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Nathan Bell
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+ About Nathan Bell

Nathan Bell has over 20 years' investment experience. Before joining Peters MacGregor Capital Management as head of research, he worked for nine years at Intelligent Investor including four years as research director. Nathan contributes regularly to the financial press and appears on Sky Business, CNBC and the ABC. He graduated from Flinders University with a Bachelor of Economics and subsequently completed a Graduate Diploma of Applied Investment and Management. Nathan is a CFA Charterholder.

Sidestep the potential pain from passive investing

Thursday, May 25, 2017

By Nathan Bell

In part one of our article series, we showed how being contrarian can produce huge returns. In part two, we explained how buying companies with owner-managers can also give you an edge.

In our last article on how you could beat the market, we’ll show why a passive investment strategy based on a broad index of the US market is risky, and how sensible active management could increase your returns and reduce risk.

 

Chart 1. Funds flows into active and passive funds
Source: BofAML Global Investment Strategy, EPFR Global

Fed up with lousy returns and high fees, a tidal wave of frustration has seen billions flow from active managers to ETFs and index funds (see Chart 1). Unfortunately, the timing may prove lousy.

If you lucked out buying the S&P 500 on 9 March 2009, you would’ve more than tripled your money to date, without ever having to know what businesses you owned, or what the best bargains were. That’s an incredible annualised return of 17%.

But in the same way a retailer can boost current profits with a sale at the expense of future profits, today’s high valuations suggest that overall market returns over the next eight years will pale next to the 17% per annum achieved since March 2009.

In March 2009, the price-to-earnings ratio (PER) of the S&P 500 was 11. To produce the 17% annualised return mentioned above, earnings have grown at just 5% per year, while the PER has increased 150% to 27. In other words, despite tepid earnings growth, investors are now prepared to pay 2.5x more at, or near, a cyclical peak for a dollar’s worth of earnings than they were in 2009.

Take McDonald’s for example. In 2016, revenue was only 8% higher than in 2009, and net income is virtually flat. Despite a large helping of share buybacks, earnings per share has only increased 5% per year. Yet, the PER has nearly doubled from 15 to 27, which contradicts the company’s inability to grow. 

It’s not surprising then, that on several measures, the US market’s current valuation is only surpassed by 1999. That is, right before the tech wreck and the period that ushered in the great depression.

Like our retailer’s sale, the long period of high returns since the GFC has stolen returns from the future, so being highly diversified across hundreds of over-valued stocks is not going to help you achieve your financial aims or protect your savings.

A better way

Fortunately, all is not lost. The gap between the most expensive stocks on the market and the cheapest has rarely been larger, suggesting that a portfolio of undervalued stocks could outperform the major indexes by a large margin once the current momentum in growth stocks and passive strategies (which are mathematically poised to produce poor returns over the medium term) wanes.

It’s worth highlighting the poor performance of the S&P 500 during the periods 1966-82 and 2000-2003 - a long period of poor performance holding a diversified portfolio of stocks is nothing new.

Let’s analyse three stocks in our current portfolio that potentially offer attractive returns and safety through a mix of dominant market positions, trustworthy and entrepreneurial management and favourable valuations.

SiriusXM

SiriusXM is America’s only satellite radio service. Due to its long relationships with auto manufacturers, its devices now reside in about three quarters of all new cars rolling off production lines. That means instead of being forced to listen to AM or FM radio, you can choose from around 150 channels of ad free music, sports, news and entertainment, including shock jock Howard Stern, for just $13 per month.

Despite the increase in online music services, SiriusXM’s subscriber base continues to grow. Free radio, replete with advertising, remains the company’s major competitor, but there are no other satellite radio services. That’s because SiriusXM spends over $300m per year on content, which makes it unprofitable for another competitor, and you’d be a decade behind even if you could convince the auto manufacturers to add your receivers to their cars.

SiriusXM

Chart 2. SiriusXM enabled vehicles to nearly double by 2025
Source: SiriusXM, Morgan Stanley Research estimates

The company’s free cashflow multiple of 17 suggests earnings won’t grow that quickly, yet its market is expected to almost double from 90m cars currently, to 175m by 2025 (see Chart 3), mainly due to an explosion of second hand cars fitted with its devices.

