Wedgewood Partners 2Q17 Letter – Market, Amazon, Oil, The Fab Five, & Celgene

Smart Money

Wedgewood Partners 2Q17 Letter, July 2017

Review and Outlook

  • -0.08% net of fees during 2Q17, compared to 4.7% in Russell 1000 Growth Index and 3.1% in S&P 500 Index
  • Year to date gain of 5.9%, compared to 14% and 9.3% in Russell 1000 Growth and S&P 500, respectively
  • Increased positions in Tractor Supply, Fastenal, and Ross Store and initiated position in Celgene
  • Defense-first investment philosophy is seemingly little match for an investing environment that rewards risk-taking to the sharp exclusion of the prudence of time-tested valuation disciplines
  • Relative underperformance occurred evenly across the quarter & YTD
    • Technology surged and contributed the most to our gains while nearly everything else detracted; tech holdings include PayPal, Priceline, Edwards Lifesciences, Apple, Visa, Cognizant Technology, Alphabet
  • We believe the immutable investing dictum that growth and value are never mutually exclusive
    • Valuation discipline has always represented very prudent divergence from pure growth at literally any price
    • Defense-first investment philosophy dictates
    • This approach has been increasingly contrarian and relatively very painful
  • We expect the market will end in similar fashion as the tech bubble (US growth stocks have surpassed “tech bubble” highs)
  • Retail sector seems to fit the mold of good companies with good long-term growth prospects but shrouded by overly pessimistic sentiment
  • Ross Stores and TJX Companies:
    • Ross Stores and TJX Companies have differentiated themselves to the point where they have taken more apparel and footwear share than Amazon
    • Both Ross and TJX procure inventory at below market rates; rapidly turn offerings on their stores; average value of transaction is too small for even the most aggressive e-commerce players to justify free shipping
    • Recently forward P/E multiples de-rated to slight discount to S&P 500 and a substantial discount to Russell 1000 Growth Index
    • Think it is much too early to declare the nearly $5 trillion US retail industry “zero-sum” between Amazon (with a low single-digit market share %) and everyone else
  • Tractor Supply Company:
    • Believe will continue to profitably differentiate itself over the next several years by focusing on serving a select demographic, specifically rural land owners who earn higher than average incomes
    • Key element of Tractor’s approach is a disciplined real estate and merchandising strategy that attempts to bring stores and inventory to this underserved customer base
    • Market participants assume Q1 weakness represents evidence that e-commerce has compromised the long-term potential of Tractor
    • Jan and Feb were unseasonably warm so inventory was marked down and monetized to make room for spring inventory

A Word on the Mighty Amazon

  • Currently follow Amazon with great interest and have owned shares in the past – but we struggle to understand how its $470Bn enterprise value can be justified by future profitability (let alone current profits at $2.6Bn)
    • Apple first eclipsed $470Bn EV in the midst of generating $40Bn in net income and went on to post another $220Bn in cumulative net income since (2012)
    • Alphabet only recently eclipsed $470Bn EV in 2015, in the middle of $16Bn bottom-line value creation and posted another $20Bn a year later
  • According to Jeff Bezos, “we get to monetize in a very unusual way. When Amazon wins a Golden Globe, it helps us sell more shoes.”
    • This sounds not far from brands endorsing celebrities and athletes to sell more products
    • What is unusual is that Amazon doesn’t appear to have the high levels of merchandise margins available to produce TV content that wins Golden Globes
    • Maintaining a high cost fly-wheel that monetizes by selling commodity products (Amazon Prime) or makes a market for others to sell commodity products (Amazon Fulfillment), makes us skeptical that retail unit can generate the magnitude of long-term profits we think are necessary to justify today’s EV
  • Even if we assume that Amazon quintuples its US market share, that would leave 90% of the US retail market up for grabs
    • Investors and retailers must be aware of Amazon but both also should be aware of the size of the opportunity to be found in the substantial portions of the market where Amazon is not
  • We have not invested in traditional retailers in suburban malls pursuing business-as-usual strategies; rather, our holdings have differentiated models based upon non-traditional buying strategies or upon targeting underserved rural populations with merchandise assortments that are often difficult for or unattractive to competitors
  • Amazon just wrote a $14Bn check to Whole Foods to admit that online retail is not as suitable in some categories as it is in others, after they tried to do it their way for 10 years

