It is my pleasure to report the results for the 12 months ended June 30, 2016.
Andrew Jackson lost his place on the $20 bill to Harriet Tubman; Donald Trump became the presumptive Republican presidential nominee; Elon Musk thinks we are living in a simulation game; the U.K. voted to leave the E.U., only to begin Googling “what is the E.U.” and “what does it mean to leave the E.U.” hours AFTER the results were announced. As a result, Athena Capital Partners’ NAV is up 15.2% (15.9% on constant currency basis). On a time-weighted basis (i.e. internal rate of return taking into account the time of contributions from July 13, 2015 to June 30, 2016), the portfolio returned 18.8% in its inaugural year, while remaining at least 40% cash at all times. During the same year, the S&P 500 lost 0.03% and the TSX Composite lost 3.35%.
How We Did It
In honesty, the first year turned out to be a bit better than expected, especially given the poor returns of the overall market. While I will certainly strive to achieve even better results in future years, it is not expected that such results will repeat itself very often.
When we started out, I outlined three founding principles for Athena Capital Partners: Proudly Cheap, Fiercely Independent, and Exceptionally Patient. In my first letter to you, I explained in further detail how we select the securities in our portfolio. Looking back, it is indeed by strictly adhering to these principles that ACP generated the returns that it did. The biggest contributor to the return is Transocean Partners (NYSE:RIGP), the details of which I set out in that same first letter. We started to build our position in RIGP when oil price tanked from $110 in mid-2014 to $45 in August 2015, with no sign of slowing down its freefall. The market became so fearful that blood started to fill the streets, and, in our independent opinion, RIGP started to trade well below its cash and contracted cash flow value, despite street consensus views to the contrary. Subsequently, the price of oil continued its fall, to a low of $28 in January 2016, dragging down RIGP along with it, from our first entry price of $10 a share to below $6 a share. After triple checking our thesis to ensure that it is still valid, we simply kept buying the security as it became cheaper and cheaper – after all, getting a dollar bill for 99 cents is satisfying, but getting it for 60 cents is a consummation devoutly to be wished! True, in the depth of the doom and gloom, no one could say with certainty when the price of oil might recover, or even how much lower it might go before it stabilizes. But patience, as Aurelius Prudentius would surely agree, is a heavenly virtue, especially in trying times. Even the most pessimistic bears would have to agree that the world is not going to completely wean itself off of oil in the next 10 years, which means that RIGP’s assets are still going to be worth something beyond the end of its contracts in three years. Had the market decided to stay foolishly fearful, we would have been more than happy to wait out the three years and let the cold hard cash speak for itself when RIGP either re-contracts or divests its assets. For one reason or another, crude oil had a speedy recovery, and so did RIGP, generating a 75%+ return including dividends over our 10-month holding period.
While it often may not appear or feel so, nothing lasts forever. In fact, as Jared Diamond insightfully observes, the very attributes that initially lead to dominance usually also become the seeds of destruction. Examples abound over the past 50,000 years of human history. The abundance of game and forage in sub-Saharan African led to the rise of the human species, but also obviated the need to develop agriculture, inhibiting its growth. Confucianism served the Chinese Imperial Dynasties so well as to preclude alternative forms of government, society and life, such as republicanism, capitalism, and the scientific revolution. The Treaty of Versailles designed to perpetuate peace in Europe ended up sowing the seeds for Nazi fanaticism and eventually World War II. The rhyme of history is astounding. It is in the same vein that the dramatic cratering of oil prices forced out much of U.S. shale production, leading to constrained supplies and a sharp reversal in oil prices. While we do not claim the benefit of a crystal ball to call the zenith or nadir of any trend, we do know that the sky is darkest before dawn. As a result, we shall continue to go against the grain, so long as our independent judgement concludes that the proverbial grain has gone too far and the price has become undeniably cheap compared to the intrinsic value of the security. For, to completely misquote Swinburne, no life lives forever, and even the weariest river, eventually winds somewhere safe to sea.
While the final result was satisfactory, as I explained in my September letter last year, we made many mistakes during the year. Fortunately, most were errors of omission. There have been more times than I care to count that days or weeks after I pass on a name (always after thorough due diligence), the firm in question is acquired by a competitor or private equity at mouth-watering premiums. Could we have done significantly better had I had the foresight to join the party? Yes, absolutely. However, I would always much rather have a big pile of errors of omission than a single error of commission. Letting “The Perfect One” slip away is painful, but much less so than marrying the wrong one and have “till death do us part” become a goal to look forward to. While I cannot promise that I will never make a mistake again, I do promise that I will emphasize avoiding the landmines that are littered across the value investing field more than getting to the finishing line faster by taking additional risks – after all, dead men rise up never, and survival is the first step of success!
