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Broyhill 1H17 Letter – Market Returns, Death of Retail, Dollar General, Cognizant, Syntel

Broyhill Mid-Year Letter, August 7, 2017

“There are no brave old people in finance.” – Steve Schwarzman

  • Generated mid-to-high single digit returns during 1H17

A Stock Market Lullaby / Stories and Storytellers

  • S&P posted positive returns in each of the first six months; second quarter saw only a single daily gain and loss larger than one percent; last time market declined by even 5% was over one year ago, making this the longest stretch without even a minor correction in two decades
  • Temporary lows in volatility have historically concluded with exploding volatility and lower prices
  • Good stories put us at ease, connect with our emotions, and invite us to let down our guards
  • At the moment, the most popular story amongst market participants lies at the intersection of supply and demand, where the marginal buyer sets the price for risk assets. Today, marginal buyer is a machine with no regard for price
    • Machines do what the algorithms tell them to do
  • Fundamental analysis plays no part in this narrative. Price doesn’t matter to a machine. It’s all about supply and demand. And demand is ultimately driven by the narrative. But narratives can change

A Very Strange Thing to Do

  • If you can’t beat ‘em, join ‘em – in its simplest form, this is the argument driving the machines and the record inflows into passive investments. It’s a very strange thing to do at this point in the cycle
  • Seems that investors have blindly accepted another compelling narrative. They’ve let their guard down at a very inopportune time without questioning the assumptions behind the story they are being sold
  • Passive investors are buying the S&P 500 today for 30x normalized earnings – implicit assumption they are making is that price doesn’t matter
  • In the long run, price follows value no matter how compelling the prevailing narrative of the day. We know today’s price. Value is a more uncertain concept, but it can be estimated with a dash of reason and a dollop of logic
  • Forecasting a range of long-term returns lacks the sex appeal of a good story, but it is likely to prove far more accurate than a blind-folded chimp chucking darts at market pundits

Numbers Don’t Lie

  • Over the last century, the US stock market has generated average returns of about 9% annually
  • To forecast a reasonable range of future returns, we’ll examine each of these building blocks – dividend yield, earnings growth, and changes in valuation – in turn, beginning with the market’s current yield
  • While long-term average dividend yield on the stock market has been about 4.5%, today’s dividend yield is below 2%
    • Right out of the gate, should knock 2.5% off the top
    • Bottom line, best case scenario for future stock market returns is 6.5% (9% – 2.5%)
  • Real earnings growth varies widely from year to year but the long-term trend is robust
    • While every cycle is accompanies by colorful stories of accelerating earnings growth, real earnings per share have continued to compound at 1.5% annually over the past century
    • This rate of growth is far lower than typical Wall Street forecasts for a simple reason
  • With a starting dividend yield below 2% and long-term average earnings growth of 1.5%, a reasonable estimate of long-term real returns around 3.5% seems like a decent starting point
    • That’s a bit lower than equity market’s historical 6.5% real return, but it’s a more realistic forecast than the typical, “past is prologue”
    • We haven’t even considered the fact that current profits are far above trend and profit margins are hovering near all-time highs
  • To get from real returns to normal returns, we need to consider inflation. Over the past century, US inflation has averaged about 2.5% per year. However, sluggish, debt-fueled economic growth since the financial crisis has resulted in sluggish inflation as well
    • Over the past ten years, average annual gains in the CPI have been closer to 1%-1.5%
  • Over the past century, changes in valuation have added about 0.5% to the average return on the markets as PE ratios have gradually increased. Suffice it to say that a further increase from today’s levels is unlikely
  • Historically, investors have paid about 15x for a dollar of earnings. Today, passive investors in the S&P 500 have bid up that price to 30x earnings – roughly double the historical average and a level only exceeded twice in market history
  • Research from Goldman Sachs Asset Management illustrates that at current valuation levels, the S&P has delivered single-digit or negative returns 99% of the time
  • High valuations can persist for years, but investors must recognize that they are betting the house on inflated prices to achieve, at best, single digit returns
  • Even a minor reversion in valuation from today’s levels would more than offset the most optimistic assumptions for earnings growth

Our Story

  • This isn’t a comforting story. But it’s a story that must be told if investors are to avoid the dangers of allocating capital on the basis of historical average returns.
    • Keep your powder dry
    • Invest anti-passive
    • Remain patient
    • Stay focused
  • Our top ten holdings at quarter end represented roughly 60% of our equity exposure. The combined weighting of those stocks make up less than 1% of the S&P

