January 28, 2024
Despite continued macroeconomic, geopolitical and interest rate uncertainty as well as elevated valuations relative to historical levels, markets finished 2023 strongly as bulls became convinced that the economy will sufficiently slow (without slipping into recession) and thus allow rate cuts far faster than anticipated earlier in 2023. While the breadth of gains began to widen in the last months of 2023, broader market gains were still overwhelmingly driven by a handful of stocks. The 493 stocks outside the “Magnificent 71” returned roughly half of the S&P 500's total advance. Many believe that artificial intelligence advances will drive significant productivity enhancements over the coming decade and that the largest technology companies will disproportionately benefit from this wave of investment. Certainly this is very possible, but it is exceedingly difficult to predict the exact magnitude of this improvement, let alone quantify the actual financial impact. Frustratingly, foreign and value names widely trailed the broader index and European financials remained among the most hated sectors we have ever seen.
2023: Patience and Value vs. Reacting to Negative Data Points
We did not drape ourselves in honor during 2023. We will review individual names in more detail below, but we thought some higher level context would be worthwhile. Certainly, there is no law preventing us from buying technology companies. As we have noted in past letters, however, we will pass on any investment, regardless of price, if we cannot properly assess the business. We have owned technology names in the past (painfully exiting Microsoft many years ago as discussed in prior letters) and we conceivably could get comfortable again. Several technology and former growth favorites pulled back in 2022 after large runups over the previous years. Despite the pullbacks, we believed that several still looked rich relative to projected growth rates. It is also true that many of the names we had thoroughly researched and discussed in prior letters were negatively impacted by the broad 2022 sell-off. Certainly, we are very conscious of the “endowment bias” where one usually prefers existing ideas (especially at lower prices) to new ones, but we believed then and now that many of our names offered favorable risk/reward profiles.
Whenever purchasing a new investment, we typically target a roughly 3-5 year holding period but certainly reserve the right to sell before or after this period (or to never sell), depending on business performance and how the price compares with our estimate of intrinsic value. Stock prices fluctuate constantly and prices may or may not reflect a reasonable estimate of business value. One of the biggest challenges in investing is assessing whether price declines reflect excessive pessimism and an opportunity to purchase additional shares or rather reflect a fundamental deterioration in the business itself. One never has perfect information when making these decisions and the “correct” answer is often not clear until years after the decision. For most value investors, ourselves included, the bias is usually towards buying additional shares when existing holdings move lower. Complicating matters further is that stock gains are not linear and that out-of-favor value stocks could be shunned for years with gains back-end weighted. For this reason, an investor can look foolish up until the point that value is finally reflected in a stock price. Of course, sometimes one's investment analysis may simply prove to be flawed and the expected gains never materialize. These “value traps” are inevitable, but the hope is that a couple of big winners will drive gains while price discipline will limit downside on mistaken investments.
Certainly, the above style of investing has not been helped by a narrow market that has applied higher multiples to rapid growth and has typically shunned slower growth or severely punished anything with a perceived secular headwind. Fund flows out of emerging markets into large technology names also have not helped. That said, we have also made our share of errors outside any broader macro or fund flow trends. We highlighted two of our mistimed investments in our third quarter letter. Additionally, we have likely been too slow to react to negative operating trends and convinced ourselves that severely discounted valuations compensated us for adverse operating trends. As we will discuss, some of our LATAM cable investments fall into this camp, and we must (and will) react better to data points or management actions (or lack thereof) that contradict our investment thesis. To be clear, wholesale selling of any underperforming names also would be a mistake, as would expecting all gains to magically appear in any single calendar year – i.e., if the name was down, sell it unless it fully rebounds in 2024. As we will detail, we believe that several of our European financial names remain materially underpriced. We still see a clear path for significant gains over a multi -year period, but we cannot definitively state the day/hour that these gains will materialize. In summary, we will not abandon our longer-term investment focus, but we will strive to more quickly identify when incoming data deviates from our stated investment thesis.
LSXMA: Godot Arrived (Almost)
Moving from macro to micro, we want to briefly discuss several different holdings. During the fourth quarter, longtime holding Liberty SiriusXM Group (LSXMA, Financial) and car radio company SiriusXM (SIRI, Financial) announced a deal to collapse the two companies' structure into a single new company (New SIRI). New Siri will be ~81 percent owned by legacy LSXMA shareholders and ~19 percent owned by legacy SIRI shareholders. Prior to the deal, LSXMA owned ~84 percent of SIRI. LSXMA essentially accepted a small amount of dilution in exchange for New SIRI taking on LSXMA liabilities. In our opinion, the deal was a reasonable compromise. Our biggest complaint is simply the length of time it took for this to materialize. LSXMA shareholders have felt like they were waiting for Godot during the past several years as LSXMA traded anywhere from 30-50 percent below the underlying value of SIRI shares. Unfortunately, the waiting is not completely finished since the deal needs a shareholder vote, tax opinions and regulatory approvals but none of these are expected to be problematic. Final approval is expected in the third quarter of 2024, but LSXMA currently trades at a ~30 percent discount to SIRI shares. It is worth noting that Berkshire Hathaway is the largest LSXMA shareholder and has been actively buying additional shares as we write this letter.
