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LBW Commentary Q1 2017


How LBW See’s It The start of 2017 came with a bang – President Donald Trump was sworn in, Tom Brady and the New England Patriots won their fifth super bowl in the past 16 years, and the Federal Reserve Bank (“Fed”) raised the federal funds rate for the third time since December 16, 2008 (roughly nine years ago). President Trump and his new administration have led the headlines in regular and financial news, and Brady’s Super Bowl jersey being stolen was a hot topic. However, the increase in the federal funds rate and the Fed’s forward guidance on the economy deserve some notable attention as our clients, prospective clients, and passerby want to know how this will affect them.

The three most common questions we get regarding rising rates are – “If the Fed continues to increase the federal funds rate: 1) Will I earn more interest in my savings account?; 2) Will mortgage interest rates move higher?; 3) Does it mean the stock market will go higher?” To answer these questions, we need to get to the root of the catalyst – understanding the correlation between the federal funds and markets’ interest rates. As we stated in our Q4 2015 commentary of “How LBW See’s It”: “The Fed does have the ability to effect interest rates by changing the rate at which banks borrow from each other, also known as the federal funds rate. However, the Fed is not the “be all” for interest rates. There are other influences, such as inflation, that dictate the actual market rates.” Recognizing that the federal funds rate is not the sole component increasing market interest rates, we can begin to dissect the questions posed. However, before we move forward we need to ask another question – “If the Fed is increasing the federal funds rate, does that mean they feel the U.S. economy’s productivity is improving thereby causing inflation to tick upwards?” The short answer is, yes. In the Fed’s most recent meeting minutes (March 14-15, 2017), they stated inflation had continued its upward trajectory and was approaching their longer-run inflation objective of 2%[1]. The steady increase in inflation was also accompanied by a strengthening labor market, continued expansion of economic activity at a moderate pace, solid job gains, little change in a strong unemployment environment, a moderate increase in household spending, and a slight firming of fixed investments by businesses[2]. As one can see, as the economy begins to improve, inflation increases causing goods and services to cost more. If goods and services cost more, then to loan someone money you want to charge an interest rate that is higher than what the dollar is depreciating at (inflation), or you will lose money. Therefore, the Fed needs to increase the federal funds rate to ensure that banks are compensated appropriately when providing overnight loans to one another. The Fed’s minutes helps solidify our statement above – “…the Fed is not the “be all” for interest rates.” Now that we squared away the correlation between the federal funds and markets’ interest rates, let’s tackle the three questions posed earlier. If the Fed continues to increase the federal funds rate, 1) Will I earn more interest in my savings account?; 2) Will mortgage interest rates move higher? When placing money into a typical liquid savings account, the bank may take that money and invest it in short-term assets, such as 90-day T-bills. Essentially, you’re giving the bank a loan and if you loan someone money, you should receive compensation for the risk you are taking. Therefore, you earn interest. So, taking what we learned from above, as the economy picks up so too does inflation. If inflation is increasing that means today’s dollars, if not invested to increase in value, will be worth less in the future. Thus, you should require a higher interest rate to compensate you for that risk. On the reverse, if you borrow money from the bank to buy a home (get a mortgage) and inflation is increasing, the bank will require a higher interest rate to compensate them for their risk. So, to ask “If the Fed continues to increase the federal funds rate…” is not entirely correct. An individual should be more curious about the economic productivity and inflation when determining if they will begin to earn more on their savings account or if mortgage rates will increase. If the Fed continues to increase the federal funds rate does it mean the stock market will go higher?