Eyes of the Beholder
Like beauty, value is in the eyes of the beholder. In the world of value investing, there have been two main categories of targets. The “cigar-butts” and the “compounders”. When the founding father of value investing, Benjamin Graham, first formulated the strategy, he focused on poor quality businesses trading at steep discounts. In the same way that picking up a cigar butt on the sidewalk may only give you one last puff, but since it was free, that puff is all profit. Benjamin’s most well-known and much wealthier student, Warren Buffett, however, gradually turned away from the cigar butts and famously quipped that he would much rather “buy a great business at a fair price than a fair business at a great price”. Their philosophical differences eventually strained their once idyllic relationship, but that is another story for another day.
The debates, however, rage on today. Most of the legends in value investing are of the Buffett school, and focus on great businesses with strong moats capable of compounding their profit and equity value over long periods of time. At least part of the reason is that as markets invariably become more democratic and efficient, with the advent of computer trading algorithms and ever decreasing transaction costs, the free money that used to proliferate in Graham’s days are now few and far between. It is safe to say that it is simply impossible to manage a billion-dollar fund by looking for the shiny $20 bill on the street.
That is not to say that finding compounders are easy, let alone finding them at “fair prices”. James at Young Money penned a brilliant post on how difficult it is to identify true compounders (as opposed to Ocwen and Valeant, two faux-compounders) ex-ante, no matter how “obvious” they might seem ex-post. In addition to James’ observations, we believe it will be increasingly difficult for businesses in general to establish and maintain unsurmountable moats.
The reason is simple. Technological innovation has accelerated to the point where “disruptions” are now the norm rather than the exception. It took the Rothschilds generations to establish themselves as the kings of finance, during a time when news and ideas traveled at the speed of your fastest horse. It took Rockefeller less than two decades to stamp out competition and establish Standard Oil as the oil king, and making himself the richest person in U.S. history, during a time when railroads and telegraph are revolutionizing the transportation of both goods and ideas. Today, it took Netflix less than three years to drive Blockbuster into bankruptcy – in fact, it took only 25 years for Blockbuster to go from opening its first store in Texas to going bankrupt. For better or for worse, we live in an age where the electromagnetic waves of twitter feed travel faster than the seismic waves of earthquakes, and news no longer need to “travel” at all – from Damascus to Dallas, Facebook Livestreams bring you the events as they happen, when they happen. How long did it take newspapers, one of Buffett’s favorite businesses with a moat, to dominate a locality? How long did it take the Internet to completely dismantle it? How much time and money went into securing the concession to operate municipal taxicabs? How much time and money did it take Uber, Lyft, and Didi to obliterate them? And this is not the story of silicon in computers destroying its brother silica in sand. In fact, the great businesses of the early 21-century that destroyed whole industries are being toppled themselves. Remember the days when Microsoft was feared, reviled, and subject to anti-trust investigations around the world? Remember the days when Blackberry enjoyed such a classic niche monopoly with strong competitive advantages in the enterprise mobile market that they laughed at Apple for trying to break in?
To be clear, this is not a verdict against the existence of sustainable competitive advantages or businesses with durable moats. The concerns are that whatever competitive advantages one may enjoy at any point in time, they are much less sustainable today than they were 100 years, 50 years, or even 10 years ago. More importantly, the train is only accelerating from here. With the abundance of venture capital and crowdsourced capital, the proverbial kid in the garage can develop the product, go to market and grow to the minimum viable size faster than ever before. It sometimes appears to your humble and cynic managing partner that the only competitive advantage a Google or a Facebook has is its deep war chest that allow them to acqui-hire talents before they become a real threat. Needless to say, the value of a moat is directly proportional to how long it can be expected to last. Paying a “fair price” for a moat that ends up lasting half as long as expected is the same thing as buying a Hyundai for the price of a Lamborghini – the car will still run, and you might even save some money on the gas, but it will not be your proudest achievement.
Fortunately for us, our partnership is small enough that we still can take advantage of the overlooked and underpriced security to generate above-average risk-adjusted returns. While the “smart money” looks for the goose that may or may not lay the golden egg, we will be happily hunting for the “50% OFF” sign in the produce lane.