SIRI faced headwinds throughout 2023, including self-pay subscriber losses, additional operating costs related to streaming investments and higher capital expenditures related to recent satellite launches. Bears have loudly proclaimed the death of SIRI for 10+ years. The iPhone, Google Play and now Spotify all were widely predicted to destroy the company, but SIRI kept turning out subscriber additions, shrinking churn rates and producing higher average revenue per user (ARPU). With 34 million subscribers and ~80 percent penetration rates in new cars, SIRI's growth is certainly more saturated versus levels 10 years ago. Additionally, SIRI must improve its streaming offering in order to attract younger listeners. That said, SIRI's unique collection of music/sports/news content helps it to maintain high customer loyalty. The continued rollout of 360L in-car audio platform will allow better data accumulation, content recommendations and ultimately higher retention rates. While we think SIRI is a good business, we invested in LSXMA because the discount allowed us to own SIRI at a considerably lower “look through” multiple. This transaction was the catalyst that we awaited. The discount should narrow as we move closer to the third quarter closing, and we will reevaluate the holding should the spread (hopefully) materially narrow.
PTSB: Dividend Blocker Removed…RWA Reform Awaits
We have described our investment thesis in PTSB (LSE:PTSB, Financial) in multiple past letters and gave a fuller update following our October 2023 trip to Ireland (see Q3 2023 letter for full details). While the pullback in PTSB's stock during the fourth quarter was disappointing, there was substantial progress in the investment throughout 2023. As discussed in prior letters, Irish government and NatWest stakes in PTSB were reduced from ~62.5%/16.7% to 57.5%/11.7% in June of 2023. Further reductions are one of the major catalysts for increasing value. In late December, the Central Bank of Ireland (CBI) officially removed PTSB's dividend blocker. Although PTSB had previously satisfied all requirements for the blocker removal, it had stubbornly remained.
The timing of the announcement is particularly helpful as PTSB will visit the U.S. during the first quarter of 2024 and many investors will hear PTSB's investment case for the first time. As we have previously detailed, PTSB's management needs to better articulate its highly compelling investment case to the broader market and we are hopeful this begins during these US conferences. The near-term prospect of dividends and buybacks should significantly bolster the investment story. Furthermore, we continue to believe that most investors do not fully appreciate the quantum of capital that could be released at PTSB through risk weighted asset (RWA) reform.
While PTSB could theoretically apply for some nominal dividend in early 2024 (based on 2023 earnings), the first dividend payment will more likely be in early 2025 (based on 2024 earnings). In terms of the size and percentage payout, we believe it will depend on certain inter-related factors that we have discussed in previous updates:
- How quickly can PTSB grow its SME/Personal loan portfolio? (SME/personal loans generate more interest income but have higher risk densities).
- Does PTSB apply for directed buybacks and how much excess capital is deployed here?
- The timing of the above mentioned RWA reform.
If PTSB can expand its SME portfolio (and we believe it will), this will increase future earnings and expand the ultimate buyback capacity. Likewise, if buybacks can be executed at substantial discounts to book value, this would be highly accretive and the higher resulting earnings per share would allow higher dividends per share over time. Additionally, directed repurchases of government shares reduce the government's ownership stake and therefore should be pursued.
We would encourage those who want more detail on the more technical RWA discussion to review our prior letters. That said, given the absurdity of the situation, we cannot resist highlighting that PTSB is currently being judged on 2013-2014 models versus 2020-2022 models used by the other two larger Irish banks (AIB and Bank of Ireland). From nearly every macroeconomic metric (e.g., unemployment rates, GDP growth, debt levels, etc.) as well as microeconomic metrics (e.g., loan-to value levels, non-performing loan (NPL) levels, capital levels, etc.), the Irish economy and Irish banks are vastly different entities today than they were in 2013/2014. What is somewhat remarkable is that PTSB is simply asking the CBI to utilize the same updated data to judge the bank that the CBI currently uses for PTSB's two larger peers. The fact that this has yet to be done implies that the CBI is limiting credit expansion for one of the three remaining banks in Ireland. This should be an outrage to all Irish citizens (even those who dislike bankers), considering the ongoing housing shortage across the country. Even assuming risk densities at a substantial premium to Bank of Ireland and AIB, we estimate that RWA reform could add 200-300 basis points to CET1/RWA ratios and ultimately mean that excess capital beyond PTSB's 14% target could approach 50-60% of PTSB total market capitalization. The removal of the dividend blocker should increase investor confidence that this enormous capital unlock can be realized. This is particularly critical since this blocker removal will likely increase the amount of NatWest/government shares that can be sold in 2024.