Once again, the question of the Fed increasing the federal funds rate, is not entirely accurate. The stock market will not increase because of the federal funds rate, but because the market perceives a rate hike as an indicator of a healthy economy. However, an increase in lending rates could be problematic for leveraged companies, because the cost of servicing debt increases, and if not structured properly could be detrimental. So, to make a broad assumption that an increase in the federal funds rate indicates a healthy economy, indicating companies are healthy as well is not necessarily true. One could make the argument that an increase in the federal funds rate moving forward could cause increased volatility in the markets. In conclusion, breaking down the proposed questions reveals a few takeaways: 1) the federal funds rate and market interest rates are not 100% correlated; 2) factors such as inflation, are key drivers when considering where future interest rates may land; 3) witnessing increased economic productivity, inflation, and interest rates does not mean the markets as a whole will increase as well. These takeaways help reframe the main part to the three questions and simplify the answers – “If economic productivity and inflation increase: 1) Your savings account’s interest rate will follow suit in order to compensate you for you risk; 2) Mortgage rates will follow suit in order to compensate the bank for their risk; 3) Market interest rates will increase and the servicing of debt could cause harm to certain leveraged companies causing market volatility.” Nathaniel’s Beautiful Mind Mutual Fund Spotlight International Value Advisors, or IVA for short, was started in October 2007 right before the 2008-‘09 financial crisis began to unfold. IVA’s portfolio managers, Charles de Vaulx and Chuck de Lardemelle, both worked together previously at First Eagle’s Global fund under the tutelage of the one of the great value investors Jean-Marie Eveillard. We like IVA because of their approach to global investing. Their ultimate goal is achieving absolute returns for their clients while also preserving their clients’ capital. They achieve this by focusing on several factors:

  1. Absolute versus relative valuations: they don’t care if a company in a sector is trading at a cheaper valuation relative to the sector’s other components. Instead, they care if the valuation is indicative of their required rate of return. For example, if the consumer staples sector is trading at 25x P/E and Nestle is trading at 20x P/E, IVA won’t buy Nestle simply because it’s trading at the lowest multiple within the sector. They will buy it if they believe, due to their research, that Nestle is worth far more than the 20x P/E it’s trading at.

  2. Do their own research: as alluded to above, Mr. de Vaulx, Mr. de Lardemelle, and their team of analysts do their own research. These guys love doing deep dives into the companies within their spheres of competence, and only pull the trigger when a security is trading at a deep discount to their conservative estimates of intrinsic value.

  3. Investment Choice: IVA wrote their Investment Policy Statement (“IPS”) to allow them the flexibility to trade in virtually any security they choose. This gives them the ability, as we and many value investors like to say, “To invest where the value is.”