Empire Builders vs. Money Makers
In our very first letter, we discussed the importance of aligned incentives between executives and shareholders. It is sadly too often that executives of public companies focus on enriching themselves than generating returns for shareholders. Unfortunately, it is a rare sight indeed to find a firm or a CEO that is truly aligned with shareholders. After all, it takes billionaires and controlling shareholders like Elon Musk of Tesla/Solar City/SpaceX, Larry & Sergey of Google, Mark Zuckerberg of Facebook, and Warren Buffett of Berkshire to completely forego a salary. More often than not, executive compensation is tied to the top line of the firm, not the bottom line. Even executives with the straightest moral compass could fall prey to the allure of the prestige that comes with steering a large company.
It may not come as a surprise, but as can be seen in the charts below, firms that expand their asset base fastest generate the worst returns, while those that spend them judiciously or return them to shareholders outperform the market.
As a rule, we avoid the empire builders. We put on our best running shoes and dive for the emergency exit when we hear the phrase “transformative transactions”. If an executive cannot run the firm he is responsible for, what makes him think he can run someone else’s better? That is not to say that corporate mergers and acquisitions always destroy value, even the mega-sized ones. On the contrary, Constellation Software built a multi-billion dollar business by rolling up and integrating small niche software companies, and Google’s $1.65 billion acquisition of YouTube in 2006 not only did not turn out to be AOL/Time Warner #2 as many feared, but created immense value for Google shareholders.
Unfortunately, such success stories are truly the exception and not the rule. More importantly, I will readily admit that I cannot predict with any degree of certainty the success of such transactions ex-ante. As a result, we will focus on firms that choose the slow but steady route, i.e. those that focus on building and improving their own business and only pursue acquisitions opportunistically, when the price is right. In fact, we would prefer those businesses that have a track record of divestitures. Such firms send us two messages: (1) the executive team is not fond of accumulating assets to build and empire, and (2), they are willing and able to unlock value for shareholders when an empire builder comes along. As William Thorndike’s stories in his book The Outsiders undeniably show, astute capital allocation is by far the most important predictor of value creation.
The Path Forward
After sounding the alarm on valuation last quarter, the North American markets continue their relentless pursuit of a new all-time high, Brexit-Shmrexit be damned. In fact, we believe the market was so overheated that ACP made a grand total of ZERO purchases in the last three months. Your portfolio currently consists almost entirely of high dividend paying stocks, thereby naturally reducing the “duration” of the portfolio. With the uncertainty in Europe putting the Fed’s plan to raise interest rates on hold, there is no telling how much higher the market can go. It is not easy to watch the little green numbers tick on the screen while 40% of the portfolio sits in cash earning peanuts, but it is times like this that tests our discipline and self-control. After all, as the Chinese proverb teaches, water can support your canoe (if it is calm), but can also capsize it (if it is treacherous) – it is only when the tide goes out that we see who is swimming naked. Looking ahead to the next 12 months, we will continue to abide by our three foundational principles, and only deploy your capital when we independently conclude that a bargain may be had. Otherwise, we shall remain patient and vigilant.
As you are well aware, Athena Capital Partners’ name pays homage to Mssr. Shouren Wang’s philosophy of knowledge and action in one. It is only fitting that I end the first year with another of his pithy remark: the difference of victory and loss is entirely in your power to hold your mind steady. If your mind is clear, nothing further needs to be explained.
胜负之决, 只在此心动与不动. 此心光明, 亦复何言!
Athena Capital Partners
It is my pleasure to report the results for the 9 months ended March 31, 2016.
If one were to film a documentary of the market in the first quarter of 2016, it could be very aptly named V for Vendetta. The S&P 500 finished 2015 at 2,044 points, fell 11.5% to a low of 1,810 in mid-February, before roaring back to finish the quarter at 2,060. According to the Wall Street Journal, it is the first time that such a drastic fall from heaven and subsequent resurrection have happened all in a quarter since the Great Depression. Since our inception on July 13, 2015, the S&P 500 fell by 0.1%, and the TSX Composite fell by 7.3%. Athena Capital Partners' NAV grew by 3.7%, with 40% of our assets in cash.
