Bonhoeffer Fund commentary for the fourth quarter ended December 31, 2019. Bonhoeffer provides a case study for LIN Television Corporation and reveals that the top performers in their portfolio are local economies of scale.
The Bonhoeffer Fund returned 5.3% net of fees in the fourth quarter of 2019, compared to 3.2% for the MSCI World ex-US, an international benchmark. Our 2019 return was 7.1% net of fees. As of December 31st, our securities have an average earnings/free cash flow yield of 19.5% and an average EV/EBITDA of 4.1. The MSCI World ex-US has an average earning yield of 5.4%. The difference between the portfolio’s market valuation and my estimate of intrinsic value is still very large (greater than 100%). I remain confident that the gap will close over time, and I continue to monitor each holding accordingly.
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Bonhoeffer Fund Portfolio Overview
Bonhoeffer’s investments have not changed significantly in the last quarter. Our largest country exposures include: South Korea, Italy, South Africa, Hong Kong, United Kingdom, and Philippines. The largest industry exposures include: distribution, consumer products, telecom, transaction processing, real estate, and media.
Since my last letter, we have added to one position in the US pipeline space. I remain excited about some firms we are investigating in Canada, Mexico, Georgia, South Korea, and South Africa.
As we approach the Bonhoeffer Fund’s third anniversary since its July 2017 launch, I’d like to take a moment to remind you of the investment philosophy and underlying beliefs that guide the decisions we make. Foremost is our embrace of independent thinking. It is our commitment to questioning the common narrative and considering alternative scenarios that fuels our approach to security analysis and selection. This type of thinking, combined with a dedication to exploring the historical context in which a business is operating, earns the Bonhoeffer portfolio distinction amongst our peers.
I have spent the past few weeks reviewing my personal stock market and fund performance over the past 13 years. This review has offered great insight into how the Bonhoeffer philosophy has shaped the strategies we deploy in the fund.
The Big Arbitrages
Arbitrage is an important driver of returns; once identified, we can capitalize on situations where it exists. As investors, we are all parties to arbitrage. As security selectors, we are engaged in arbitrages between our securities and other securities in the market, as well as between our securities and what we think these securities should be worth.
Some of the larger arbitrages that Bonhoeffer participates in are between debt and equity securities, as debt security yields have declined while equity security yields have declined far less by comparison. For perspective, Aswath Damodaran provides various forward-looking estimates for equity security yields.1 These currently range from 5% to 6.5%, while the 10-year bond yield is 1.5%. However, the incremental return for investing in equities is more the 2.5 times the incremental return of investing in bonds; the historical average since 1960 has been 1.4 times. The low has been 0.32 times in 1999, while a high of 3.3 times was reached in 2011.
In this instance, there are two ways the arbitrage can close. First, interest rates can increase. To reach the historical average incremental returns, interest rates would have to rise to 3.0%. Second, stocks can have a lower equity yield closer to 3.6%. This would imply an increase of about 100%. So the question is whether you believe the bond market or the stock market is incorrectly pricing risk. I believe the answer is the bond market for two reasons. First, bond pricing is a lot easier than stock pricing, considering you only have to be concerned about downside risk as your upside is capped at par value of the bond. Second, the bond market has many participants, making it very efficient. This dynamic is also playing out amongst individual stock and bond pairs in the market today as described below.
Another arbitrage that Bonhoeffer participates in involves emerging and developed markets. This arbitrage will continue to play out over time, as emerging markets become more like developed markets. Bonhoeffer’s holdings in South Korea, Hong Kong, the Philippines, and South Africa offer ample exposure to this type of arbitrage.
Stock and Bond Return Trends Over the Long Term
My world view is that life and economic wellbeing will continue to get better. History has proven it, and most—if not all—pessimists have been proven wrong over the long term, even in the cases of truly evil regimes such as the Nazis in Germany and the Communists in Russia and China. This belief is reflected in Bonhoeffer via investments where the market says things will get worse (primarily emerging markets in the small-cap value space). This view is also reflected in Bonhoeffer’s approach to interest rate and equity returns. The Bonhoeffer thesis implies that as economic wellbeing continues to improve, the results will include lower interest rates, higher equity cash flows, and lower equity yields.
One way to express this in investments is via a leveraged balanced fund or the equivalent of buying stable assets with low-cost debt from investments like well underwritten debt or projects. Examples of the latter include business development companies (BDCs) like TPG Specialty Lending, triple net lease (NNN) real estate firms like STORE Capital, or infrastructure investments like Brookfield Infrastructure Partners (BIP). One way to reduce the risk of levered firms in our portfolio is to have a portfolio of them via pools of private firms or debt (like BIP or TPG Specialty). Portfolios of firms versus individual firms can be obtained from a leveraged balanced fund like WisdomTree 90/60 US Balanced Fund (NTSX), which can also be a good default option for cash.