With operating margins expected to increase above 40%, and a service that is insulated against economic downturns due to its low price and great value, we intend to own this compounder for a long time to come.

Even better, if you buy the holding company Liberty SiriusXM (as we did), whose only asset is a 67% stake in SiriusXM, you’ll enjoy a further 19% discount and the benefit of both companies buying back shares.

ING Group

The European banking industry has largely been a trap for investors since the GFC, with problems taking longer to sort out than they did in the US. Finally, there are signs of progress. Embattled Deutsche Bank has raised €8bn in a rights issue, and Italy’s largest bank, UniCredit, raised €13bn to cushion against bad debts.

That’s helping make the entire sector safer, but ING Group rid itself of its GFC-related problems some time ago. What’s left is a vanilla retail bank with dominant market positions in Luxembourg, Belgium and Germany. Quite remarkably, ING has built a €100bn deposit franchise in Germany from a standing start in 1994.

You likely recognise the ING brand from its TV commercials featuring comedic actor Isla Fisher. As the bank doesn’t have a large branch network (in Australia at least), it can offer more attractive online savings rates to grow deposits. Once its base of customers is established, it can then sell additional products, such as mortgages.

ING has been at the forefront of digital banking, and by investing nearly a billion Euros over the next four years, it should stay there. The stock is currently trading at a price-to-tangible book value of 1.2. With a sensible strategy to increase profits steadily, along with a 4.3% dividend yield, this high-quality bank nestled in the wealthy bosom of northern Europe could produce total annualised returns (dividends plus capital gains) above 15%, as sentiment turns more positive across the sector in the same way it has recently in the US.

NVR Inc

Homebuilders aren’t usually a happy hunting ground for investors. Their returns in the good times are often lousy due to intense competition, but during a recession, they often go broke taking on too much debt to buy land.

After going broke around two decades ago, NVR solved this problem. Instead of buying land, NVR pays a 10% premium for an option to buy a parcel of land in the future. This means the company operates with next to no net debt, allowing it to survive recessions and buy back shares. In fact, this company is a cannibal, buying back 75% of its shares over the past twenty years.

US_builder Chart

Chart 3. US homebuilder stock total returns between 1 May 1997 to 30 April 2017
Source: Morningstar Direct

That’s led to unheard of returns for a homebuilder operating in such a cyclical industry. NVR’s total return over the last 20 years is 17,207% (see Chart 4 for comparison to its peers), and it was the only US homebuilder that turned a profit during the GFC.

Chief executive, Paul Saville, may shun quarterly earnings discussions with analysts, but his $270m stake in the business should benefit from several tailwinds blowing behind the industry.

The millennial cohort is America’s largest ever, and they’re reaching an age that involves marriage, babies, and the inability to keep living at home. Not only is this bullish for home building, which is stuck at barely 50% of the peak in 2007 and 20% below the long-term average, but the inventory of homes available for sale is also reaching a near-record low. In most of the areas that NVR operates, it’s also cheaper to buy than rent, in contrast to Australia, for example.

So, Plan A is that NVR builds lots more homes and increases its earnings, but our confidence in a satisfactory outcome is increased by Plan B, which is that the share price languishes and the company buys back shares hand over fist. We also note that homebuilders currently represent 0.1% of the S&P 500 index, which means their stocks aren’t influenced by value-agnostic ETFs.

In summary, this is a remarkable company operating in an unpopular sector with insiders that have skin in the game. As we’ve explained, that trio is a very promising starting point for any investment.

Activate your portfolio

The key point from this analysis is that there’s always value somewhere. And unlike index funds and ETFs that will eventually face major headwinds when investors reassess valuations, the potential returns for the businesses we’ve described are much higher and, in our view, offer far more safety.