What Goes Around…
Last quarter we discussed how the main positive contributors to the market were the technology darlings: Facebook, Amazon, Netflix and Google. Of the bunch, only Facebook continued its meteoric rise in the first quarter. Google is down 3%, Netflix 10%, and Amazon 13%. On the other hand, the two downtrodden names we discussed in the last letter, Labrador Iron Ore Royalty Corporation (TSX:LIF) is up 21%, and Transocean Partners (NYSE:RIGP) is up 1%, although not before both experiencing a 25% drawdown in mid-January. As if providence wanted to test how true we will stay to our core tenets of independence and patience, we were presented with such a drastic adverse change in our largest holdings in our first year. Luckily, your managing partner’s stomach was strong enough to pass the test. Much of the gains we experienced in the first quarter can be attributed to us continuing to enlarge our positions in these two names in January, at the nadir of public opinion on iron ore and oil prices. Now, I would like to emphasize again that we did not make these investments as a means to bet on commodity prices – indeed, we have absolutely no idea where commodity prices will go in the next month, quarter, or year, other than that iron and oil will continue to be used by the human species for various functions and therefore worth more than zero. We made these investments because of the bond-like nature of their cash flows in the next 3 to 5 years, and their pristine balance sheets with not an ounce of debt (and a ton of cash in the case of RIGP). The risks are more than compensated by the double digit returns Mr. Market was offering to sell the securities at. While we sincerely wish that they did not experience the run-up, so we would have more opportunity to accumulate an even bigger position, we will gladly play with the hands we are dealt.
During the quarter, we also started to build positions in a few other securities, including CDI Corp (NYSE:CDI) at $4.50 and Northern Tier Energy (NYSE:NTI) at $24.
CDI is a human resources consulting/staffing business, a highly commoditized business with incredible competition from all around. While not a phenomenal business that we would proud to own, it did have cash on hand and accounts receivable (which they have almost always collected within 80 days) of $5.32/share, so the entire business is valued at an astounding NEGATIVE $0.72/share at our entry price. While the business is experiencing difficulties and suffered a loss in 2015, we did not believe that the business, without any debt, is worth anything negative. To wit, a new senior management team was put in place in 2013 and their compensation package is structured such that most of their upside is in bringing share price up to above $20. Unfortunately, the shares shot up 50% before we could establish a sizable enough position. But we will always much prefer to miss an opportunity to make 50%, than to risk your capital by chasing increasingly more expensive securities. As in your corner grocery store, there will always be something on sale. If we what we like is sold out this week, we will simply patiently wait for next week’s sales.
While we will continue to keep a sizable portion of our portfolio in cash (for reasons that we will discuss in the next section), we will also strive to earn a few more pennies on the dollar in addition to the non-existent interest rates on cash balances. A (somewhat) safe way to do so is to engage in merger arbitrage (i.e. purchase shares in firms that have announced and signed definitive agreement to be acquired by another firm, at a price above what it is currently trading in the market). Northern Tier Energy is such an investment. It is currently controlled by Western Refining (NYSE:WNR), which announced in late 2015 that it will acquire the rest of the NTI it does not already own. The offer is combination of cash ($26/share) and/or stock at the election of NTI shareholder, subject to certain maximums. The reason why we decided to take advantage of this opportunity over other similar ones is three-fold. Firstly, with WNR controlling NTI, the transaction cannot fall apart due to shareholder opposition. Secondly, regular dividends will continue to be paid by NTI before the transaction closes, without impacting the purchase price. Hence, the risk of a long delay in the closing of the transaction is almost completely mitigated. Thirdly, independent of the takeover offer, NTI is simply the most gross margin profitable refinery in the U.S., with WNR rounding up the top 3. Hence, even if more shareholders elect the cash option and we end up owning WNR shares instead of being paid out in cash, we can still sleep well at night. It is unfortunate that the share price of WNR fell significantly since announcing the offer, leading to the price of NTI falling in tandem. But as with our other investments, we really could not care less about short term changes in price. If it continues to fall, we will simply continue to acquire.
He Who Forgets History…
As the S&P 500 continues its charge with no sign of running out of adrenaline anytime soon, many have questioned whether the 7-year-old bull will get to celebrate a happy and healthy 8th birthday. While we have never had the fortune to acquire a crystal ball, and hence always refrain from making macro forecasts into the future, we are students of history. We often find it helpful to review the past in order to understand the present and prepare for the future.
