July 21, 2023
Higher Rates? Possible Recession? Buy Technology and Growth (of course…)
Stocks broadly rallied during the second quarter despite multiple seemingly negative headwinds (higher interest rates, Ukraine war, dysfunctional politics, etc.). The US economy has generally surprised to the upside and, thus far, there is little evidence of the nearly universally predicted slowdown/recession. Many would note the lagging impact of monetary policy and opine that a contraction has not been avoided – but simply delayed – until later in 2023. And if the recession doesn't occur in 2023, it will surely happen in 2024. And if not 2024, surely 2025. Or definitely 2026. Or maybe…there are too many variables interacting with each other to offer any type of truly accurate forecast. This latter thought continues to encapsulate our economic forecast thinking – we read all the same headlines and see the same economic data points that anyone reading this letter also views but have no edge in translating this information into to actionable investment ideas. While empirical data1 would support this thinking, it provides little short-term comfort and certainly invites harsh criticism should the recession occur sooner and risk assets tumble. But, as discussed in prior letters, yearly gains are often driven by a smaller number of trading days and getting back into the market after large rises is often exceptionally difficult. As noted in our Q2 2022 letter, there is incredible wisdom in famed Fidelity manager Peter Lynch's quip that far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections.
Many of the market's second quarter gains were led by various technology names and a rally in some of the more speculative (to be kind) areas of the market (meme stocks, cryptocurrency other "growth/hope" names) while more traditional value areas have lagged. Interest rates ultimately act as something akin to gravity for financial assets (the more of it, the harder it is to go higher), and therefore we would expect additional dislocations if interest rates remain elevated. It is somewhat puzzling that "growthier" assets, in theory those names more sensitive to interest rate levels, have continued rallying while multiple economic data points suggest a "higher for longer" interest rate environment. Of course, we also struggle to understand how cryptocurrency has a value above zero, let alone near $30,000.
As discussed in past letters, we haven't owned the largest technology names, and this sin of omission has certainly hindered performance. We understand that these are fantastic businesses (certainly easier with the benefit of hindsight) but have no expertise in any of these businesses and have struggled getting comfortable with their absolute valuation levels. If the next five years play out exactly as the past five years and Amazon, Facebook, Google or artificial intelligence darling Nvidia provide the bulk of market returns, then admittedly it will certainly be a struggle to keep up with the broader indices and the line of tired, grumpy, downtrodden value managers at local bars will continue growing. Of course, we think rumors of value's death remain exaggerated and we still believe that there are other names besides these technology behemoths that offer substantial value. We are finding new opportunities and will discuss two of these in greater detail (we will hold off describing another new holding until next quarter) after providing brief updates on a couple of other portfolio names.
PTSB: Government Starts Selling
During the second quarter, the Irish government and NatWest sold 10 percent (5 percent each) of their shareholdings in Permanent TSB (LSE:PTSB, Financial), taking each group's total ownership to ~57.5 percent and ~11.5 percent respectively and increasing the freely tradeable float by ~50 percent. We believed that government sales would begin in 2024 so the earlier sale is certainly a positive development as a larger float allows a broader group of investors to own PTSB shares. We believe that NatWest wants to fully exit its investment in PTSB and therefore further sales in 2023 are distinctly possible, and we believe the government will sell concomitantly. As we described in previous letters, PTSB's acquisition of Ulster's loan book and the rise in interest rates from negative levels have both materially changed PTSB's earnings trajectory. We believe the company is on a path towards double-digit returns on equity in the years ahead. Shares trade at only ~0.5x book value and just over 4x the earnings that we project by 2025/2026. We believe PTSB shares can materially rerate as the government sells shares/freely tradeable float increases, as earnings ramp in the years ahead, and as a dividend is ultimately paid. We also believe that PTSB remains meaningfully overcapitalized and some of the crazy risk weightings discussed in previous letters will ease over the next 1-2 years, thereby significantly increasing PTSB’s excess capital.