Passive strategies play an important role in portfolios, but they make the most sense when valuations are low. At current valuations, many of these products are priced to produce lousy returns over the next decade but, as we’ve shown, with a little effort you can find great businesses that will protect and grow your portfolio for decades to come.

This is a sponsored article by Peters MacGregor Capital Management.

Nathan Bell is Head of Research at Peters MacGregor Capital Management. Peters MacGregor is a value-focused global fund manager based in Sydney, Australia. Visit petersmacgregor.com for information about investing in our global fund for patient, long-term investors.

Disclosure: Peters MacGregor Capital Management Limited holds a financial interest in ING Groep, Liberty SiriusXM and NVRep, Liberty Sirius XM and NVR  through various mandates where it acts as investment manager.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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Why it pays to be contrarian

Thursday, April 06, 2017

By Nathan Bell

In part one of this three-part series, we explained how buying companies where management has their own wealth on the line can help you beat the market. In this article, part two, we’re going to analyse a current portfolio holding to show how you can trounce the market if you’re prepared to be contrarian.

Being contrarian is not a simple mathematical formula. Nor does it guarantee success, which is why value investing is not more popular. Instead, it requires a detailed knowledge of how a company and its industry works so you can handicap what expectations are priced into its stock and act accordingly.

Most importantly, though, being contrarian doesn’t mean doing the opposite of other investors just for the sake of it. As the father of value investing Ben Graham once said, ‘You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.’

While it’s necessary to do the opposite of what most other investors are doing to make large returns, your factual reasoning must also be correct. This is what gives you the confidence to go against the herd. If you don’t know the inner-workings of the business you’re buying, or the industry it operates in, how can you estimate whether the stock’s prospects are accurately reflected in its stock price?

Liberty Broadband

Let’s analyse a contrarian investment we bought in February 2016. Liberty Broadband is a holding company that we bought at a discount to the value of its only major asset, a shareholding in cable TV company, Charter Communications.

Figure 1. Negative press in the media. Source: Wall Street Journal

Last year, you couldn’t open the Wall Street Journal without reading another obituary about cable TV companies. The perception was that cable subscribers were falling and would fall faster over time as more people switched to cheaper online entertainment alternatives, like Netflix or Stan. As the market often does, it put these ‘facts’ together and assumed the days of charging customers over $100 per month for their cable service were at an end.

Adding to concerns was Charter Communications’ bid to acquire Time Warner Cable, which would make Charter the second largest cable company in the US in an industry where size matters. The 800-pound gorilla of the cable industry, Comcast, had effectively been denied the right to acquire Time Warner Cable just one year earlier. The market figured Charter’s bid would suffer the same fate.

Different conclusion

After performing our due diligence, the facts provided a different view of Charter Communications’ prospects compared to the consensus.

First, Charter Communications wasn’t losing cable TV subscribers. It was mainly the satellite cable TV providers that were suffering, as their service was inferior and they didn’t offer phone and broadband services that you could bundle with your cable TV subscription in comparison to at Charter, where you could save money (also known as the ‘triple play’).

Second, while over time we expected Charter to lose cable TV subscribers, its broadband internet service should enjoy strong growth and increasing average revenue per subscriber for years to come. That’s because most people upgrade their internet service when they cut their cable subscription to make sure online services like Netflix aren’t slow or interrupted. It’s also worth noting that that the broadband business enjoys much higher margins than cable TV, as the incremental cost of adding a broadband subscriber is minimal.  

We were also confident that Charter Communications would receive regulatory approval to acquire Time Warner Cable, as Netflix’s CEO Reed Hastings had given his blessing along with the New York state regulator. Our view turned out to be correct, but if we were wrong we expected it to be a case of heads we win, tails we don’t lose much. These odds are what we look for in all our investments.

Contrarian view

So here was a classic case where a very high quality business was undervalued because the market was myopically focused on one part of the business, instead of its many virtues, including its highly recurring revenue, huge barriers to entry (as shown recently by Google’s failed attempts to expand fibre to the home – it’s very expensive digging up the sidewalk to install cables and wires), fast-growing broadband internet service, and the potential to create a huge amount of value from an impending acquisition; all overseen by CEO Tom Rutledge, who is widely regarded as the cable industry’s best operator.