Again, the dividend news is welcome, but it is only one of the tailwinds working to support the PTSB's long-term value creation opportunity. Among them are Ireland's strong economic backdrop, the need for more housing in the Irish market, and the consolidation within Ireland's banking sector (including PTSB's transformative Ulster transaction), all of which provide a foundation for sustainable earnings growth at PTSB. When combined with PTSB's scaling SME business, the absence of any commercial office exposure and meaningful potential near-term RWA relief, these trends support a highly compelling investment thesis for PTSB shares. This is especially true when considering PTSB's overly discounted current trading level in the market (~35% of tangible book value, or ~3-4x outyear earnings). We still believe PTSB offers a compelling risk/reward at current prices.
As we have already used our quota of space to discuss Irish investments, we will not further detail our investment thesis in Irish homebuilder Glenveagh Homes (GLV). Please see our Q2 2023 letter for further details. We would simply note that the investment is tracking well to expectations and Ireland's drastic need for additional housing remains a powerful tailwind for GLV's business.
CAB: Some Preliminary Green Shoots…But Still Cheap Assuming No Improvement
We discussed CAB Payments (LSE:CABP, Financial) and Metro Bank (LSE:MTRO, Financial) extensively in our third quarter letter. We doubled our position in CAB and sold MTRO shares for tax purposes and will repurchase in 31 days. CAB provided a brief update in mid-January and reported slightly stronger fourth quarter revenue than planned. More details will be shared when the company reports full-year results in March. Additionally, some of the negative headwinds facing CAB that we described in our Q3 letter have begun easing. Based on our conversations with the company, CAB suggested that 2024 consensus estimates showing growth might be reasonable (versus our assumptions that revenue would decline). Obviously, this could change, but with the stock trading at ~6x our 2024 earnings estimate with the possibility of materially faster growth in the years ahead, we further increased our position earlier this year. For those who want even more detail, we presented CAB at the 2024 Manual of Ideas Best Idea Conference and would be happy to share a link to the presentation.
LATAM Cable: Operational Trends Must Improve
In past letters, we have talked extensively about our Latin America cable names - (Liberty Latin America (LILAK, Financial), Megacable (MEX:MEGACPO, Financial), and Millicom (TIGO, Financial). Except for TIGO, which we only entered at the time of its rights offering and is now ~29 percent owned by activist investor Xavier Niel, the other two names have underperformed. Certainly, all three-look inexpensive on multiple metrics and we still believe smart capital allocation and small changes in investor sentiment could materially rerate all three holdings. That said, we must acknowledge that recent operational performance has been below our expectations. Megacable remains confident in its fiber rollout, but it is still unclear whether their extensive expansion project will produce acceptable returns. We are well aware that LILAK's performance has been particularly disappointing. We recently sent a detailed letter sharing our thoughts with the senior team and will carefully assess LILAK's operational trends and capital allocation decisions over the next several quarters.
BX: Strong 2023 Rebound…Secular Tailwinds Still Present
We also wanted to briefly give a couple of thoughts on two other longer-term holdings. In our 2022 fourth quarter letter, we gave a detailed history of our experience with private equity firm Blackstone (BX, Financial) and explained why we believed that the business would continue to benefit from the secular growth of alternative assets and why we believed that concerns over Blackstone Real Estate Income Trust (BREIT) (BSTT, Financial) would prove manageable. After a punishing pullback during 2022, the stock rallied during 2023. That said, BREIT still faces redemptions, albeit at reduced levels. Additionally, BX requires enormous asset inflows to meaningfully increase its $1 trillion+ of assets under management (AUM) and the current fundraising environment remains challenged. It is also true that BX shares will likely sell off should equity markets broadly move lower. While the stock likely does not offer the same degree of upside as other names mentioned in this letter, BX is a stronger business overall and possesses one of the most valuable franchises in the entire financial services industry. Much to the chagrin of many in the value investing community, allocators do not lose their jobs by sending money to Blackstone. BX has significant opportunities to grow its credit and infrastructure assets under management and we believe the company has opportunities to further expand its AUM with insurance companies and retail investors. While we will be conscious of overall position sizing levels, we intend to maintain a healthy position in BX going forward.
