Mar Vista Investment Partners Second Quarter 2014 Review
“Keep Calm and Carry On”
Seventy-five years ago this month, the British Ministry of Information printed a couple of million posters with the slogan “Keep Calm and Carry On” to strengthen the citizenry’s morale ahead of anticipated attacks during World War II. The campaign was ultimately scrapped and all but a few dozen of the posters were recycled for pulp after the war. It was only in the last decade or so that the original posters resurfaced becoming a pop-culture catchphrase and predictably, in a highly stimulative monetary environment, sell at auction for more than $20,000 each.
After a more hesitant first quarter, investors heeded Chairman Yellen’s missive to “Keep Calm and Carry On” as prices on most risk assets – stocks, government debt, high-yield credit, real estate, art, classic cars, and, yes, original posters from World War II – were marked up in the second quarter. The Fed’s commitment to keep rates low for an extended period has been the key driver of this market’s multiple expansion with earnings growth a distant second. Combining cheap capital with a dearth of organic revenue growth opportunities, as well as an onerous domestic tax code, has led to a frenzied $1.7 trillion wave of mergers and tax-driven inversion arrangements so far this year.
Although the “wealth effect” on consumer spending from the 200% rise in the market over the last five and one-half years has been curiously absent, there are emerging signs that the central bank’s accommodative policies are igniting animal spirits in the real economy, not just the equity and bond markets. Data across a wider swath of the economy - housing, labor, manufacturing, automobile production - are showing steady, albeit mostly lackluster, improvements. On another promising note, management from several of the large banks and industrial firms we cover suggest the appetite for investments in capital projects and use of credit lines is improving.
Despite the encouraging economic data, it remains to be seen how the markets, business managers and consumers will react as the Fed completely eliminates their quantitative easing and likely starts to raise rates over the next 12-18 months. With our average margin of safety, or upside to fair value, compressed at 8%, extended valuations are providing minimal downside protection. We will remain prudent in allocating your capital in the current environment.
Mar Vista’s investment philosophy and process are built around the belief that capital preservation is equally important as appreciation. So while we are pleased to have enhanced the purchasing power of our investors’ capital relative to passive benchmarks over nearly every time horizon, we are equally proud that we have achieved it with materially better down capture (72% and 77% versus the Russell 1000® Growth and S&P 500®, respectively) and lower beta (0.83 and 0.89, respectively) yet still attractive up capture (89% and 95%, respectively) over the ten and one-half years since our inception.
Portfolio Changes
With eerily quiet volatility and a market that is somewhere between fairly and over-valued, our friend, Mr. Manic-Depressive, hasn’t provided many opportunities to deploy capital at highly attractive expected returns. Nevertheless, the Mar Vista investment team isn’t sitting around twiddling our thumbs. Fat pitch opportunities can present themselves quickly and come from unexpected areas. Allergan, for example, sold off nearly 30% over a period of nine weeks last summer gifting us with an unexpected asymmetric opportunity.
We think another gift was handed to us this quarter when Discovery Communications’ stock declined 20% from its highs. The company has built a wide and durable moat around non-fiction shows which generate greater economic profits due to the timelessness of documentaries (a National Geographic documentary from 2004 isn’t dated unlike a Friends episode), lower production costs and content that is easily translatable for international markets. With the majority of revenue derived outside the U.S., Discovery should also benefit from its scale and exposure to faster growing international markets where pay television penetration is almost one-half that of the US. We expect management to leverage the content across their global platform and compound free cash flow over 15% while returns on capital expand from 12% to 20% over our time horizon.
Adobe Systems was also a new buy during the quarter. We believe the market underappreciates its strong competitive position and higher lifetime value of each customer due to their transition from perpetual licenses to a subscription revenue model. This should drive more predictable revenue streams, a broader addressable market, stickier customers and more ubiquitous upgrade cycles. We believe the new model will further expand Adobe’s durable moat as the standard operating system for the creative content ecosystem.