Chart 1. Liberty Broadband share price chart. Source: Capital IQ, Peters MacGregor Capital Management

With Liberty Broadband’s price almost doubling over the past year, it became our largest holding as investors regained their senses and recognised its true value. Telecommunications company Verizon has also shown interest in acquiring the business recently, again showing that it was vastly undervalued for such a high-quality business when we bought it.

The large gain so far was only possible because the market was myopically focused on the cable TV business, and wasn’t thinking long-term about the broadband internet division to uncover the stock’s true worth. The facts were available to anyone prepared to do the work, but you had to stand against the crowd and be prepared to wait for the value to be realised.

Betting on macroeconomic changes consistently is virtually impossible. But if you look for reliable indicators of value, such as insider ownership and low valuations, and most importantly you’re prepared to back your judgment despite the consensus arguing otherwise, you can beat the indexes too.

This is a sponsored article by Peters MacGregor Capital Management.

Nathan Bell is Head of Research at Peters MacGregor Capital Management. Peters MacGregor is a value-focused global fund manager based in Sydney, Australia. Visit petersmacgregor.com for information about investing in our global fund for patient, long-term investors.

Disclosure: Peters MacGregor Capital Management Limited holds a financial interest in Liberty Broadband through various mandates where it acts as investment manager.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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How insider ownership can thrash the market

Wednesday, March 08, 2017

By Nathan Bell

‘Past performance is no guarantee of future performance.’ 

Like a food label warning that your favourite box of chocolates may contain traces of nuts, we’ve all read something similar when analysing the performance of a fund manager. 

But this warning also applies to individual stocks. Just because a stock has a stable history, for instance, doesn’t mean its future is assured. Do you remember Allco and Nokia? Both were coveted growth stocks before they were swiftly knocked off their perch. 

As long term investors, we’re always looking for reliable indicators that can help us beat the market. One of the best is finding owner-managers i.e. companies where management has a large stake in the business. Let’s look at the performance of three owner-managers that feature in our portfolio.

John Malone

John Malone is the doyen of the US cable TV industry and the lead protagonist in the book, Cable Cowboy. He produced 30% annualised returns as CEO of TCI between 1973 and 1999 (twice that of the S&P500 – see Chart 1) before selling the company at the height of the tech boom to AT&T.

Chart 1. TCI returned 30% p.a. between 1973-1999

 

Source: Center for Research in Security Prices (CRSP) and TCI annual reports

From the ashes of the tech wreck that followed, Malone emerged with a large stake in Liberty Media, which spawned numerous companies with interests in cable TV content and distribution, satellite radio and broadband internet, just to name a few.

We own several Liberty names with businesses diversified by industry and geography. They don’t typically screen well due to a host of factors. Management focuses on maximising free cashflow to buy back shares, rather than reporting high profits that attract high taxes, for example, which depresses return on equity even though the company produces high returns on investment. 

As complications like this keep most investors away, despite management’s remarkable track record, we’ve no problem taking advantage of the discounts overlooked by others.

Paul Saville 

Paul Saville watched the original incarnation of homebuilder NVR go broke before becoming CEO in 2005. Unlike virtually every other listed homebuilder on the planet, he learned from the experience and constructed a way to protect NVR from recessions. 

Instead of dangerously leveraging the balance sheet to accumulate land for development, NVR lays down 10% of the purchase price for an option on future development. This means the balance sheet isn’t highly geared, allowing the company to buy back 75% of its shares on issue over the past 20 years. That’s a remarkable feat for any company, let alone a home builder.

In 2009, NVR was the only listed US homebuilder to make a profit and post respectable shareholder returns through the GFC (see Chart 2). With US housing stock now reaching record lows, interest rates still low and the millennial population – the country’s largest ever – reaching a median age that suggests they’ll soon start having families of their own, the company is well placed to benefit from an increase in homebuilding. If housing doesn’t pick up, we expect the company to buy back plenty more shares.