MKL: Next Five Look Poised to Outperform Last Half-Decade
We have talked less about Markel (MKL, Financial) in recent quarterly letters, but the company continues to be a core holding. At the simplest level, conservative underwriting, combined with intelligent investing, forms the backbone of a fantastic business franchise. MKL has been profitable on an underwriting basis in 9 of the past 10 years. Because of this, MKL has something even better than low-cost “float”: it is essentially being paid to invest premiums. In MKL's 2021 annual report, the company discussed an aspirational goal of doubling the size of its core insurance operations by 2025 and achieving a 10 percent underwriting profit. Achieving all parts of this “10-5-1” ($10 billion of premiums within five years and at annual underwriting profit of $1 billion…for those wondering, it is unclear if they drew inspiration from the late Herman Cain's “9-9-9” plan) depends on the underlying health of the industry and whether or not MKL can find business that meets its strict underwriting criteria. Nevertheless, MKL has noted that it has significantly invested in the technology, people and products necessary to achieve this growth if the underlying backdrop is appropriate. CEO Tom Gayner (Trades, Portfolio) has a fantastic long-term investment record and MKL's equity portfolio comprises ~35 percent of its total investment portfolio. Tom also oversees a conservative fixed income portfolio which matches duration to insurance claims. Finally, MKL purchases entire businesses through its Markel Venture portfolio which has scaled through acquisition and organic growth from EBITDA of $170 million in 2018 to a 2023 run rate of ~$630 million. We have met various members of the MKL team over multiple years and can attest to a unique corporate culture that emphasizes teamwork and long-term thinking.
MKL has done both well for decades but admittedly the last 5 years, the internal of time over how MKL judges itself, have been less impressive with MKL's book value per share and stock price growing at compounded annual rates of 8 percent and 4 percent, respectively. These results are below expectations, but a couple of observations are worthwhile. First, the past five years have been among the most challenging periods for the insurance industry. Changing weather patterns have produced insurance losses due to natural catastrophes of over $100 billion in five of the last six years. These losses have negatively impacted the company's insurance linked market (ILS) business. Rather than keeping all exposure on insurance company balance sheets, the ILS market matches underlying insurance risk with capital providers who seek returns uncorrelated with other markets. ILS can be structured in multiple ways, including catastrophe bonds (bonds where investors may not receive principal or interest in the event of a natural disaster) or sidecars where risk is transferred to a separate pool of capital. MKL believes the ILS market will achieve strong secular growth over the next decade and believes the various acquisitions made since 2015 have created an industry leading platform. While this vision could prove correct, the acquisitions have collectively not met expectations: one simply failed (CATCo), one has thus far generated improving results, but still below expectations (Nephila) and the final one has generally performed well (State National). MKL has been transparent about its ILS operations' shortcomings but has maintained its optimism over the growth prospects of the business. As noted, one of the basic ideas behind MKL's ILS push is for the company to collect fees for matching up buyers and sellers of risk versus assuming risk on its own balance sheet. It is also worth noting that MKL has actively altered its core insurance risk to assume far less exposure to natural catastrophe events.
MKL's book value growth over the past five years has also been burdened by over $800 million of intangible amortization. While we won't detail the accounting rules regarding amortization charges, it is fair to say that these charges do not necessarily correspond to the overall health of the underlying business. MKL Ventures includes 19 different businesses -- not all businesses always perform consistently and some are more sensitive to the economic cycle. Ventures companies take write-downs over the business cycle whenever discounted forward projections drop below values ascribed at the time of the original acquisition, hurting book value per share. Unfortunately, the same accounting rules do not allow write -ups when business rebounds or if forward results simply exceed expectations at the time of the original deal. Finally, MKL has maintained a squeaky-clean fixed income portfolio and did not materially reach for yield during the extensive period of low interest rates. However, because of rapidly rising interest rates over the last ~two years and a bond portfolio that matches maturities to insurance claims, MKL had $1.1 billion of unrealized losses on its fixed income portfolio as of 09/30/23. 99 percent of MKL's fixed maturity portfolio is rated AA or better, and unrealized losses should therefore reverse as securities mature. Intangible amortization and unrealized losses total over $1.9 billion or roughly $145 per share (14 percent of September 30, 2023 book value).
In summary, MKL's formula of conservative underwriting, intelligent investing and unique culture should produce very acceptable returns over time. It is worth noting that MKL has been actively repurchasing shares and insiders (including Tom Gayner (Trades, Portfolio)) have been personally buying stock. Trading at ~1.4x trailing book value per share, we believe MKL is very reasonably priced against potentially double-digit book value per share growth over the next decade.
In closing, we do believe that many of the names described above continue to have meaningful value that has yet to be reflected in current stock prices. That said, not all investments will play out as expected and, as detailed above, we are committed to respond more quicky when incoming data contradicts our investment thesis.
Patrick Brennan, CFA
Brennan Asset Management, LLC
1 Amazon, Meta, Google, Apple, Microsoft, Tesla, and Nvidia.
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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.
Past performance is not indicative of future results, which may vary. The value of investments and the income derived from investments can go down as well as up. It shall not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities mentioned here. While BAM seeks to design a portfolio which reflects appropriate risk and return features, portfolio characteristics may deviate from those of the benchmark.
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