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:
- Simple businesses – If we have to bust out a dictionary to read the company description, it probably is too hard. Life is too short and investing too hard to dabble in fields that cannot be easily understood and analyzed.
- Sound business models – Not to wallow in an existential crisis, but we believe only firms that are adding value for all stakeholders in order to survive and perhaps thrive for the long term. To do that, one has to offer a valuable product for customers, a rewarding environment for employees, in addition to a meaningful return for shareholders.
- Consistent earnings power – By consistent, I do not mean smooth. In fact, like Warren Buffett, we would rather take a volatile 15% to a smooth 12%. However, we do prefer businesses that, over a substantial period of time, has demonstrated that it can remain viable and relevant through thick and thin, leveraging the invariable trough in the business cycle to build out the organization and emerge better poised than ever to take advantage of the equally invariable recovery.
- Clean balance sheets – Despite the advances in exotic financial instruments over the past half century, cash still seems to be the most widely accepted form of payment. Some businesses, such as lending institutions and heavy industries, are optimally financed with a combination of debt and equity. In most cases, some level of working capital borrowing is beneficial. If a business relies on obtaining debt financing to grow or operate, however, sooner or later the market will turn, credit will dry up, lenders will start breathing down management’s neck every day and forcing the organization to focus all of its energy on meeting coverage ratios or getting waivers.
- Deep discounts – Price and Value are the two most important concepts in investing. Price is what you pay for, and value is what you get. In today’s rapidly changing environment, where almost no sector is immune to disruption, which sometimes turn into complete and utter devastation seemingly overnight, the value part of the equation is more and more difficult to pin down, especially in cases where it relies on long term profit forecasts. Hence, it is ever more important to at least get one part of the equation right: the price paid. Typically, that means going against the grain and “be fearful when others are greedy, and be greedy when others are fearful” – so long as we are confident in the long term viability of the business we invest in.
- Proper Incentives – We have come to appreciate the power of incentives, which drive motivations and in turn drive behavior. Hence, we pay special attention to the design of the compensation system for senior management teams. While we might have faith in the honesty and integrity of people in general, we would rather not use our money to test the power of temptation. Borrowing a page from private equity, we love firms where senior management owns a meaningful portion of the business, does not take excessive salaries, and has demonstrated that they plan to get very rich – through increasing the value of their shareholdings, rather than through fleecing their shareholders.
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