Chart 2. NVR 10-year total shareholder return vs competitors as at 31 December 2015

Source: NVR annual reports

Richard Liu

Richard Liu is the founder of Chinese online retailer JD.com. He’s fanatical about delivery times, the condition of the goods once delivered and eradicating fakes, which is a huge problem in China.

While its larger rival, Alibaba, measures delivery times in days, JD.com measures them in hours, usually promising same day delivery if you order before 11am. This incredible feat reflects huge long-term investments in warehouses and delivery fleets, which Alibaba has avoided to keep current profits as high as possible. It also required a culture change in an industry not usually associated with caring much for the state of parcels to be delivered.

Over time, we expect JD.com’s delivery advantage will allow the company to expand its range of goods and take market share from Alibaba. But, it requires Liu’s fortitude to sacrifice profits today for much higher profits tomorrow.

No guarantees

Investing in businesses with large inside ownership is no guarantee of high returns, but the successful operators have common traits.

First, they think long term. After investigating stocks in the S&P500, Ronald Anderson and David Reeb discovered that founding shareholders are more likely to invest in long-term projects and think harder about succession planning.

This contrasts with typical corporate behaviour, or the ‘institutional imperative’ as Warren Buffett calls it, where executives favour high immediate earnings and share buybacks over long-term investments to maximise bonuses at the expense of the long-term health of the business.  

Inside-owners are often more entrepreneurial, and aren’t afraid to do something different if it makes financial sense. Note NVR’s unique land acquisition strategy, or JD.com’s expensive supply and distribution strategy, compared to Alibaba’s preference to outsource its delivery to maximise current profits.

They’re also smart about acquisitions. They don’t bet the company, and are typically buying valuable assets in downturns while their contemporaries are busy fortifying their balance sheets. 

According to research by von Lilienfeld-Toal and Ruenzi, ‘The acquisition activity of firms with high ownership is significantly lower than that of low ownership firms … Overall, these findings suggest that high ownership firms engage less in empire building’.

Though owner-managers are more interested in increasing profits than owning marquee businesses for bragging rights, they aren’t usually driven by greed. Charles Schwab, who founded stock brokerage company Charles Schwab Corporation, explains why this unique group often keeps working decades after they became wealthy.

‘The man who does not work for the love of work, but only for money, is likely to neither make money nor find much fun in life.’ In short, they work because they enjoy it. 

In an environment where revenue growth is hard to come by, we believe entrepreneurial managers are worth their weight in gold as they adapt to keep their businesses growing. Our job is to keep finding more of these talented individuals to partner with so that your savings continue to grow alongside theirs.

Disclosure: Peters MacGregor Capital Management Limited holds a financial interest in JD.com, Liberty Broadband and NVR through various mandates where it acts as investment manager.

Disclaimer: This is a sponsored article by Peters MacGregor Capital Management. Click here to find out more about the Peters MacGregor Global Fund.

Peters MacGregor Capital Management Limited do not take into account the investment objectives, financial situation and advisory needs of any particular person, nor does the information provided constitute investment advice. Any information, material or commentary by Peters MacGregor Capital Management Limited is intended to provide general information only. Please be aware investing involves the risk of capital loss. Before acting on any advice, any person using the advice should consider its appropriateness having regard to their own or their clients’ objectives, financial situation and needs. You should obtain a Product Disclosure Statement relating to the product and consider the statement before making any decision or recommendation about whether to acquire the product. Past performance is not a reliable indicator of future performance.

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Value stocks with growth potential

Wednesday, September 28, 2016

By Nathan Bell

Many investors currently feel sandwiched between accepting low growth on one hand, and having to pay gross prices for high-growth stocks on the other.

Gone, it seems, are the days where you could pay a fair price for a wonderful business – forcing you to accept lower returns by paying up for good businesses or taking uncomfortable risks with lower-quality businesses.

History suggests that value stocks outperform growth stocks nearly 90% of the time (see chart below).

With growth stocks potentially at, or near the end of their second-longest winning streak over value stocks, the case for value stocks is simple.