KW: Love the Deals…Hate the Equity Payments
Real estate holding Kennedy Wilson (KW, Financial) partnered with its largest shareholder (Fairfax Financial Holdings (Fairfax)) to purchase a $5.7 billion loan portfolio from embattled regional bank Pacific Western Bank (PacWest). The Loan Portfolio is comprised of floating-rate construction loans that carry a weighted-average interest rate of approximately 8.6%, with approximately 80% of the portfolio secured by high-quality multifamily and student housing properties. The remainder includes mainly industrial, hotel, and life science assets. Despite the strong collateral, low loan-to-values (LTV) of ~51 percent and completion guarantees by the project equity sponsors, Fairfax and KW purchased the loans at ~90 percent of face value, thus locking in double digit returns on capital deployed. Fairfax will hold 95 percent of the loans with KW holding the balance, but as asset manager, KW will earn fees on the entire balance. KW has had a relationship/familiarity with PacWest for years and this relationship, along with KW's prior partnership with Fairfax, allowed KW to source an opportunistic acquisition.
Investors generally cheered the above announcement, and the deal certainly sounds great and speaks to KW's ability to source attractive deals. But to finance its share of the 5 percent purchase, KW was forced to issue $200 million of perpetual preferred stock (6 percent coupon) to Fairfax as well as 12.3 million 7-year warrants with a $16.21 strike price. We love the opportunistic deal, but we are less enthralled with another equity financing2. While the company would credibly argue that the dilution (~9 percent3) was modest relative to the acquisition opportunity, we think the need to issue warrants speaks to the problem of the company's common dividend, which is too large relative to KW's capital deployment opportunities. Assuming KW can consistently source 12-15+ percent IRR opportunities as it has demonstrated over its history, then paying out ~$140 million in annual distributions makes less sense - we have made this point multiple times to the company. In our opinion, KW increased its dividend to levels that strained the company's ability to pursue additional investments without utilizing equity financing, and now any change in dividend policy becomes difficult, as the institutional shareholder pressures for maintaining the payout are enormous.
KW is not a real estate investment trust (REIT), but its shares have been pressured with other REITS as a higher rate environment has raised the discount rate (capitalization rate) investors have used to value real estate holdings. As demonstrated by the PacWest deal, the higher rate environment also should allow value accretive investment opportunities and we are confident that KW will have success sourcing these. The question is how does the company pay for them? KW will likely continue to rely on its stable of investment partners (as demonstrated with Fairfax and the PacWest deal) to partially fund investments. KW's development and leasing pipeline are anticipated to generate nearly $100 million in additional NOI by 2025, with the biggest chunk added in 2024. Additional asset disposals will also be a source of funds. The concern would be that continued equity issuances dilute the per share upside for the company and create a larger absolute payout over time as KW must feed additional "dividend mouths." We think KW's more liberal use of equity financing has hindered returns for its common shareholders over time, and recent experience suggests further equity offerings are possible. Additionally, KW does face some nearer debt maturities along with the possible renewal of interest rate caps at higher prices. We would also note that criticism over KW's overall SG&A base (driven by compensation expense) is justified. We still believe that KW is a truly elite real estate investor, and we have full confidence the team will find attractive opportunities in the quarters/years ahead. But, considering the concerns discussed above, we are no longer comfortable owning the name in the same size as we did previously and reduced our position accordingly.
LATAM Cable: Opportunity or Widow Maker?
Our LATAM cable names continue to be unloved as Liberty Latin America (LILAK, Financial), Megacable (MEX:MEGACPO, Financial), and Millicom (TIGO, Financial) all lagged the broader markets despite dollar weakness during the quarter. TIGO (discussed in greater detail in our Q1 letter) lowered its multi-year guidance after passionately defending these projections over the past year. This withdrawal casts further doubt on the management team's credibility (which many believed was low to begin with). We would be more alarmed by this cut if an activist (Xavier Niel) hadn't already built a ~24 percent position in the name or if private equity hadn’t been circling the underperforming company since the start of 2023. Additionally, TIGO continues to pursue a divestment of its tower portfolio, which could be worth a meaningful percentage of TIGO's total enterprise value. TIGO has clear value and we think sales of non-core assets and Niel’s activist actions can unlock this value.