As we have just seen, price eventually catches up to value, and sometimes much sooner than one might expect. The average price/earnings ratio of the S&P 500 is around 16x, and it has been quite stable, whether one averages the past decade or century. As of March 31, the S&P 500 is trading at over 22x, meaningfully above its historical average. Now, the simple P/E ratio is quite flawed, as accounting earnings can give absurd results in certain circumstances. To wit, the P/E ratio stood at 123x in May 2009, on the eve of the current bull market. The reason is simple: so many firms took one-time charges in the preceding year that accounting earnings became unrealistically low for that one year, but the simple ratio did not take it into account. To correct for this and the business cycle in general, one may use 10-year average earnings to compute a PE10, or Shiller’s P/E. The pattern is quite telling:
The only times that Shiller’s P/E was higher than what it is today was right before the market crashes in 1929, 2000 and 2007. Not so warm and fuzzy.
Now, just to play the devil’s advocate, is this time different? Yes and no. While there is no “right” multiple in the absolute sense, the ratio should be higher than average when earnings are expected to grow faster (e.g. higher economic growth due to demographics in the 60’s), and lower than average when required rate of return is higher (e.g. high inflation and interest rates in the late 70’s early 80’s). Today, both factors are heavily skewed by the loose policies of the Federal Reserve. The economy seems to be adding jobs and lifting wages in the first quarter, but most of the gains occurred in the retail and construction industry, both of which rely heavily on the easy credit. Real return on U.S. treasuries turned negative in March, forcing capital to seek higher returns in the stock market. Unfortunately, what the Fed’s newfound magic cannot do is to create profits. Corporate earnings in almost every sector from banks to energy to heavy industrials to luxury retail all continue to trend down, for a variety of different reasons. If the current market is artificially sustained at current levels only because there is nowhere else for investors to preserve the real purchasing power of their capital, what would happen when the dividends offered by utilities and other blue chips are finally brought more in line with what the underlying businesses are generating, and the Federal Reserve finally start raising interest rates, as it has indicated it will do later this year? This artificial level of support for stock prices is especially pronounced in Canada, where a lack of corporate and municipal bond market forces even more capital, from individual investors and pension funds alike into the equity market.
Many have pointed to the robust mergers and acquisitions activities recently as indications that all is well. After all, why would our beloved CEOs whose compensation package is strongly correlated to the size of their company as opposed to actual long-term shareholder returns go on a shopping spree unless the market is incredibly cheap? A quick look in the history books would be incredibly telling. Over the last 20 years or so, the highest M&A activity occurred in 2006 to 2007, right before the financial crisis, while the second highest occurred in 1999 to 2000, right before the dot-com bubble burst. M&A activities took a siesta after the crisis, only to almost double between 2013 and 2015. In essence, all around the world, the helicopter money has led to more deal-making rather than investments in the real economy, with predictable results to come in the future. But I will leave the herculean task of drawing the natural conclusions to the reader.
We were thrilled at the beginning of the year as the market swoons, ready to put our cash to work. However, with the market roaring back so quickly so soon, we were not able to deploy as much as we had hoped. At current prices, we are struggling again to find any bargains. Consequently, we will again patiently wait on the sidelines while staying hawkeyed for any potential sales to flare up. In this volatile environment, we hope we won’t have to wait long.
January 1, 2016
It is my pleasure to report the results for the 6 months ended December 31, 2015.
2015 turned out to be quite a year. It appears that we can find water on Mars, take selfies with Pluto and land a rocket upright after going to space, but struggle to maintain any semblance of sanity in the global commodities market. Oil has crashed from US$100 a barrel in mid last year to US$37, with the U.S. ending its 40-year ban on exports. Not to be outdone, natural gas dropped from a high of US$5 to less than $2. Iron ore fell from US$100 to US$50 a ton, continuing the trend from a high of US$180 in 2011. Since our inception on July 13, 2015, the S&P 500 fell by 0.9%, and the TSX Composite fell by 10.6%. Athena Capital Partner’s global equities portfolio fell by 3.9%. The fund remains over 50% in cash, and with the recent market correction, we find our days much brighter and much more interesting.
I have to admit that I am almost embarrassed to finish the first full quarter on such a down note, so I will focus this report mainly on the mistakes that I have made and the lessons I have learned.