 

 

Value wins out eventually

Source: Franklin Templeton Investments, Eugene Fama & Kenneth French. Templeton Global Research Library

But investing in value stocks doesn’t mean you have to forgo growth. In the current environment, it means digging deeper to find wonderful franchises priced to produce healthy long-term returns, regardless of the macro-economic environment.

Let's analyse one example.

Tune into Liberty SiriusXM

If you’ve hired a car in the US in recent years, it was probably equipped with a satellite radio service called SiriusXM.

For local drivers, a monthly subscription of ~$15 provides access to around 150 channels of ad-free entertainment, including exclusive access to shock-jock Howard Stern, scores of curated music channels to ensure your drive to and from work is as stress free as possible, major sports coverage including the NFL, NBA and MLB, numerous news channels from the world’s most trusted sources, such as the BBC and CNN, and other content that you won’t find anywhere else.

SiriusXM is America’s only satellite radio service, but up until 2009, there were two rival services – Sirius and XM.

Together, they were spending $450m per year on content, and neither was making a profit. As the biggest competitor to this pair is free radio, the regulators approved their merger application and unleashed a financial powerhouse. Revenue and free cash flow have doubled and tripled respectively since the merger.

SiriusXM total subscribers (in millions)

Source: SiriusXM Holdings

Digital music services such as iTunes, Spotify and Pandora have failed to stop SiriusXM’s subscription growth. Regular advertising-supported radio services are the bigger threat, as SiriusXM subscribers are paying for a vast array of entertainment, not just music.

That variety has also minimised the risk to profits of Howard Stern retiring or leaving, which used to be a major issue.

Opportunities

There are four major sources of value that aren’t currently reflected in SiriusXM’s valuation. First is the large increase in potential customers from second hand cars fitted with SiriusXM chipsets. SiriusXM has been working for over a decade to encourage most large automobile manufacturers to fit their cars with SiriusXM devices.

In 2009 (aided slightly by the cash-for-clunkers program, where individuals received a $3,500-$4,500 credit to put toward a new car – usually fitted with a SiriusXM device) new car purchases began a long recovery following the GFC.

With the average new car owned for six or seven years, those new cars are now putting a rocket under the number of used cars currently fitted with a SiriusXM device, expanding SiriusXM’s market from 85m cars currently to 160m by 2025.

Second, better technology and information on the used car buyers means Sirius can better tailor its marketing to this rapidly growing pool of new potential customers.

SXM17 is the company’s new chip set that will finally allow the company to stop broadcasting blindly by using a car's modem to monitor viewership and make it much easier to activate a subscription. For example, you will be able to sign up through your dashboard instead of calling the company.

Third, the long relationships SiriusXM has with auto manufacturers puts the company in the box seat to deliver in-car internet services, whether that’s for traditional vehicles, or the driverless vehicles of the future. It’s impossible to predict whether these services will add materially to the bottom line, but at the current valuation, you’re not paying anything for it.

Lastly, by 2025, SiriusXM will be in a position to merge its separate Sirius and XM signals, and in turn, free up spectrum, which is in increasingly short supply. It could be sold, or used to provide new services, such as those previously mentioned, or perhaps a cheaper advertising-based offering to sign up customers initially unwilling to pay $15 per month.

Like in-car internet services, we’re not factoring this in to our valuation and consider it a free option.

Why own Liberty SiriusXM?

There’s one last twist in the story. While SiriusXM is listed in the US, we own Liberty SiriusXM, whose chief asset is its 65% shareholding in SiriusXM, as it trades at a ~15% discount to SiriusXM.

As SiriusXM continues to buy back shares at a rapid clip (it has shrunk the share count by 23% over the past three years), Liberty SiriusXM’s stake in SiriusXM keeps increasing.

SiriusXM currently trades on an attractive price-to-free cash flow multiple of 16, which isn’t lost on Liberty SiriusXM.

The company failed in its attempt to acquire the shares it doesn’t own in SiriusXM in 2014, offering $3.68 per share compared to the current price of $4.17. Eventually, we expect a deal will get done and Liberty SiriusXM’s discount will disappear.