These factors, amongst others, are specifically why we appreciate the IVA team. They have a deep bench of investment acumen, long-term thinking, and a solid process that is hard to find in the actively-managed fund universe. Ebbs and Flows We all see the ebbs and flows of the stock market on the average business day. One stock swings to a 30 percent decrease while another shoots up with a 300 percent increase, all in one day. We experience this too at LBW, but typically not to this extent. What does sometimes happen is we see a company’s stock price decrease 25 percent from our initial buy-in price. If this occurs, we are phased, but that doesn’t mean we run for the door. After all, what the stock market may value a company via its market price for is in no way indicative of its intrinsic value[3]. Instead, a number of thoughts run through our heads as we dissect the purported cause for the price decrease, whether it really matters to our thesis, and whether or not we should remain owners of the company. A recent example of this scenario is Liberty TripAdvisor (“LTRP”)[4]. LTRP is an asset-backed[5] equity in which its principal asset is approximately 30.95 million (MM) shares of TripAdvisor (“TRIP”). These 30.95 MM shares are split between two share classes, “A” and “B” shares, wherein the “B” shares have ten votes per share and the “A” shares have one vote per share. Seeing as this is a Liberty entity you can bet they have their hands on some of those supervoting “B” shares. In this particular case, they own all the “B” shares (totaling 12,799,999 shares). With the addition of their “A” shares, LTRP controls TRIP with a ~56 percent voting stake. Now that we have that tasty morsel out of the way, we can move onto the good stuff. TRIP has been going through a transition since 2014 as they have been rolling out a feature they call “Instant Booking” (“IB”). Some of you may have noticed over the past couple of years that when browsing TRIP’s main website, you may be offered the option to book a hotel via TRIP amongst all of their other buying options from Booking.com or Expedia (this is a part of their metasearch offering – more on this later). No, TRIP is not an Online Travel Agent (“OTA”). It is simply acting as the conduit for another OTA or hotel. If you choose the TRIP option, you are taken to a clean, simple, TRIP-branded page where you are asked to enter your information as you would anywhere else. The difference is that you are still within TRIP’s website, and not the actual OTAs whose booking you have chosen. Why is this so critical? TRIP typically is paid via a paid-per-click model known as metasearch[6] that would normally take you to Booking.com’s website to enter your information and complete the reservation. TRIP gets paid for your click regardless of whether or not you make a reservation. Instead, as you are entering your information into TRIP’s website, TRIP is now retaining this information so that you, the site visitor, can easily return and book future trips while Booking.com actually owns the sale. Booking.com will be the contact for you up until your stay is complete, and then pay TRIP instead of the metasearch paid-per-click model. Now, on a desktop this doesn’t sound like such a big deal, but now think about that on a mobile device…you see where I’m going with this. The biggest drawback for TRIP’s mobile users is being taken to Booking.com’s website and having to enter in their personal info on that small screen. With IB, you enter your info into TRIP one time, and you don’t have to enter it in again for future purchases! The move to mobile isn’t the only advantage of IB – IB is highly intriguing to small hotels because it levels the playing field against the big OTAs and hotel chains. Both metasearch and IB revenue models use similar inputs: number of clicks, conversion rate, commission rate paid to TRIP, and average booking $ amount. Assuming the number of clicks and the average booking $ amount are constant, the remaining variables, conversion rate and commission rate paid to TRIP, are the levers to the equation. TRIP will more likely partner with the provider that has the higher conversion rate and a lower commission rate (e.g. OTA) vs lower conversion rate and higher commission rate (e.g. small hotel). The OTAs can deliver a conversion rate that even when paired with a low commission rate (say <10 percent) delivers higher revenues to TRIP versus the converse argument for small hotels. This is what happens in metasearch. The OTAs outbid the small hotels for top placement with their higher conversion rates due to OTAs’ higher amount of alternative hotel options. IB now allows small hotels the opportunity to increase their conversion rates by offering richer content and more accurate and cheaper pricing to the customer. As the small hotels improve their content and become more competitive with the OTAs, a dynamic marketplace/auction will form within TRIP due to conversion rates becoming comparable. As the small hotels and OTAs duke it out, bidders will increase their commission rates. This is why it was so critical for TRIP to bring the big OTAs Priceline and Expedia onto the IB platform – to create competition for all providers. So, if both conversion rates and commission rates will increase, TRIP’s revenues will increase as well! As you know, TRIP is one of the top traveler review websites. They have gone through several revenue transitions, from pop-ups to metasearch to IB. All of these transitions have been completed in the attempt to capture more of the travel industry’s revenues. The big OTAs Expedia and Priceline typically charge hotels anywhere from 20-30 percent commissions; TRIP, via metasearch, typically averages 7-15% commissions. The intent of IB is to close this gap. With regards to TRIP’s IB transition, they did not realize it would take as long as it has. So, since summer 2014, TRIP’s stock price has taken a tumble from $110.21/share[7] to today’s range within the low 40’s/share with LTRP closely following suit. This rather large price drop has brought LTRP to appetizing levels. There are various assumptions that one could make if they were to purchase LTRP today:

  • The IB transition from metasearch is just that, a transition. Revenue has been stagnant, but will soon return to growth as more OTAs and hotel providers get onboard.

  • As IB becomes more widely-used, the commission rates that TRIP receives will increase, as noted previously.

  • IB was not meant to completely replace metasearch. Instead IB will most likely become a complement to metasearch, and eventually, depending on the marketplace’s dynamics within TRIP, could supplant metasearch. Time will tell.

  • At ~$110/share, TRIP was overvalued. It was priced to grow at 21-24 percent per year for the next ten years, which did not make sense for its future plans with IB. Such unreasonable assumptions are commonplace on Wall Street as we noted in our past blog post “Wall Street Guidance Estimates – Do They Matter?” posted November 30th, 2016[8].

