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:
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.