The negative results for the quarter is mostly attributable to two investments in the mining and oil sector, namely Labrador Iron Ore Royalty Trust (TSX:LIF) and Transocean Partners (NYSE:RIGP). Truth be told, while I still believe the overall thesis, I did not expect the commodity rout to be as severe as it turned out to be. As a result, when I thought I was picking up some nice Wusthof knives on Black Friday sale, it was more like trying to catch all them falling. Barehanded. To quickly recap, LIF’s source of cash flow is an overriding royalty on one of the lowest cost and highest quality iron ore producer in the world, which means the cash flow is secure so long as the price for iron ore is above the mine’s marginal cost and the mine stays in operation. Further adding to the security, the mine’s expenses denominated in CAD but revenue in USD, creating a natural hedge against deteriorating commodity prices. Similarly, most of RIGP’s cash flow is generated from its two fixed price contracts with Chevron and BP, which expire between 2016 and 2020. While the terminal value of the rigs after that is certainly subject to the then prevailing oil price and producers’ capital budget, the shares were already trading at a level that ascribed minimal terminal value. In actuality, the multi-billion dollar rigs, which typically have 30-year useful lives, will have been less than ten years old, and is certainly worth something more than scrap.
The key problem, which I was aware of but clearly did not appreciate enough, is that a few factors worked in concert to create the opposite of Charlie Munger’s lollapalooza effect. The first factor is operating leverage. With technological advancement and the insatiable demand from China over the past decade and a half, mines have been getting much bigger and much more automated. While these mines are much more expensive and takes much longer to build, the marginal cost of production has come way down. In fact, most of the cost of production is fixed, regardless of whether it runs or not. The second factor is that to build these expensive mines, most producers have taken on a tremendous amount of debt, financed by the easy money since 08 and aided by the commodity supercycle. The debt load not only increases the fixed cost for the miners in the form of interest expense, but also exacerbates the pressure to produce in order to avoid a default. The third factor is the declining power of the likes of OPEC, as they control less and less of the global market. When OPEC controlled the majority of the global oil market, they had every incentive to keep prices high, as the marginal benefit would mostly accrue to its member states. However, as Russian and US shale production increased dramatically over the past decade, any supply constraint created by a production curtailment from OPEC member states would be more than offset by these new kids on the block, who are not bound by the old rulebook. As a result, OPEC is now more incentivized to keep production high and prices low, so as to discourage new capacity growth from non-OPEC states and especially the new higher cost producers. The combined result is that when commodity price craters, most producers have no choice but to increase output, as their cost base is increasingly fixed, and the lack of a swing producer only compounds the problem. Hence, the positive feedback loop became a self-fulfilling prophesy like the bankruns at the turn of the 20th century, leading to an unprecedented collapse of almost all commodities.
Despite the general malaise, there remains a bright spot in the market – the FANG. Over the past 6 months, Facebook was up 22%, Amazon 57%, Netflix 24%, and Google 45%, while the NASDAQ index as a whole was up a mere 1%.
While I am a devout customer of all four companies, and I firmly believe that they each enjoy a unique competitive advantage that will allow them to do fantastically well in their respective fields, their valuations are beyond my humble comprehension. For instance, after Amazon announced that it would breakout AWS results in its next quarterly report, AMZN shares rose 25%, before the actual report was issued. Similarly, when Google announced that it would reorganize itself into Alphabet, and report its core operations separately from the other alpha bets, GOOG shares rose almost 30% overnight, also before anyone actually had an inkling of idea how the core operations were actually performing. While increased transparency should certainly be celebrated, and the additional information could theoretically enable better analysis and thereby reduce perceived investment risk, I find it difficult to understand the value assigned to the announcements, especially before the additional information became available.
More importantly, these firms were not trading at a discount for nondisclosure before the changes in reporting. They were already priced for almost perfection, with significant growth and market dominance implied by the lofty multiples. While, individually and independently, one might argue that Amazon and Google have incredible cloud computing offerings, or Netflix and Youtube have unparalleled distribution for video content, etc., not all of them can be winners at the same time. The situation reminds me of the epic battle for market share between Uber vs. Lyft. Both have been darlings of the VC industry, and both have engaged in a cutthroat price war to win customers. I personally received more than $300 in credits from each of them over the course of two years, and still checks both apps for prices/availability before I book a ride. Most of the drivers I spoke with are registered with both companies and take customers on whichever one that happens to have higher fares/more customers at the moment. No one can predict the future winner of the war, or whether there can be only one winner, but I would go out on a limb right now and boldly predict that they cannot both end up with a majority of the market at the same time. When the probability of success assigned by their respective investors (or the same ones – aye, here is the rub, there are investors that invested in both companies) do not add up to 100%, something is amiss somewhere.