The synergies from LILAK's various deals described in past letters (the largest from the Puerto Rico acquisition) should flow into LILAK's free cash flow in the back half of 2023 and mark a meaningful inflection in free cash flow. While this expected jump in free cash flow looks compelling in our excel sheets (and we suspect in management projections as well), the company needs to execute and deliver these higher free cash flow levels. Moving further north into Mexico, Megacable needs to demonstrate that its fiber expansion is generating positive returns. If the project delivers as Mega claims, then investors should see a meaningful pickup in total broadband additions over the coming quarters. In summary, while there appears to be substantial asset value for all three names, shareholder restlessness is palpable. Our patience is not limitless, and we will continue to evaluate all holdings in the quarters ahead. Please see our previous letters for further details on all three names.
ARCO: Bigger, Stronger, Faster…and 20 Percent Less Competition
We wanted to briefly note the continued strong execution from Arcos Dorados (ARCO, Financial) - the company that licenses the McDonald's brands in 20 countries and territories in Latin America and the Caribbean. While we discussed some of ARCO's success in our Q1 2022 letter, we thought another update was appropriate. ARCO continues to post record dollar results over the last several quarters. While the company has benefited from recent favorable currency moves against the US dollar, the record dollar results still incorporate a large amount of currency depreciation since the company's 2011 IPO. While ARCO's operational execution was strong before COVID, the company has clearly been a COVID beneficiary as a large percentage of all restaurants (20 -30% depending on the country) permanently closed. Meanwhile, COVID helped turbocharge digital and drive-thru sales. Digital (delivery, self-order kiosk, and digital marketing) sales accounted for nearly half of total sales volumes in Q1 2023, up from 36 percent in 2021 and substantially higher than ~11 percent in 2018. Digital sales are accretive to overall sales levels and therefore the unit economics of individual stores have improved because of ARCO's transformation. Meanwhile, systemwide comparable sales have been running ahead of inflation and the company has taken market share against competitor Burger King. ARCO's phone application is among the most downloaded apps among all Latin American restaurants and this app allows more targeted marketing messages to customers. While we are conscious of total LATAM exposure, ARCO is hardly expensive – trading at ~60 percent of sales, and 6x/11x 2024E EBITDA/earnings – this continues to feel very reasonable for a business with a much stronger competitive position and substantial new store opportunities in the years ahead.
GLV: Irish Eyes Also Smile on Homebuilders…Especially When Cheaper to Buy vs. Rent
In previous letters detailing our Permanent TSB investment, we described the strong Irish economy, the more favorable demographic trends and the enormous supply/demand housing mismatch that will likely take years/decades to resolve. In our Q1 2022 letter, we described how we walked through multiple Glenveagh (LSE:GLV, Financial) and Cairn (LSE:CRN, Financial) developments and spent time with GLV's CEO Stephen Garvey. After following the Irish householding industry as part of our PTSB investment for the last several years, we started a position in Irish homebuilder Glenveagh (GLV) during the past two quarters. The investment thesis for GLV is remarkably simple:
- Ireland needs a ton of homes over the next 30 years.
- Ireland's economic and demographic trends are among the best in the developed world.
- To stay in power, the Irish government needs to show progress on the housing crisis and therefore it will spend whatever is necessary to build more homes.
- GLV and CRN are the only scale builders in Ireland and both firms have enormous advantages over smaller operators in Ireland.
- As opposed to other markets where there is a supposed housing shortage, Ireland is unique as it is far cheaper to buy a home than to rent one.
As noted, Ireland has among the strongest economies in the developed world with unemployment at all-time lows (3.8%), modified domestic demand (GDP has been more impressive but the figure is skewed by multi-national exports) running at ~3% , and the country has been running budget surpluses that have been continuously revised higher over the past year.
Additionally, Ireland has among the strongest demographic trends across Europe with 1.3% annual population growth from 2016-2022 (vs. 0.1% for the EU). Thirty -three percent of Ireland's population is aged 0 -24 (highest in Europe), and there have been 190,000 net immigrants (doesn't include the surge from Ukraine) over the last 6 years and 66 percent have college degrees.