Portfolio Update

  • Perhaps the only downside to rising prices is a diminishing margin of safety
  • Sold most of our Time Warner position, too low and too early
  • IRSA rallied 25% in the first six months of the year after a 50% gain in 2016
  • Liquidated our investment in Dell Technologies as the stock tacked on an additional 16% in the first half of this year. At our cost, we were buying the VMWare tracking stock at a substantial discount to already depressed VMW shares. Over the past 12 months, discount has narrowed and the multiple investors have been willing to pay for a dollar of VMW earnings has surged from 10x to 20x
  • Re-rated shares of eBay significantly higher in the first half – as such, trimmed our position with the stock gaining 23% during this period. Our investment pre-dates the PayPal split and demonstrates the potential benefits of holding a non-consensus view and giving the market time to catch up to that view

New Positions

  • Starting in December of 2016, began building a basket of closed-end municipal bond funds
  • As rates spiked higher following the election of President Trump, most investors reacted like the proverbial deer in the headlights. This was our takeaway at the time:
    • Since the financial crisis, we’ve seen 3 major corrections in bond prices
    • Each sell-off was accompanied by consensus calls for higher rates and higher inflation
    • Each spike in rates created a panic in bond markets, marked by larger capital outflows
    • Each panic created excellent buying opportunities for investors as rates retreated to new lows
  • The spike in rates created the best buying opportunity that we’d seen in years
  • The average fund in our muni basket gained 6% YTD through June, with much of that performance generated by tax-free income to our investors. While discounts have narrowed on most holdings, others remain quite wide, with ample opportunities on offer

The Death of Retail

  • Death of retail has been greatly exaggerated. Amazon is invading every corner of the industry and investors are reacting according to plan: sell first, ask questions later
  • Retail sector (XRT) has underperformed the S&P by nearly 40% in the past 2 years
    • For good reason – most of these businesses are melting ice cubes. The only question is how fast Bezos will turn up the heat
  • There are few business models insulated from global warming in the retail sector. We think the dollar stores fall into this select group despite currently depressed sentiment
  • Long term investors in shares of Dollar General have been well rewarded by the company’s high growth and high margin operation. Since it was taken public by KKR in November 2009, the shares have compounded at 17% annually even after underperforming the S&P by 35% during the past year
  • Consequently, many investors were surprised by the recent pause in same store sales – declined 0.9% in FY17. Consensus points to the increasingly competitive landscape as cause for concern. Amazon is clearly stepping up its pressure on retail and grocery markets. This in turn has driven Wal-Mart to step up its game and price more competitively
  • Dollar General has faced a lollapalooza of headwinds over the past year. Food price deflation has pressured comps. Core customers have struggled with declining benefits from the Supplemental Nutrition Assistance Program
  • Good businesses rarely trade at good prices. But occasionally the market mistakes a cyclical lull for a structural shift. The threats facing Dollar General today are well known and should be discounted in today’s price
  • Believe downside risk is limited as sentiment is washed out. Traditional growth investors have already given up on the name. At its recent peak in July 2016, 86% of Wall Street analysts rated the stock a buy. Less than a year later, buy ratings have dropped to 40% while P/E multiple on the stock has fallen to historical lows
  • As stores lap weak comps in the coming years, we think the stock can rerate sharply higher as investors realize that even Bezos can only juggle so many balls without dropping a few
  • Consider that same store sales at Dollar General grew on average more than 6% in the four quarters following the failure of Lehman Brothers. Defense wins ball games

IT Services

  • Shares of Cognizant lagged peers by over 100% as the stock’s multiple was cut in half
    • While Cognizant earns gross margins in line with the best of its peer group, operating margins are a full ten points lower than the smallest players in the space
    • Business generates substantial cash flow, but net cash has remained stagnant on the balance sheet even as shares traded at their lowest valuation since the financial crisis
    • Good news is that there is plenty of room for improvement and management has announced plans to address both the margin deficiency and capital structure in recent quarters
  • In contrast to lackluster capital allocation at Cognizant, owner operators at Syntel recently paid out $15 special dividend to shareholders last year, largely refuting the bear case for the stock
    • When a controlling shareholder calls the shots, incentives are easy to understand. They are a function of shared economic interests rather than suboptimal targets laid out in a proxy statement
    • Managers follow the incentives. Owners pinch pennies
    • Management at Syntel has prioritized more measured growth with a focus on high margin business
    • Business is far more concentrated as a result, with Syntel’s top 3 clients accounting for nearly half of sales. While this level of concentration has helped margins, it has clearly increased risk
    • At 10x earnings, roughly half the average multiple of peers, we own a high-quality, owner-operated business, which has compounded sales at 13% annually for the past two decades, while big players in the space seek out small, tuck-in acquisitions to inflate stagnating top line growth
Image Source: Broyhill Asset Management
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