2016 is poised to be quite an interesting year. The hulking driver of global growth is sputtering, all but the largest commodity producers are in distress, the Fed’s promise to raise interest rates is putting itself in a bind, and the market continues to swoon. But it is in these uncertain and terrifying conditions that great opportunities present themselves. Over half of the partnership’s capital remains in cash, and after spending six months agonizing over the sky high valuations, things are finally getting interesting.
Athena Capital Partners
It is my pleasure to report that the birthing pains of Athena Capital Partners is now behind us, and the partnership is in full investment mode as of July 13, 2015.
In the first (partial) quarter of Athena Capital Partners’ existence, the global stock market experienced volatility not seen since 2011. The VIX “fear gauge”, having averaged around 14 over the past three years, decided its moment of glory has come, doubled up its efforts and leapt to 28 on August 21. To wit, on July 20, one weeks after our partnership funded its accounts and began its investment activities, the S&P 500 closed at 2128, flirting with its glorious all-time high of 2131 previously set on May 21. Then, barely a month later, on August 25, it decided that fame and fortune are but a mirage, and settling down with a more mundane girl next door might suit it better, so it promptly moved to close at 1867 points, within whisper range of the 52 week low of 1862 previously set on October 15, 2014. The index closed out the quarter at 1919, down 7.6% from July 13, the day ACP began investing. Globally, in Q3, the ASX 200 fell 7.3%, FTSE 100 fell 8.2%, and the Shanghai Composite Index fell 25%.
This partnership, however, was not set up to follow the dating habits of the S&P. Rather, our goal is to identify severely undervalued securities in the market, and patiently wait for its price to trend back to its intrinsic value. And by patient, we mean unwearyingly patient. If we cannot find any bargains in the market after diligently turning over every stone for them, we would gladly sit on the sidelines with our idle hands stingily clutching our money pouch. Even after the fall, the overall market is far from what I would describe as cheap. To this end, we spent most of the quarter with 70% our assets in cash, and ending it with approximately 50% in cash 50% invested in various securities. Unsurprisingly, though we escaped the bloodbath in the general market, we ended the quarterly with very uninspiring results – our Net Asset Value was up a negligible 0.18%. For consistency and simplicity, all results are stated in Canadian Dollar equivalent terms, with all foreign currency and securities converted to Canadian dollars based on the closing exchange rate published by the Bank of Canada on the date of the report.
While the end result may be dull, the journey there was anything but. This being the first report, with not all that much going on in the actual portfolio, I would like to take this opportunity to get in my soapbox and lay out my overall philosophy in security selection. In general, we look for:
To illustrate the results of our selection, I have outline my thinking on two of our largest current holdings below.
Transocean Partners (NYSE:RIGP)
Our biggest position at the end of the quarter is Transocean Partners (NYSE:RIGP). The entity is a high yield partnership spun off by Transocean to hold its long-term contracted rigs and semi submersibles. In simplest terms, RIGP has 2 deep ocean rigs and 1 semi sub that are on contract until 2016, 2018 and 2020. These assets will earn its contracted dayrate, subject to standard operational adjustments until their maturity. The contracted cash flow is worth approximately $7/share in NPV. While nothing is guaranteed after the contract period ends, the business will still have its rigs with another 20 years or so of useful life. Granted, should oil price continue its nose dive or even just remain at $40/barrel, these rigs are probably not worth very much more than scrap, as no developer would rent at the currently prevailing rates ($545,000/day) to drill for oil in the deep ocean. However, should the global economy find its footing in the next three to five years, and oil price recover to a $60 level, it would not be unreasonable to expect another $3 - $4/share in the residual value of these assets, whether contracted out or sold.
Now, I never have and never will profess an ability to even remotely guess future oil prices (or any other macroeconomic statistic), but I am fairly confident that oil producers will not continue to pump the black gold only to burn their real gold. Hence, either prices have to go up to a level more consistent with their overall long term cost structures, or they will find ways to reduce costs such that they can generate a profit at current price levels. Either way, there is a conceivable use of RIGP’s assets in the future, although it may be at a significantly reduced profit level, which we have taken into account in the estimated residual value.
