Advertisements
Recent

Wedgewood 4Q16 Letter: Bull Market, Berkshire, Fastenal, Visa, Charles Schwab, et al.

Wedgewood Partners 4Q16 Letter

“Many shall be restored that now are fallen, and many shall fall that now are in honor” – Horace, Ars Poetica

Review and Outlook

  • Gained 2.3% during 4Q16 relative to 1.01% gain in Russell 1000 Growth and 3.82% in S&P 500; gained 4.55% during 2016 relative to 7.07% gain in Russell 1000 and 11.96% in S&P
  • 2016 was a seminal year with so much unexpected change (Brexit, Italy reform, Trump); interest rates bottomed as 10-year fell to 1.36%, corporate earnings bottomed after a five-month recession, and oil bottomed after OPEC reversed its strategy
  • Companies that have engaged in share repurchases have been on winning streak this entire bull market; dividend payers have been a winning strategy since 2011
  • Looking ahead, may be at a changing of the guard moment in terms of market enthusiasm for the recently favored C-suite capital allocation strategies
    • Returned over $1 trillion to shareholders in the form of dividends and share repurchases
    • Corporate America’s collective debt load is approaching 25-year highs
    • Debt for dividend/buyback spigot could shut off rapidly
    • Success in growing sales and income has been found by buying “growth” via M&A
  • Always preferred to invest in higher quality, less-indebted companies that reinvest bulk of earnings

The Great Bull Market of 2009 – 2016

  • Great Bull Market will likely celebrate its 8th birthday come March 2017
  • One of the greatest in terms of cumulative gains but also in terms of consistency
  • By almost every relevant measure, stock market has priced in good tidings – they are at nose-bleed levels
  • GOP’s various pledges for fiscal stimulus have helped rekindle cyclical animal spirits
  • In mid-December, ECB extended its pledge to continue vacuuming up risk-free assets which we think could put a lid on debt-issued cost of capital
  • The Fed, more than Trump’s fiscal or regulatory initiatives, will most likely drive the direction of the stock market in 2017
  • At what level does the rise in interest rates bite hard enough? Peak bite in 2000 was 6.5% and in 2007 was 5.25%

Berkshire Hathaway

  • Continues to be one of our largest holdings
  • Maintains a long-term competitive advantage, evidenced in its below-average cost of capital, which should become more valuable in an environment of heightened equity market volatility and/or higher cost of borrowings
  • Could be a huge beneficiary of meaningfully lower corporate tax rates; outsized impact by reducing Berkshire’s deferred tax liability (if rates go down to 15% from 35%, book value could rise double digits)

Fastenal

  • Established a differentiated position by investing heavily to get closer to a generally smaller, less urban customer base than its competitors; most evident in more than 2,500 locations
  • Grainger, its largest competitor, only has 300 branch locations despite having twice the revenues; this led to fairly healthy segmentation between the company and its competitors
  • Competitors specialize in larger, more urban clients who have more distribution and service requirements
  • We observe the healthy and steady returns on investment across the major competitors and view this as confirmation that major players have managed to carve out profitable segments of an attractive industry without tipping over each other
  • Became increasingly interested in the stock around the middle of the year, when valuation began to imply an accelerated decline in its end markets
  • With the stock trading at or near recession-lows, believe Fastenal should continue to grow at an attractive pace, particularly due to continuous reinvestment and focus on profitability

Charles Schwab

  • Company stands to benefit from continued normalization of US monetary policy
  • Understand market’s desire to discount near-term “embedded option” of money market fee waiver relief – continue to invest in the name for its industry-leading pretax profit margins and asset gathering capabilities
  • Low-cost model and scale allow them to pass savings on to advisors and clients in the form of competitively lower fees, in exchange for mid-single digit platform asset growth

Stericycle

  • Exited investment after determining that company’s competitive advantage in its core regulated medical waste business was not robust
  • Despite recent stumbles in non-core hazardous waste business and slower than expected integration of Shred-it, RWM business continued to serve as the engine to double-digit growth in free cash flow
  • Previously believed that Stericycle’s unrivaled scale served to insulate its RWM profitability from competitive pressures; however, management began disclosing that long-term contracts with newly consolidated customers were coming up for renewal at significantly lower prices
  • Not clear why company gave up on pricing; company can spend this time recovering economics through more cross selling but this strategy is unproven and potentially dilutive

TreeHouse Foods

  • Relative detractor from performance and unexpectedly missed earnings
  • Since merger with Private Brands, seeing multiple areas where longer-term guidance is still understated – remain comfortable that they will hit long-term growth expectations
  • Should benefit from secular shift toward private label, particularly in higher margin natural and organic segments while driving out costs in lower growth segments, through unmatched scale in both manufacturing and distribution

Tractor Supply Company

  • Management has executed a disciplined retailing strategy where they carved out a niche, serving rural land owners with higher than average incomes
  • Deliberately positioned itself to be distinct from its competitors (Home Depot, Lowe’s)
  • Profitability and value proposition will be insulated over time as they have made key tradeoffs to avoid competing with big box retailers without impairing returns
  • Traded at 18x NTM earnings when we bought the stock, near a five-year low; stock had been hit by few issues in 2016 – think we are closer to the end of a multi-year downturn or at least an inflection point but recessionary expectations continue to be built into the stock

Visa

  • Valuation came under pressure following the election as the market saw a rotation out of higher-multiple tech and financial securities and into more cyclical names; used this opportunity to increase weightings
  • Consistently grown its revenue, EBITDA, and earnings double digits – effectively represents the collective economic bargaining power of many of the US’ and Europe’s credit and debit card issuers
  • Fully expect to see growth trajectory continue with added help from integration of Visa Europe

Wedgewood Partners is an investment management firm based in St. Louis, MO and was founded in 1988 by Anthony Guerrerio. David Rolfe, who joined in 1992, currently serves as CIO.

Source image: ThinkAdvisor
Advertisements

Leave a Reply

Your email address will not be published.