In a market where high-growth companies are trading at nosebleed valuations, this example shows that there are still growth businesses trading at value prices.

With Australia only representing a small portion of the global share markets (about 3%), you may have to look overseas to uncover opportunities like Liberty SiriusXM.

To learn more, download this quick guide or contact us

Disclosure: At the time of writing, Peters MacGregor Capital Management Limited holds a financial interest in Liberty Sirius XM Group.

Disclaimer

This is a sponsored article by Peters MacGregor Capital Management.

Peters MacGregor Capital Management Limited do not take into account the investment objectives, financial situation and advisory needs of any particular person, nor does the information provided constitute investment advice. Any information, material or commentary by Peters MacGregor Capital Management Limited is intended to provide general information only. Please be aware investing involves the risk of capital loss. Before acting on any advice, any person using the advice should consider its appropriateness having regard to their own or their clients’ objectives, financial situation and needs. You should obtain a Product Disclosure Statement relating to the product and consider the statement before making any decision or recommendation about whether to acquire the product. Past performance is not a reliable indicator of future performance.

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How investors can gain a competitive edge

Monday, September 12, 2016

By Nathan Bell

Choosing the right fund manager isn’t easy. While a long-term track record of outperformance helps narrow your choices, you need to understand a manager’s investment process to judge its likelihood of future success.

Questions to ask include: 

  • Is the process repeatable, or does it rely on a specific individual, or only work in certain circumstances that aren’t likely to persist?
  • Are the manager’s returns based on luck, or skill?
  • How aggressive is the manager?
  • Does the manager speculate using leverage, or has their process stood the test of time and likely to work in the future, given enough time?

The easiest way to illustrate how to answer these questions is with a case study. What follows is the sort of opportunity we look for to diversify a portfolio with world-class businesses that aren’t available on the ASX.

Liberty Broadband

Predicting changes in macroeconomic variables with any consistency is impossible (which is why there are no economists on the Forbes 400 list), so we prefer to bet on trends that will persist regardless of the macroeconomic environment.

Along with the rapid growth in mobile usage, internet usage for entertainment in the home is another trend that’s growing quickly. According to Cisco, mobile data usage is expected to increase nearly eightfold over the next five years, as we watch more entertainment services (such as Netflix) on our mobile phones (the majority of this mobile data will be off-loaded from cellular networks to less congested Wi-Fi networks).

You’re likely familiar with the ‘FANG’ stocks benefitting from similar trends. FANG stands for Facebook, Amazon, Netflix and Alphabet (formerly Google). They currently command lofty valuations as their business models are well known, and their size allows large fund managers to invest huge amounts of money in them. Furthermore, their continued growth is an easy sell to potential investors in a world of elusive growth.

But if you’re prepared to look where others aren’t, you can find similar attractive businesses without having to pay a hefty premium. One example is Liberty Broadband.

Liberty Broadband’s only major asset is a 20% stake in Charter Communications, which recently merged with Time Warner Cable to become the second largest cable company in the US.

The new Charter Communications will boast 17m video subscribers who pay, on average, US$80 per month (this is essentially the same as paying for Foxtel here in Australia), and 19m broadband internet subscribers who pay US$48 per month.

Cord cutting

You may have read that many cable customers are switching to less expensive online, or ‘over-the-top’ entertainment options, which begs the question: why would you want to own a cable business?

Well, first, we don’t need rapid growth in Charter’s video subscribers to do well. This issue is well known and has already been priced into cable company valuations. Second, we expect Charter’s video subscribers to decline slowly, despite the rapid falls experienced by some rivals.

Our contrarian view is based on two factors. First, the biggest falls have been suffered by satellite TV providers, which have inferior technology to Charter. Charter’s video subscriptions have actually increased recently, as they have been able to keep video prices low, while bundling in faster internet packages. Satellite services don’t offer high-speed broadband connections.