  • Even if IB fails, and all website traffic shifts back to metasearch, TRIP will still make money. As a part of the IB rollout, TRIP has been spending money on advertising that they didn’t do for metasearch. IB fails, all that money spent on advertising is retained and reinvested by TRIP.

  • As a result of IB leveling the playing field for the small hotels versus the big OTAs and big hotel chains, TRIP is making it such that the small hotels won’t want to leave their platform. Their relationship will just become stickier with time.

  • LTRP is a play on its voting control over TRIP. LTRP is controlled by Greg Maffei, who owns the majority of LTRP’s supervoting “B” shares, and is the man who works for and with the cable pioneer, John Malone. Maffei is rumored to have been behind Liberty Media’s investment in SiriusXM radio in 2009, and has shown via his and Malone’s actions that he’s all about building shareholder value.

For our purposes, let us assume that we bought LTRP’s “A” shares (“LTRPA”) at an average cost basis of such that we are now at an unrealized 25 percent loss. Below, you will find a few of the checklist items that an investor is thinking about with regards to LTRPA’s price decrease and our answers, in italics, to them:

  1. Unrealized losses do not equal realized losses: Remember, real money is lost only if you sell your shares.

  2. Was our initial thesis wrong?: No, while TRIP’s management may have underestimated the transition timetable, LTRPA’s price at these levels is still appetizing.

  3. Were our initial assumptions of various inputs and metrics including free cash flow (“FCF”), return on invested capital (“ROIC”), incremental return on invested capital (“IROIC”), return on equity (“ROE”), net debt, invested capital (“IC”), 5-year and/or 10-year growth rates, long-term (post 10-year growth rates) growth rates wrong?: No, all input and metric assumptions check out.

  4. What, if any, of the above has changed? Are the differences temporary or fundamental? Is there something that we missed? Is there a secular change afoot?: Nothing substantial was missed in our opinion. There are secular changes occurring within the travel industry, but we feel that TRIP is ahead of this curve.

  5. Bias: did we subconsciously ignore a negative aspect of the company that significantly alters our inputs and/or metrics?: No.

  6. What is the current catalyzing event or news that has caused the stock price’s decrease?: Wall Street’s disappointment that they aren’t seeing growth in TRIP’s revenues for fiscal years 2015 and 2016.

  7. Compare this versus our research notes. Does it materially change our initial thesis?: No, we were planning on low to no revenue growth in our initial investment thesis.

  8. If all the above check out, should I buy more?: This is where portfolio management enters the fold. It depends on LTRPA’s current weighting within the portfolio, the client’s comfortability with concentration, and my confidence in my research. If all of these items check out, then “yes”, I should buy more.

The above list is a small subset of our overall investment process. We are diligent in reviewing our holdings on an ongoing basis, performing “post-mortems”[9] on our winners and failures, and searching for new ideas to further expand our circles of competence. We take our job seriously here at LBW because like IVA above, our job is to deliver our clients absolute returns while also ensuring that we preserve their capital for the long haul. ​Sincerely,

LBW

[1] https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20170315.pdf [2] https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20170315.pdf [3] You remember one of our favorite topics, right? [4] Yes, I know we have a lot of Liberty entities. They do keep us busy as opportunities can abound because Wall Street refuses to the deep dive analysis required to truly comprehend some of these entities. When a Liberty company is misunderstood as advertised by its market price, we start buying hand over fist if the price is really right. [5] “Asset-backed” refers to an equity in which most of its value comprises of an asset that is not a part of its regular operations e.g. Liberty Sirius is a play on SiriusXM (“SIRI”). [6] As referenced previously [7] June 27th, 2014 closing price [8] http://lbw-wealth.weebly.com/blog/wall-street-guidance-estimates-do-they-matter [9] A post-sale analysis of whether our initial thesis proved correct, did a fundamental change occur to our thesis, why it may or may not have, and why we decided to sell.

#quarterlycommentary #federalfundsrate #stockmarket #mutualfunds #LibertyTripAdvisor #LTRP #valueinvesting

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Madison, WI 53719

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