Note that both Discovery and Adobe, along with Oracle and Mettler-Toledo, deepen our stable of “cannibals,” or companies that buy back large amounts of their own undervalued stock, reducing shares outstanding and increasing per share intrinsic value.
Standing on the Corner of Value and Growth
One of the more common questions we get during due diligence meetings is, “How can a growth manager justify owning businesses like Exxon and Berkshire Hathaway? Aren’t they value stocks?” It is also among our favorite questions as it allows us to express our comfort as growth investors who also enjoy wearing the clothing of value investors – some might call it intellectual cross-dressing but we consider it to be just intelligent investing.
Unlike the traditional definitions of growth which are based on revenue and earnings, our measure is based on the growth of shareholder value, or the reinvestment of capital that generates returns greater than its cost. Operating profits are an important component of that formula but how much capital is required to produce that growth is equally important. Growth will actually erode value if the profits aren’t sufficient to compensate for the cost of additional capital required.
We tend to scratch our heads when it is suggested that Berkshire Hathaway is not a growth business; the collective earnings power of their wholly-owned and publically-traded stocks have compounded at a mid-teens rate over the last five and ten years compared to the S&P 500’s earnings growth of 7% and 9%, respectively. This expansion in earnings isn’t evident by looking at the typical income statement metrics but the information is there for those willing to dig into the financials. On top of this profit growth, Berkshire is able to employ capital that has almost no cost to it. Nearly $80 billion of float is on their books that has a negative cost of capital, since they get paid via underwriting profits to hold onto policy holder premiums. In the wrong hands, cheap capital could be dangerous as most business rollups have eventually proven. But in the hands of arguably the two greatest capital allocators of all time, the combination is nirvana for shareholder value creation.
Exxon also screens poorly using traditional growth metrics: production growth has been anemic and profits fluctuate with an unpredictable commodity price. But our framework identifies a business that has a corporate culture centered on generating excess returns on capital over nearly all time horizons. While it may take time to show up in revenue growth and earnings per share, we believe Exxon is on the cusp of a material acceleration in free cash flow and shareholder value growth. Over the last several years, Exxon has aggressively invested enormous capital in unproductive projects that are just now starting to yield high-margin barrels. As unit production improves and capital spending abates, returns on capital and free cash flow should accelerate which we believe is not reflected in the current stock price.
On average and over time, we think that owning these types of cross-dressers -- growth businesses masquerading as value stocks -- will lead to better than average outcomes.
Our Commitment to Our Investors
Though there are never guarantees in investing results, the Mar Vista team remains committed to the foundations of our success:
•Focus on the process, not the outcomes
•Emphasize capital protection as much as upside potential
•Think like rational business analysts first, not traders of individual stocks
•Identify good capital allocators that think and act like Outsiders
•Exploit the manic-depressive nature of Wall Street
•Take concentrated positions when the expected returns relative to the risks are favorable
•Align our economic incentives with our investors
As always, we appreciate the trust you have instilled in us as stewards of your capital. Our role as fiduciary is paramount to everything we do and open communication about how we are managing your capital is an important part of that responsibility.
All the best,
The Mar Vista Investment Team
1 We are not clever enough to coin this term. Full credit goes to Warren Buffett in his 1992 Berkshire Hathaway shareholder letter.
A complete list of portfolio holdings and specific securities transactions for the investment strategy during the preceding 12 months, the top contributors and underperformers calculation methodology and a list of every holding’s contribution to the overall performance during the period is available upon request. The securities mentioned in this letter were held in the account of a Strategic Growth client that Mar Vista believes to be representative of the accounts that Mar Vista manages for this investment strategy during the period from March 31, 2014-June 30, 2014. Other Mar Vista clients managed with different investment objectives may hold different securities than those listed. The securities listed in this letter should not be considered a recommendation to purchase or sell any particular security. The reader should not assume that investments in the specific securities identified herein were or will be profitable. Risk data is being provided as supplemental to the Strategic Growth GIPS performance presentation, which is available upon request. Past performance is no guarantee of future results. Not FDIC insured, no bank guarantee, may lose value.
© Mar Vista Investment Partners