The below chart gives a snapshot of the housing supply/demand mismatch but understates the degree of the housing crisis. Unpublished research by the Irish Housing Commission late last year indicted that based on small tweaks to population size, average household size (fewer forced roommates/kids living with parents into their 30s), and housing stock obsolescence, the government is now estimating that 40,000-60,000 homes may be needed for the next ~30 years. (We kid you not4)
While housing shortages are often mentioned by homebuilder bulls in other markets (most commonly in the US and UK), the central difference between Ireland and these other markets is the significantly higher cost to rent a home versus the cost to purchase a home. This buy versus rent dynamic is a critical differentiator for GLV as the financial incentive for home purchases (versus renting), combined with the institutional pressure for the government to increase supply, greatly protects GLV's earnings story even in the event of an unexpected recession. In a nation of ~5.1 million people, there are less than 1,000 units to rent across the entire country according to industry data5. Rental prices have risen at double-digit levels. Mortgage rates could rise another 200 basis points from current levels and it would still be cheaper to buy versus rent…and by a large margin in multiple cities.
As discussed in past letters, the 2007/2008 recession hit Ireland particularly hard and essentially wiped out the banking and home building industries. CRN (2015) and GLV (2017) only went public within the past 8 years and are by far the largest two players in a fragmented industry. Last year, Ireland built nearly 30,000 homes; GLV (1,354) and CRN (1,526) built fewer than 3000 combined, but their outputs were multiples of the next largest player. To maximize efficiency and scale, GLV partially assembles parts of homes at its own manufacturing facility, which we toured in early 2022. These investments help minimize the impact of cost inflation and CEO Stephen Garvey noted that they also minimize the amount of worker time spent on building sites. In 2022, GLV acquired timber frame manufacturer Harmony Timber Solutions Limited (Harmony). When Harmony is combined with existing manufacturing facilities, GLV expects to be able to produce 2000+ timber frames per year starting in 2024. GLV's manufacturing investments should allow GLV to continue to scale its production (GLV has guided towards the delivery of 2,000 units in 2024) and further increase the gap between GLV and subscale builders.
GLV trades very near 2022 book value per share and ~6x projected 2024 earnings. Since the start of 2021, GLV has repurchased nearly 34 percent of its share base at prices near current levels. CEO Garvey owns ~9mm shares of GLV and current stock compensation awarded in 2022 is based on ROE and EPS targets6. We believe GLV will further scale the number of homes delivered over the coming years and we would expect continued share repurchases should shares trade near current levels. Considering GLV's low leverage7, multi-year growth story, and inexpensive valuation we believe that GLV could become an interesting private equity takeout target (arguably, the company is a rolling public buyout currently) should investors continue to ignore company's growth story.
CODI: A Mouthful to Explain…But Growth Upgrade Worth the Effort
During the first 6 months of COVID, we purchased preferred shares in middle-market focused "public private equity" firm Compass Diversified Holdings (CODI, Financial). As credit markets healed during 2020, CODI’s preferred shares moved closer to par value and we sold most of the position. During the past two quarters, we purchased CODI common stock. Before our preferred purchase, we had followed CODI for 12+ years having first read about the name in the aftermath of the Global Financial Crisis (GFC). At a different firm, we became one of the Company's larger shareholders and spent considerable time with various CODI executives. CODI has 10 subsidiary companies with seven in the consumer sector and three in the industrial sector. CODI has also hired a new healthcare head to pursue acquisitions in the healthcare services sector over the coming years. Over the next 30 pages, we will detail our LBO model for each of CODI's subsidiaries – kidding, kidding. Obviously, CODI can be a bit of a mouthful to explain so we'll provide a higher-level summary here. For those who want more details, we can share a recent presentation we did on the name at an investment conference last month.