Risk Parity – The Search for Alternative Sources of Return
Bonhoeffer’s focused strategy on high-quality, low-valuation firms leads to exposure to neglected parts of the market, namely emerging markets in the small-cap value space. One way to increase diversification without sacrificing returns is to examine secure recurring revenue streams in other asset classes that are funded with low-cost debt. To this end, I am currently examining oil and gas midstream firms, as well as real estate and infrastructure assets which will provide this diversification.
Another form of diversification is risk parity. Risk parity is a concept that includes adding different asset classes to a portfolio but levering the lower expected volatility and return assets to a given level of risk. An example would be levering up bonds to the point where their volatility will equal equity levels of volatility in a balanced portfolio.
A real-world example of this is in PIMCO StocksPLUS Long Duration Fund (PSLDX)—a 2x leveraged balanced fund—which has been around since Aug 2007 and, more recently, a more simplified NTSX (a 1.5x leveraged balanced fund). PSLDX has had a historical volatility of 13.5% versus 12.3% for the S&P 500 but delivered returns of 21.8% annually versus 13.8% for the S&P 500. These securities can act as default options for our cash, and they can also diversify our small-cap value exposure.
Good Leverage – The Banking Model: Local economies of scale
A great takeaway from the review of my personal and fund performance has been recognizing that the securities that added the most value to the portfolio had some sort of leverage at low interest rates in comparison to the rate of returns generated by the assets of the subject firm. This is similar to banks where the bank lends to customers at a higher rate than it pays on deposits. The key to bank profitability and growth is correctly underwriting the loans and having a consistent flow of new loans with similar underwriting.
In the case of levered companies, it is underwriting the assets. Two aspects of assets that increase their value and safety are recurring revenues from revenue models such as transaction processing, leasing or subscriptions, and local economies of scale.
In the case of firms where both the debt and equity are publicly traded, you can see how the market prices two sets of securities with the same set of cash underlying both and illustrates the debt/equity arbitrage described above. The debt receives claims to the first set of cash flows generated by the firm and the equity to all the remaining cash flows. As an example, Bonhoeffer-holding Gray Television’s debt trades at a yield of 4% and its stock trades for a 19% free cash flow yield.
The market is implying that the equity cash flows are about five times riskier than bond cash flows and is putting no value on the potential growth of the cash flows; instead it is expecting a decline. Normally, the equity risk premium is about 5%, so if Gray Television’s equity traded at 9% free cash flow yield, then the market would expect flat free cash flow.
But at 18.5% free cash flow yield, the market expects Gray Television’s free cash flows to decline by 10% per year. In this way, you can measure the market’s expectations and test them against reality. In this case, although Gray Television’s cash flow may decline at some point in the future, the historical and near-term prospects for cash flow growth is closer to 20% growth. So even if Gray Television has no free cash flow growth going forward, the stock is at least a double.
This approach can also be applied to the market statically (where we are today) and dynamically (where we are going). One way to examine this in a dynamic way is to examine long-term trends in interest rates.
Based upon long-term data from Schmelzing2, long-term interest rates have been declining from the 1300s primarily due to risks declining and more capital being generated from profit-making activities in free markets than being destroyed by destructive activities like war, famine, and epidemics or less efficient generators of capital such as communism. As long as the expectation is for less war, famine, epidemics, or communism, interest rates will trend lower reflecting the increasing supply of capital.
Recently many of the largest producers of economic value are requiring less capital than in the past. If we start in 1300, most profit-making activities required land (a capital-intensive asset). As time has passed, the requirement for capital has declined through the Industrial Revolution (which required less capital-intensive factories or workshops) and the Information Revolution (which required significantly less capital than factories). The increase in capital from profitable businesses and the lower capital requirements of information and service industries have led to a capital glut, as seen through lower interest rates (the cost to use capital). As a snapshot of this trend, the level of S&P 500 cash flow to capital expenditure, to cash flows in the mid- to late-1990s of 61% declined to 40% in the mid- to late-2010s3 reflecting the decline in the demand for capital to generate cash flows. Over this same period, both sales and cash flows per share have increased.
Putting the increased supply of capital and the declining demand for capital together results in a capital glut and lower interest rates—the cost to borrow capital. This basic glut is exacerbated by other factors such as flows of capital from regions where the investors are not as confident in how or whether they can monetize their assets. Given the low interest rates and the historic trend, what are the best ways to capitalize on this? One way is to buy recurring cash flow assets and finance the assets with low-cost debt.
