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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.

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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