CODI's current external manager started deploying capital for the Teekay shipping family in the late 1990s and generated top decile returns (~40% annualized) up until its 2006 IPO. CODI went public with an unusual structure (Delaware Trust) and multiple portfolio companies. To attract investors, the firm paid a higher dividend that it maintained or increased up until its 2021 restructuring (more on this in a bit), and this dividend attracted a fiercely loyal group of retail shareholders that helped CODI to generate strong returns as a public company. The public listing provided permanent capital and this structure has provided a competitive advantage versus various middle market private equity funds that CODI competes against for acquisition opportunities. CODI can provide sellers with more certainty to close individual transactions and CODI, unlike competing middle market funds, does not have to arbitrarily divest names at the end of a 5–7-year life.
CODI vs. S&P 500 May 2006-June 2023:
CODI: +504%
S&P 500: +370%
While the higher yield that was paid throughout the GFC drew sticky investors, it also created multiple capital allocation inefficiencies. CODI had to frequently issue stock to fund new acquisitions and this newly issued shares created additional "dividend mouths to feed." (sound familiar?!) When CODI sold a business, there would be periods when the dividend was not fully covered by distributable cash flow, and this created pressure to find new acquisitions. Despite these headwinds, CODI still managed to find multiple attractive investments and to sell multiple portfolio names at high multiples. We show the full list of sales in the appendix to this letter, but we would highlight that a large part of CODI's success was derived from several large gains while simultaneously avoiding meaningful losses on investments that did not work out as planned. It is also worth noting that while the median holding period of sold companies was 5.3 years, multiple investments were held for over 10 years, including Advanced Circuits, which was held for nearly the entire duration of CODI's public life (~17 years). While CODI's outside management team certainly deserves credit for this investment track record, the team would quickly note that CODI's pubic structure has been an integral part of its success.
It is worth highlighting that the services of CODI's manager do not come cheap. The manager charges a two percent annual management fee and a twenty percent incentive fee on all returns above seven percent. Because the carry is based on equity deployed, with debt capital internally deployed at the portfolio level, the fees are actually much higher than the twenty over seven structure first appears. While we believe CODI should modify this fee structure, we get comfort on this concern from two sources. First, CODI's public market returns, and private equity returns before this, show a history of outperformance despite the higher fees. Second, as noted in our Q4 2022 letter, our experience with Blackstone, where we passed on the name at ~$5 post the GFC over fee concerns (that noise that you heard was a head whacking the screen), has shown that higher fees and successful investments are not always mutually exclusive.
As a partnership, CODI was a "K1 investment" (some readers just recoiled remembering this dreaded tax form) and this severely limited the number of funds that could hold the name (including some of our nontaxable accounts). Furthermore, the historical structure did not allow CODI to deduct multiple corporate operating expenses from taxable income and the higher taxable income was passed on to limited partners (who often resided in higher tax jurisdictions). Taking all of the above into consideration, CODI converted into a C corporation (no K1s) in 2021. As part of the conversion, CODI lowered its dividend from $1.44 per share to $1.00. The conversion also created a substantial tax asset that should shield a good portion of tax on future divestiture gains. CODI's move towards a C corporation mirrored the conversions from Blackstone (see our Q2 2019 letter) and other alternative equity managers. But, unlike the alternative firm's large rally post conversion, CODI shares have declined ~25 percent since the September 2021 conversion, driven in part by recession fears across the business and by some destocking issues at two of its newer businesses. This drop has allowed us to revisit and ultimately purchase a strong manager with complete look through disclosure on a group of high-quality companies.
While CODI has produced strong returns with slower-growing, steadier-return businesses purchased at attractive prices, CEO Elias Sabo has made a concerted push to divest slower-growing businesses and invest in names with larger-market opportunities or faster-growth profiles. In 2019, CODI sold two businesses (Manitoba Harvest & Clean Earth) for a combined multiple of 19x EBITDA. The timing couldn't have been better as CODI entered COVID with lots of liquidity. Over the course of 2020-2022, CODI acquired four businesses that have rapidly grown and likely have far higher growth prospects than historic portfolio companies. All four the businesses have at least doubled EBITDA since 2019, with Lugano up nearly 3.5 times (see appendix for full historical performance details)
- Marucci Sports: Leading provider baseball bats, baseball/softball gloves, and other gear https://maruccisports.com/
- BOA: Leading provider of "fit system" offering better performance versus laces, buckles, and Velcro https://www.boafit.com/en-us
- Lugano: Leading designer/manufacturer of high-end jewelry ($238,000 average price) https://luganodiamonds.com/
- PrimaLoft: Leading provider of synthetic insulation and materials used primarily in consumer outerwear and accessories https://primaloft.com/
These four companies along with apparel/footwear provider 5.11 produce 51 percent of CODI's revenue and 65 percent of CODI EBITDA and will likely drive returns in the years ahead.
