have learned a great deal and thought you might be interested in hearing a few of them. Company Debt and Cash Flows The importance to a company when structuring its debt appropriately relative to its cash flows and utilizing the appropriate type of debt is absolutely critical for it to remain a going concern. We are constantly flummoxed by some companies’ inability to understand these basic principles. As an example of well-structured debt, please refer to 2015’s fourth quarter commentary where we discussed how National Oilwell Varco (NOV) had structured their debt. As for a bad example, look no further than Weight Watchers (WTW). WTW decided in 2012 to repurchase ~17.5% of their shares via Dutch Tender Offer and their controlling shareholder Artal Holdings agreed to match whatever was purchased via the Dutch Tender Offer such that Artal’s ownership percentage would remain the same post-repurchase. As of their fiscal year 2011, WTW had reached one of their highest earnings of $304 Million (MM). They procured funds by issuing almost ~1.4 Billion (B) in term loan debt. The term loan debt was actually a part of the company’s credit facility which had specific maturity dates assigned to different tranches of term loans within the credit facility that ranged from January 2013 through March 2019 (the ~1.4B debt used to repurchase shares matured in 2017 and 2019). Therefore, while the debt’s interest was variable, it was also very low due to low interest rates during the period. Based on their prior year earnings and low interest payments, had WTW’s shares been undervalued at the aggregate purchase price ($82.00 per share), then this taking on of debt to repurchase shares would have perhaps made some sense. As it turned out, WTW had repurchased their shares at extremely high valuations and had taken on too much debt for their future earnings to pay off, and in fact it’s share price proceeded to swoon from their repurchase price of $82 per share in early April 2012 to as low as $4 per share in July 2015. The company’s earnings proceeded to fall as well to as low as $33MM in 2015, and as their earnings decreased they were forced to rollover most of their term loan debt into one large tranche due April 2020, due to their inability to pay the smaller term loan balances with shorter maturities. First, WTW should have never repurchased shares with credit facility funds, which have short term maturities and variable interest rates, and second, they clearly did not understand how much their company was worth and made a terrible capital allocation decision in repurchasing their shares with borrowed funds. We like to read about companies from either ends of the spectrum with regards to how their capital structure is constructed because stories like NOV’s or WTW’s are excellent learning opportunities and teach us what qualities to look out for, both good and bad. Voting Machine in the Short Term The market really is a voting machine in the short term, regardless of the companies’ fundamentals that comprise it. We saw this in January and February 2016’s selloff, and we were once again reminded of how powerful investing with a Margin of Safety can be to the investor – we saw this in spades during this period. We were able to take advantage of the downturn by buying more of our established positions and a few new ones as well. We did this not because prices may have simply decreased a significant percentage versus their respective highs, but because the price decreases enabled us to buy companies at increased discounts to their intrinsic value! To say the least, we enjoyed the downturn as it gave us multiple opportunities that we subsequently took advantage of. The Power of Saying “No” We humans are inherently wired to be active, especially when it comes to investing. It is very hard for someone to sit on their hands and do nothing, that is, to not be trading all the time. Now, put that on top of how we invest as value investors, and there happen to be no buyable opportunities. Imagine sitting on your hands for a year or maybe two before you have fully invested a client’s portfolio, and the S&P 500 has returned 10% per year while the client’s has only returned 5%. During this period, there may have been some securities that came down in price and may have gotten close to being cheap versus their respective intrinsic values, but were not to the point of having an adequate margin of safety that we felt comfortable enough buying them. We need to say “No” to these situations because we’re waiting for those purchases where we can get the great returns at minimal risk to our clients. While this concept is similar to the previous section regarding the market as a voting machine in the short term, it also displays how we can choose to stand against the temptation to be active and trade frequently because instead we’re waiting for that fat pitch to deploy our clients’ funds at the right price. Learn from Other Investors’ Mistakes Whenever possible, learn from other investors’ mistakes versus making your own. This has been invaluable advice to us. We recently came across Guy Spier’s post-mortem writeup on one of his fund’s holdings Horsehead Holdings. Horsehead is a low-cost producer of zinc that filed for bankruptcy, and Spier’s fund lost 100% of its investment. Mr. Spier’s memo is an excellent example of this concept because it detailed his original investment thesis, how the thesis played out (not to his liking to say the least), and what he learned from his experience. By living vicariously through investors such as Mr. Spier and his experiences, we can mitigate our own possible future mistakes, and thereby have a higher probability to attain greater returns for our clients. Read. All the time. This is such a simple concept, but incredibly powerful if consistently applied. One of the goals that we have is to compound our knowledge daily. The more we learn, the more we grow our circles of competence, the more we can apply to learning more about the companies we may own or would like to own at the right price. This advantage has already proven itself this year and will continue to do so for many years to come. Summing Up There are of course many more on the list that we couldn’t possibly fit here, but you get the idea. We will continue to build a foundation based upon what we are continuously learning that will last for many years into the future while concurrently continuing to provide excellent service to our clients. In the meantime, we are enjoying our respective jobs more and more every day and can’t wait to beat the goals we set out in our annual meeting for 2017.
LBW  Graham, Benjamin. The Intelligent Investor: The Definitive Book on Value Investing (Revised Addition). Collins Business, 2006.  The index used represents total return.  Dates reflect prices as of the close of each business day.  http://www.cnbc.com/2016/11/08/stock-futures-waffle-after-first-election-results-emerge-showing-tight-race.html  http://www.cookandbynum.com/fund-information/performance/  Lowest cash balance = 2011, second quarter: http://www.cookandbynum.com/fund-information/shareholder-information/holdings/  Highest cash balance = 2013, fourth quarter: http://www.cookandbynum.com/fund-information/shareholder-information/holdings/  Accounting principle: The going concern principle is the assumption that an entity will remain in business for the foreseeable future.  The Aquamarine Fund  Spier, Guy: “Horsehead Holding Writeup for Aquamarine Fund DDQ”, December 12th, 2016: https://d2qvtfnm75xrxf.cloudfront.net/docs/f07c23f1-ab25-4c4a-971a-eeb2230c4409/doc.pdf?response-content-disposition=attachment%3Bfilename%3D%22Horsehead%20Writeup.pdf%22&Expires=1483896323&Signature=PKNadUBMpRw70e6zK9H68FdxSWtydLnY9RNm5ZacEUxyJS4OqyNcB72kOgP8McDWiTvUYe39l6ZWVvp7OUTzpmPsKcl9AgTSV1xXWCGgQVI98p2ld5jK6eiSfG~KdGDcU9Ss52fO93d5IO~fAJnKpAjlmc~QkjUPSM8iUse1hU5E2aYhZuHiBQx3I6zAUo77tmdiGaOJ9n1jhh0zspQ1Ewqk8sNTSk35BPwmaYBOzXHvzKmlZdIp6Ibp9FnDDmE33onctMCuX-SrsXgWbLkbNKMBBCBwnfzyC7BLtLBLov-UJvheIE8q3jnLjcUfJX9ZFb7CkF12zpxEGC8b0Qkzog__&Key-Pair-Id=APKAJJ6CB5SJRFO4TVPA  this may change due to an equity committee being setup by the bankruptcy court allowing for equity owners to perhaps get some of their investment back