Examples of this can be found in individual companies (such as in the case of Gray Television described above), in the overall market (in the case of leveraged balanced funds), or in groups of projects which emphasize recurring revenue (like Brookfield Infrastructure Partners). In leveraged balanced funds, the recurring cash flows are the returns generated from the balanced fund. In all these cases, the investor is capitalizing on the relatively large discount that the market is placing on equity cash flows versus debt cash flows and financing the equity cash flows with low-cost debt.
Local Economies of Scale
Another characteristic of the top-performing firms in Bonhoeffer’s portfolio are local economies of scale. Top industries are local TV and radio, leveraged leasing, and telecommunications. An example of levered local economies of scale is LIN Television Corporation, which I personally held in the early 2010s and serves as this quarter’s case study. Car dealerships, infrastructure assets, subscription-based telecom firms, and distributors are other examples of local economies of scale. Examples of these types of firms are described in the 2Q2019 and 3Q2019 letters.
Finally, all of these firms operate in countries with an embedded free enterprise model. The Anglo-Dutch free enterprise system was born in the Netherlands, then transported to the United Kingdom, then to most of the British colonies and Empire, as well as the former United States possessions. This narrative is described in The Birth of Plenty, the book we provided to our limited partners as our year-end gift. We have expanded this Anglo-Dutch base to countries where governance is improving towards the Anglo-Dutch model in places like South Korea, Taiwan, Georgia, Poland, and slowly in Japan.
Over time, more opportunities associated with this good leverage strategy should present themselves. Using good leverage in conjunction with Bonhoeffer’s three frameworks (compound mispricings, mischaracterized companies, and public LBOs) should provide some nice opportunities and diversify the portfolio from the primarily emerging market small-cap value current composition. Areas we are now examining are midstream energy firms, leveraged balanced funds, and leveraged alternative asset funds.
As a reminder, in March we will provide our semi-annual portfolio snapshots to any investor who would like to receive them. Please contact Jessica (firstname.lastname@example.org) if you are interested. I will be attending the Daily Journal Meeting in Los Angeles (February 11-13), the Fairfax Financial Meeting in Toronto (April 13-17), and presenting at the Willow Oak event during Berkshire Hathaway’s Annual Shareholder Meeting weekend on May 2 (I will be in Omaha from April 29 through May 4). I would be very happy to connect during any of those times.
As always, if you would like to discuss the Bonhoeffer Fund, our philosophy, strategies, or investments in deeper detail, then please do not hesitate to reach out. Until next quarter, thank you for your confidence in our work and have a fun winter season.
Keith D. Smith, CFA
Case Study: LIN Television Corporation & local economies of scale
This is a historical case studying LIN Television Corporation, a local broadcast television business in the United States. I purchased LIN Television in late 2010 for a price of $3.99 per share and sold the final block of stock for $24.75 per share in 2013. LIN Television had the attributes of both local economies of scale in its core business and a levered LBO in its capital structure; in 2010, LIN’s debt to equity ratio was 2:1. Local television station economics are also favorable based upon, at the time, five key factors (retransmission fees, political spending, ownership of spectrum, non-urban populations, and well-defined cost and revenue synergies) described in detail in our 2Q2019 analysis of Gray Television.
LIN Television was purchased by Media General in early 2014 for $1.6 billion ($25.97 per share) as a part of the consolidation of the local television business in the United States. Historically, this segment was a profitable segment of the media landscape with a wide moat (greater than 20-year competitive advantage). The moat has been eroded over time to a narrow moat (at least a ten-year competitive advantage) by streaming competition and the direct-to-consumer model. The uncertainty associated with continued competitive advantage is reduced by two factors. First, strong election spending targeting the largest local TV viewers (older voters). Second, retransmission fees have allowed local television stations to monetize the content they provide to viewers.
In late 2010, LIN had a free cash flow of 23.5%, while LIN’s debt had a yield of 3.5%. In late 2013 (the last date of sale), LIN’s free cash flow yield had declined to 7.5%, while LIN’s debt had a yield of 3.5%. Additionally, LIN’s free cash flow increased from $50 million in 2009/2010 to $120 million in 2013/2014.
Tom Murphy successfully implemented a local television consolidation via Capital Cities/ABC from 1966 until its purchase by Disney in 1995 with a CAGR return of 19.9% for Cap Cities/ABC versus 10.1% for the S&P 500 over the same period.4 This consolidation included cost controls for non-core operations, cost synergies in clustering acquisitions, and spending in core operations. This is described in detail in the book The Outsiders. The CEO of LIN Television was a Cap Cities/ABC alumnus, and he executed this strategy at LIN which generated great returns for shareholders. This was a historical example of what we see in the current industry consolidation in firms such as Gray Communications and Nexstar Broadcasting.