Of the companies mentioned above, we believe BOA might be the name with the most outsized growth potential as it has ~70% and ~50% market shares of the addressable snowboarding and bike shoes markets but is currently not present in court sports (We suspect BOA may turn up on the NBA hardwood someday). BOA believes that any sports requiring lateral movement can benefit from BOA systems (and the company has copious research/testing supporting this belief) and therefore BOA believes it has a low-single-digit share of all addressable markets at present. CODI's CFO mentioned to us that the company would be uninterested in selling BOA below $2 billion. As a frame of reference, CODI purchased BOA for ~$450 million and CODI's market capitalization/enterprise value is ~$1.5/$3.5 billion.
Applying our best estimates of appropriate multiples across CODI's various businesses, we believe CODI's shares are worth at least $30 today. It is worth noting that CODI is targeting 15+ portfolio companies and $1 billion+ of EBITDA by 2028, with existing portfolio growth of eight-to-ten percent annually. Importantly, if we only look at existing portfolio companies and assume these businesses grow at the lower end of CODI's growth trajectory, we believe free cash flow per share can approach $2.00 per share by 2025 (or $2.60 if one excludes growth capex). This higher distributable free cash flow distinguishes CODI from several other special value situations where a hypothetical "sum-of-the-parts" valuation suggests significant upside, but this upside is only realized if there are actual sales. While CODI has a history of selling subsidiaries (and we expect sales in the years ahead - likely including one or more of its industrial businesses), we think the rising free cash flow per share - driven by faster growth at the five portfolio companies mentioned above - will ultimately rerate shares. CODI does face some near-term destocking headwinds in the first half of 2023 at a couple of its subsidiaries (BOA and Primaloft in particular), but these temporary headwinds will likely be followed by faster-than-trend growth as retailers replenish inventories. While several of CODI's businesses would likely prove resilient should a recession materialize, growth would undoubtedly be negatively impacted if this long-discussed recession takes hold. That said, we are confident that there is considerable upside to multiple businesses over the next three to five years and have left ourselves room to purchase additional shares should there be a further pullback in the stock.
In closing, we believe that considerable uncertainty remains given the higher rate environment, but there is no way to know the timing of a recession or whether one occurs at all. We still see considerable value in several of the names we have discussed over the past several letters, but we are committed to changing our opinion if the facts change. We do believe there are other interesting opportunities outside the largest technology names and hope the details above help illustrate a couple of concrete examples.
Thanks for your support.
Patrick
1 Hites Ahir and Prakash Loungani Can economists forecast recessions? Some evidence from the Great Recession
2 KW issued convertible preferred stock in 2019, perpetual stock with warrants in 2022, and “at-the-market” equity in Q1 2023.
3 The dilution is closer to 7.5 percent if one assumes that a higher stock price causes all convertible securities and unvested restricted stock grants outstanding to fully convert.
5 The Daft.ie Rental Price Report Q1 2023
6 Under the scheme, 25 percent of the ~4.6mm shares options vest at ROE and EPS targets of 11 percent and €0.12 respectively, with the remaining options vesting pro-rata up to 100% if ROE/EPS are 16.2 percent and €0.20 respectively. GLV has targeted a 15 percent return on equity in 2024.
7 ~€80 million of total debt, equal to <10% of total assets or ~1.15x operating profit
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BAM’s investment decision making process involves a number of different factors, not just those discussed in this document. The views expressed in this material are subject to ongoing evaluation and could change at any time.
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