Bundles of profits

The second factor is that Charter offers bundles where you receive a discount if you combine more than one service e.g. telephone, video and broadband (the ‘triple play’). Charter also hopes to offer a ‘quad play’, with an added mobile phone service, but that may require regulatory approval to do a deal with one of the major mobile carriers.

 

The benefit of bundles is that they produce much stickier revenue (or less ‘churn’ to use industry jargon) than if a customer only buys a single service, which can be easily replaced by a rival.

Though we expect video subscribers to fall slowly over time, that doesn’t worry us too much. We have confidence in Tom Rutledge’s stewardship; Charter’s chief executive who is widely regarded as the best operator in the cable industry.

Now that Charter has merged with Time Warner Cable, we expect Rutledge to take a hatchet to costs and reduce the company’s high debt levels before buying back shares. The operational improvements under a combined Charter and Time Warner Cable outfit should more than offset any video subscription losses in the medium term.

This brings us to our final point as to why we’re not overly concerned by video subscriber losses; the growth in broadband subscriptions, and the average price per customer, should provide plenty of growth in Charter’s cash flows.

This is one of the most overlooked points with cable companies. Broadband internet has none of the associated costs that video programming does, so broadband margins are significantly higher than video margins.

Assuming monthly broadband bills advance from $48 to $60, broadband subscribers increase from 19.4m to 27.1m, and we apply a multiple of 11 to pre-tax free cash flow of US$11.2bn in 2019, we estimated our returns could reach 18% per year based on our initial purchases in February.

That provides a decent margin of safety if video subscriptions fall faster than we anticipate, but our ‘Get out of Jail Free Card’ is that broadband subscriptions should increase if more people switch to over-the-top entertainment options. A case of heads we win, tails, we shouldn’t lose much.

US broadband providers enjoy monopolistic positions, so broadband usage should surge over the next five to ten years as our favourite online entertainment services become just another regular monthly bill.

And keep in mind that the cost of adding an extra broadband subscriber is minimal, so small increases in revenue can have a large impact on the bottom line. The costly part is investing in the best technology and content.

Discount on a discount

We could’ve bought Charter and done very well, but there was another way to increase our returns without assuming more risk.

Instead of Charter, we bought Liberty Broadband. Remember, Liberty’s largest asset is its stake in Charter, as it was trading at a 12% discount to the value of its interest in Charter.

Better yet, we’re invested alongside John Malone, who has made billions investing in cable around the world. 

Let’s summarise the investment merits of Liberty Broadband and how it reflects our investment process.

Liberty Broadband is a perfect example of the type of monopolistic business — run by one of the world’s greatest managers with his own money on the line — that is simply unavailable on the Australian Stock Exchange.

As value investors, we need to go against the crowd when the facts contradict widely held views. In this case, the market was myopically focused on video subscriptions and cord cutting, instead of the operational improvements from a combined Charter and Time Warner Cable led by Tom Rutledge, and the increasing cash flows from the rapidly growing broadband business.

By looking in unusual places, we also found an opportunity to own Charter at a discount by purchasing Liberty Broadband instead.

As an investor, you need to have an edge, otherwise it’s impossible to consistently beat the index. Our edge in this case includes our long-term view (i.e. we’re looking out five years rather than focusing too much on the short term), our contrarian view on video subscribers, and a full appreciation for the economics of the broadband business.

To learn more, download this quick guide or contact us.

Disclaimer

This is a sponsored article by Peters MacGregor Capital Management.

Peters MacGregor Capital Management Limited holds a financial interest in Liberty Broadband through various mandates where it acts as investment manager.

Peters MacGregor Capital Management Limited do not take into account the investment objectives, financial situation and advisory needs of any particular person, nor does the information provided constitute investment advice. Any information, material or commentary by Peters MacGregor Capital Management Limited is intended to provide general information only. Please be aware investing involves the risk of capital loss. Before acting on any advice, any person using the advice should consider its appropriateness having regard to their own or their clients’ objectives, financial situation and needs. You should obtain a Product Disclosure Statement relating to the product and consider the statement before making any decision or recommendation about whether to acquire the product. Past performance is not a reliable indicator of future performance.

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