But this is not all. RIGP is set up, like most of its competitors, such that public unitholders have preferential access to the cash flows until a certain threshold is reached. The manager of the partnership (Transocean) is highly incentivized to at least meet the minimum distribution requirement to convert their subordinate units into common shares, and subsequently maintain or increase the distributions to trigger the huge performance payments. Unlike most of its competitors, however, RIGP was not born with heavy shackles made out of debt around its ankles. In fact, it was in a net cash position as at June 30, 2015. With one of the longest remaining contract terms and the least amount of debt on its balance sheet, even if the bottom were to fall out of the global oil market, RIGP is positioned well to be the last survivor on the island, after most of its competitors have been forced into bankruptcy or asset sales at distressed prices by their heavy debt load. Just like us, RIGP has the financial freedom to remain patient and stay on the sidelines if the market is not offering the right price, but can also act aggressively to win contracts when appropriate. Thus is the benefit of having a spectacularly clean balance sheet.
As a result of the turmoil in the commodities market (with oil prices sliding from $100 to $40), RIGP was accorded the same laurels as that bestowed upon a high school delinquent. Hence, we were able to establish our position between $9 and $10 per share, far below the intrinsic value of the assets. While RIGP is not a prime example of the business we are looking for, it does fulfill three of our four criteria, with a current yield in excess of 15% (from the contracted cash flows until 2019). We would gladly park our cash here and continue to evaluate other potential investment opportunities.
American Public Education Inc. (NYSE: APEI)
Our second largest holding is American Public Education Inc. (NYSE: APEI). APEI traces its history to 1991, when it was founded as American Military University to serve military officers seeking an advanced degree through distance learning. Today, in addition to its loyal current and ex-military student body (52% of students), it also operates the American Public University, offering undergraduate and graduate degrees online in niche civilian studies (e.g. homeland security, space studies, emergency and disaster management, rather than the ubiquitous business studies or management sciences), and Hondros College of Nursing, providing nursing education through its four physical campuses in Ohio.
The for-profit education sector has taken on an extremely bad rep over the past few years, and mostly for good reason. Just like the junk-bond financed buyout boom in the 80’s and 90’s and the subprime financed housing boom in the 00’s, the party cannot continue indefinitely when the music is tuned to tricking customers of limited sophistication to borrow amounts of great burden in order to buy something of dubious value. Unlike most of its less scrupulous brethren, however, APEI actually offers great value to its customers. In a world where education is becoming prohibitively expensive (and I say this with big bruises on my face after spending a quarter million dollars to attend Columbia Business School), APEI’s tuition remained unchanged from 2000 to June 2015, when it was raised by less than 10%. Today, its tuition remains over 30% below average in state rates for public universities with government funding. Despite the incredibly low tuition level, APEI enjoys one of the best margin profile AND student satisfaction in the industry. In fact, it is ranked #6 by Military Times for veterans, and #27 in online education by U.S. News, with only 3 other for-profit institutions in the top 100 (Kaplan at #79, U of Phoenix at #82, and Berkley College at #87).
The institution has encountered its own set of problems over the past few years. In an effort to grow enrollment, it took on more students on Title IV federal aid, many of whom joined solely because they could get more loans than the tuition would cost. This has led to a decrease in student quality and APEI’s Cohort Default Rate, a key metric tracked by the Department of Education, fell from top quartile in 2009 to third quartile in 2011, the last year information is available, although it is still leaps and bounds above most other for profit institutions. What is important for us is that as soon as the able and focused management team realized this problem, they began to proactively course-correct, significantly increasing the quality of incoming student body by only recruiting students that intended to obtain a degree rather than cheap debt. Due to the long term nature of the business and the metric, however, the full impact of these actions may only be achieved three to four years after the medication, which should be early next year.
The general malaise facing the industry, the pending regulatory changes, and other short term operating issues have pushed the market value of the company far below its intrinsic value. With a stellar reputation and student satisfaction, over $100m in net cash ($6.25/share), strong cash flow generation being used to aggressively repurchase shares (11% reduction in shares outstanding over the past 5 years), and an able management team that is compensated for performance, APEI represents a textbook case of our favorite type of investment. We established our position between $20 and $24, and look forward to the business continue to outperform its competitors in the future.
We have always said that we are investing for the ultra long term. In fact, we exist because we perceive an inefficiency in institutional money management that favor short term results and rampant activity. As a result, short term (read: a year or two) results, good or bad, do not mean much. We are slowly building a portfolio of securities that we believe will earn us outsized returns over our investment lifetime, and we will strive to be extraordinarily patient in our efforts.
Athena Capital Partners
Athena Capital Partners was officially established on May 28, 2015, and began investing on July 13, 2015 with capital committed from its partners.