Energy Market

  • Oil prices recently entered bear-market territory on persistent oversupply fears
  • Invested companies often trade directionally similar to the commodity, often challenged by the idea that Core Labs and Schlumberger are simply bets on the price of oil
    • Over longer investment horizon, we find that stock performance correlations relative to oil are low
    • Schlumberger’s r-squared with oil since 2011 has been 29% (12% to S&P 500): this is hardly the same as concluding that a long-term investment in Schlumberger is equivalent to simply owning a commodity
  • Despite oil’s bear market performance year-to-date, oil development activity in North America has exhibited a “V”-shaped recovery with the US rig count more than doubling over last year’s depressed levels
  • Market largely has ignored the fact that OPEC and its partners have been behaving remarkably rationally over the last several quarters – a marked departure from what we had seen for the prior 2 years
    • Compliance with production cuts has been historically high
    • Most governments involved, many of which are quasi-authoritarian, are uneasily watching the events unfolding in member states, where the unwinding of governmental ability to placate populations with the proceeds of high oil prices is causing massive unrest
  • Believe it remains in OPEC’s long-term interest to do everything it can to support oil prices
  • Despite headlines crowing about tight US oil output, think there is less than meets the eye
    • According to EIA data through April 2017, US onshore production has risen just 350,000 bpd above its September 2016 trough, which should be more than offset by global demand growth of over 1 million bpd, in addition to over 1 million bpd of OPEC cuts
    • Oil rig counts have started plateauing as early as April as full-cycle economics of $40-$50 oil is challenging to even the best operators
    • We are now in the middle of a 3rd year of constrained investment in the development of large-scale fields and we continue to believe that this will lead to longer-term supply-demand imbalance

The Fab Five

  • The Great Bull Market 2009-2017 Fab Five are Apple, Alphabet, Microsoft, Amazon, and Facebook
    • First four stocks’ collective market cap fell to about $400 Bn at the Great Bear Market of 2007-2009
    • Facebook joined the parade in the spring of 2012: after a sharp dip to almost $15 after the Company’s less than smooth IPO, stock is up 100-fold
  • Fab Five combined market cap is nearly $3 trillion: wealth created by these 5 companies alone over the past +8 years is the stuff of Carnegie and Rockefeller
  • One could argue that ownership of these five companies (or the lack thereof) has been the make or break element of a firm’s performance rankings
  • Just a simple equal-weighting in each of these five stocks would have produced a gain of 21% over just the past 6 months
  • Quality of the leading technology companies today in terms of competitive advantages, market dominance, profitability, and balance sheet strength is unparalleled compared to the vast majority of the tech hit parade circa-2000
    • That said, investor enthusiasm for current crop of tech darlings does suggest that this is becoming a very “crowded trade”
    • Fab Five alone makes up 23% of the benchmark (Russell 1000 Growth); the benchmark itself has morphed into a focused tech fund
  • In late-1990’s, the dichotomy of the returns of the tech sector versus Berkshire Hathaway was striking: the extreme return differential was a poignant microcosm back then between dismissal performance of Value strategies versus Growth strategies
    • Specifically 15 months from the start of 1998, Russell 1000 Growth Index compounded at 37.8% while Russell 1000 Value lagged considerably at 10.3% (small cap Russell 2000 Value was a no-show at a rate of -1.4%
  • During the 2000-2002 bear market, the Nasdaq 100 fell -83% while Berkshire Hathaway stock gained 35%
  • At market highs, greed can morph into a permanent state of complacency
    • Margin debt is approaching $550 Bn now – about double the amount at the top of the tech bust in 2000
  • If there is a bubble anywhere, there is a huge bubble in volatility (or the lack thereof)
    • If this era’s historically low volatility is the new norm, investors of all stripe could be forgiven
    • Current generation of central bankers abhor market volatility
  • Some Central Banks have joined the Fab Five party too – Swiss National Bank owns nearly $80Bn in just US stocks (up from $27Bn at the beginning of 2015): they own more Facebook shares than Mark Zuckerberg

Celgene Corporation

  • Celgene is a global biopharmaceutical company engaged primarily in the development of therapies for the treatment of cancer and immune-inflammatory diseases
  • Current blockbuster drug is Revlimid, an indication for the treatment of patients with multiple myeloma, a cancer that forms in plasma cells
    • While a relatively uncommon cancer, it’s the 2nd most common blood cancer in the world
    • Revlimid accounted for more than 60% of Celgene’s 2016 revenues
  • Strong sales in a single drug resulted in the stock trading at a lower valuation than its biotech peers as investors are concerned about whether Celgene will be able to replace its revenue stream once Revlimid goes off patent in 2027
  • Management is not concerned with a pipeline and R&D model that they believe will create significant growth potential through 2030
    • Current 2020 targets for revenue to grow 17% on a compounded basis and earnings growth of more than 20% annually
    • Their confidence, as well as ours, in this long-term guidance is backed by a plethora of pending data that could result in potential value-creating events as data readouts are expected from 17 Phase 3 trials over the next 18 months
  • One of Celgene’s drugs that investors are awaiting with much anticipation is Ozanimod, which Celgene added up to its line-up via its acquisition of Receptos in 2015
    • Expected to enter the market next year but has already been noted as having the potential to be a best-in-class oral agent in Phase 3 trials for Inflammatory Bowel Disease (IBD) and Relapsing Multiple Sclerosis (RMS)
    • While deemed expensive at $7.2Bn, this acquisition enhances Celgene’s Immune-Inflammatory portfolio and diversifies the company’s revenue stream beginning in 2019
  • By fiscal year-end 2017, Celgene expected to have 4 drugs with sales exceeding $1Bn each and well on their way to diversifying their revenue stream
  • Celgene generates billions of dollars in FCF each year that the company can spend on drug development as well as share buybacks and additional acquisitions
Image Source: AP Photo

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