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Broyhill Annual Letter – Trump, Active/Passive Investing, SeaWorld

Broyhill Asset Management Annual Letter, February 24, 2017

“A strong moral compass will do many things in life, but it will not help you navigate capital markets. Seeing the world as it is rather than as you wish, will”

  • Year ending 12/31/16, Broyhill generated low-to-mid single digit returns across the majority of separately managed accounts

It’s Business Time

  • Plenty of ink spilled on the ideological shift since last November – we’ll offer the following perspective from Barron’s cover story:
    • “Judging by the stock market’s reaction, the Trump administration so far has been a grab bag of policy proposals, some good for the economy, some bad, some potentially disastrous. Our future depends on the president’s ability to champion the good ones and his willingness to back off the disastrous ones”
  • “Kicking and screaming like a toddler who was just told he can’t wear his Spider-Man costume to dinner will not make Spider-Man a more acceptable dinner guest. Rather than kick and scream about how the world should be, our job as investors is to see the world as it is and position accordingly”
  • Flexibility and humility allows us to admit what we don’t know, and accept that there is little to gain from investing as it should be
  • Investors are seeing the world as they wish – they have decided perilously high valuations can be ignored and rising uncertainty is of no concern
  • Consensus views the current backdrop analogous to Ronald Regan’s shift to the right – in this particular case, starting point matters:

reagan-trump

  • Free trade has not been all rainbows and unicorns but it doesn’t mean unwinding free trade will bring them back
    • Smoot-Hawley Tariff in 1930 raised US tariffs on over 20,000 imported goods – successfully cut American imports by half; retaliation by our trading partners ensured that US exports fell the most – when our returning blue collar work force has to shell out $75,000 for a Chevy Malibu, people will wake up
  • Investors are chasing momentum and buying more of what has gone up the most – FOMO has blinded investors to the risk of falling back to reality

Benchmark Envy

  • Goal is to construct portfolios capable of generating as high a return as possible, without subjecting your wealth to significant loss
  • Nothing clouds judgment more than watching your neighbor get rich – but you don’t get rich by taking risk at the end of the cycle; you stay rich by being patient
  • Only a focus on the inputs can determine the long run success of the outputs

Passive Aggressive

  • In theory, passive investing is perfectly rational; if you can’t beat the market, why bother trying? If you can’t beat them, join them
  • Increasing number of investors have decided to “lock in” the long-term returns offered by broad market indices; this is theory; in practice, these same investors are the most active traders of indices
  • Annual stock turnover is about 120 percent (on average held for 10 months); annual ETF turnover is about 880 percent (on average held for about a month)
  • Movement toward passive index funds is well supported by empirical data – in practice, consensus does not have a great track record of capitalizing on investment theory
    • It’s tough to earn the long-term returns of the market if you only hold “the market” for a month

We Have Been Here Before

  • According to Morningstar, average US equity manager has underperformed the S&P 500 over the past one, three and five years
    • “Death of active management” is becoming a popular consensus sentiment
  • Might this be a cyclical phenomenon? If so, when have we seen this before? Most importantly, how did it play out last time?
    • During the later stages of a bull market, growth of passive funds can create an artificially high demand for stocks widely held by market indices; as a result, indices benefit from the bubble they create
    • Once passive investing distorts pricing, ultimate result is the underperformance of the original beneficiaries of that distortion
    • Future performance of any investment strategy is significantly altered once it has been widely imitated; don’t write off active management just yet

Orcas and Drunken Sailors

  • Theme parks are mediocre businesses; they earn low returns on capital and pile on debt to juice equity returns for investors; that being said, they have attractive characteristics such that buying at the right price can be very profitable
  • Thought we bought SeaWorld at the right price
    • Initiated a position in August 2014 at what we believed was the point of maximum pessimism (backlash from Blackfish)
    • Investment thesis correctly identified company’s animal rights challenges as a temporary problem likely to be solved via the passage of time
    • Recognized that heightened competitive environment represented bigger risk
    • Incorrectly assumed that the unique experience that SeaWorld has successfully offered for decades would be enough to differentiate the parks from Disney and Universal
  • Every investment cycle sows the seeds for its own conclusion; excess spending reaches a level which is unsustainable, and industry participants eventually figure out that if they cut back on ridiculous levels of spending, profits quickly improve
    • Assumed this cycle would be no different
  • Disney and Universal were spending like drunken sailors and new attractions at SeaWorld failed to drive the rebound in attendance we expected
    • Two years seemed like a sufficient time horizon for SEAS to get its house in order
  • Even though we bought SEAS at a bargain price, heightened competitive environment gradually eroded margin of safety
  • Lost money on SEAS but believe our judgment was sound; identified the primary risk before getting involved and bought with a sufficient margin of safety which limited downside risk
    • Over time, odds like this should shake out in our favor; a collection of investments with similar payoff profiles should result in quite satisfactory long-term gains

Time Is On My Side

  • In last year’s annual letter, rehashed investment thesis in Time Warner which was our largest position and also our largest loser for the year
  • Less than one year later, in October 2016, AT&T announced it would acquire Time Warner in a stock-and-cash transaction valued at $107.50 per share, more than $20 per share higher than what 21st Century Fox bid for the company
  • We incorrectly assumed Rupert Murdoch would increase his bid; we were wrong on timing but we were proved correct in our estimate of value
  • Short term results are unpredictable and beyond our control; this holds true for individual investments and for our portfolio in aggregate
  • Volatility is like a visit to the doctor who tells you, “This is going to hurt,” right before he gives you the shot you need to get back into the game

Earning Our Keep Doing Nothing

  • Absolute focus on “beating the benchmark” forces institutional investors to view “the benchmark” as home base – what this means is that proceeds from stock sales must be reinvested in the benchmark or a similar security or the manager risks veering too far from the index
  • We keep them separate so that the decision to sell a stock is not influenced by our menu of purchase options; our default option is cash
  • Cash has accumulated in the absence of attractive priced opportunities – we can deploy large chunks of capital quickly
  • Doing nothing is hard to do, especially when we are paid to do something – inaction is easier said than done
  • We harvested losses in Arcos Dorados (ARCO) and Coca-Cola FEMSA (KOF); exited Paypal Holdings (PYPL) as the stock approached our estimate of fair value
  • At year end, largest equity positions were Time Warner, Oaktree, Gilead, CDK, and LabCorp
Image Source: m.e.designlab
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