Thoughts on Investing

Antrim Blog

Thinking like private equity: DESP, and the advantages of long term horizons.

On Wednesday, April 1st, I published the very first issue of my investment ideas newsletter, Idiosyncratic Risk, which can be found on my website, featuring a "long Despegar" recommendation (DESP 12.38 +0.24 +1.98%). As a result, over the ensuing news cycle I was hyper-aware of a constant refrain from pundits and guest commentators alike on CNBC that went something like this:

"You have to be selective in this market. You can't just own the index, because the index owns travel stocks, and the index owns highly levered companies, and while you can look for buying opportunities right now, you cannot own travel stocks, and you cannot own heavily indebted companies." To which I would haughtily reply, "I can do whatever I like, thank you very much!" but I do understand the sentiment, and I do challenge myself not to be contrarian merely for the sake of becoming an iconoclast, without better reasoning and rationale. In addition, I received some interesting questions and feedback from those who did read my newsletter, so I felt it would be appropriate to follow up and explain exactly why it is that I own in the middle of a global pandemic and travel lock down, and to whom, precisely, I would recommend purchasing shares.

One of the core beliefs I hold that inform my investment style and philosophy is that it is far easier to predict the general arc of the future than it is to predict the specifics. As an example, I could not presume to guess what the price of a barrel of oil will be at the end of Q3 this year. But I can say with moderate conviction that global dependency on fossil fuels as the predominant source of energy will be significantly reduced over the upcoming decade. Without getting into politics, I would imagine most meteorologists would tell you that they have greater confidence in the IPCC global climate model's predictions about average temperatures five years from now than they do in predicting the likelihood and amount of local precipitation in one week's time. And if I might attempt to circle back to the topic at hand, which is travel, travel related stocks, and, I cannot tell you precisely when the U.S. and Mexico will ease international travel restrictions and border controls, but I do believe that Cabo and Cancun will remain popular vacation destinations for U.S. travelers 3 years hence - and 5, and 7, and 10 years from now for that matter.

Honestly, none of that is really very controversial. The problem, as the "you-can't-own-travel-stocks-right-now" crowd sees it, is the opportunity cost of capital. Most professional investors, try as they might to maintain a long term investment horizon and benefit from the "easy" predictions like, "Cancun isn't going away," are beholden to mark-to-market accounting and short term performance reporting requirements. Their clients are free to redeem their investment and fund a manager with better near term performance. The CNBC pundits are similarly aware that their audience has a great short term memory, and that they are only ever as smart as their most recent recommendation. Where we might all agree that DESP is worth more than its current price, and will likely trade higher over the next 5 to 7 years, we will find no agreement or certainty as to what the next 6 to 9 months hold. It is highly likely, in fact, that Despegar will not be the best performing stock on the NYSE over the next six months. In all probability, it will not be anywhere close. Capital parked in DESP over that time period is no more likely to outperform the S&P than in any other stock a blind monkey could hit with a dart. And THAT is the cost that most are unwilling or unable to pay. The opportunity cost of missing out on today's hottest issues is simply too great, and many or most would prefer to pay a higher price for DESP, later, armed with the certain knowledge that travel restrictions are easing and vacationers are emerging from self isolation. To most, it feels smarter to attempt to invest in near term certainty, despite the utter lack of evidence that there is profit to be made in certainty, and the plethora of evidence that would suggest long term market inefficiencies like, "low P/E ratios," persistently outperform.

There are those, however, who do manage to fight the current of popular opinion and ignore mark-to-market volatility. Investors like Seth Klarman at Baupost, who enjoy a more-or-less permanent base of investor capital or Warren Buffet at Berkshire who enjoys a permanent base of capital. And private equity. Private equity requires investors to agree to a lock up period of 7-10 years during which their illiquid investments in whole companies are allowed to mature largely free of a mark-to-market performance reporting requirement. And while some under-perform, it is rare to see a private equity fund actually squander investor capital and produce negative returns. Your author counts himself amongst those who enjoy a permanent capital base - I invest only my own money, and I don't have to worry about clients redeeming. I need only satisfy my own investment goals to continue employing myself. As a result, I try to think like private equity as much as I can.

In the case of Despegar (DESP 12.38 +0.24 +1.98%), it is plainly obvious that Despegar is a company of the caliber that long term investors should find attractive. Despegar is the leading online travel agency in Latin America by both market share and brand awareness. Statistically speaking: Despegar increased gross bookings +26% in 2019 in local currencies, despite -3.5% GDP growth in their second largest market, Argentina. In 2015 and 2016 they reported USD revenue growth in excess of 30% despite -3% annual y/y GDP in their largest market Brazil, in both years, and overall LatAm GDP growth of -0.5% in 2016. As recently as 2017, the company generated $40M of free cash flow ($0.58 per share), and they remained cash flow positive even during a difficult 2019. The company has grown revenue in USD at almost an 8.5% CAGR over the past three years, despite macro-economic weakness in Latin America and difficult currency translation headwinds into their reporting currency, USD. They generated, at peak (2017), $0.61 of earnings per share, and 13.6% operating margins. As of their December 2019 investor day, they expected the company to double in size over the next five years. And why not? Euromonitor estimates that the LatAm travel market is growing at over 9% annually, with the online travel market growing even faster, and Despegar continually taking share from a fragmented base of local travel agencies.

But at what cost comes this growth? Surprisingly little, in fact. Despegar operates with negative working capital as a result of the fact that they take cash from customers up front, and pay hotels (in most cases) 45 days after their customers check out. The company has over $300M in cash on its balance sheet at its most recent reporting date (12/31/19) and only $19M in debt. They have one material liability, which is $261M in accounts payable that represents, for the most part, future payments to hotels that will not be made due to the current global pandemic, and instead turned into one-time cash refunds to their customers. But DESP has enough cash on their balance sheet to refund 100% of their current payables balance, with money left to spare. They have agreed to make an up front payment to acquire the Mexican travel agency "Best Day" of $88M during 2020, but I strongly suspect that the material adverse change clause of their merger agreement will allow Despegar to renegotiate either the price or the terms of the deal, or walk away entirely, should such a need arise.

In Despegar, we find a late-stage growth company, self funding its own investment in local currency revenue growth in excess of 25%, with net cash on the balance sheet, trading at barely 10x 2017 EPS, and taking market share of a fragmented growth industry. If I allow myself to think like a private equity investor, or a late stage venture investor, I find that I am absolutely salivating at the prospect of taking a stake in DESP today, to be valued 5 to 7 years hence, when the global Covid-19 pandemic is naught but a sour memory. If I can't escape the need to generate near term mark to market performance, I would, however, be unable to "get in front of" the company's customer refund liability and the uncertainty regarding the timetable for a resumption of so-called "normal" travel demand. Therein lies the opportunity, as I see it, for investors with a sufficiently long term horizon and the ability to ignore near term price fluctuations. You can expect above average 5-7 year returns, with greater-than-average conviction.

But I must give my readers one important caveat: you do have to be honest with yourself about your capital needs over the next 5 to 7 years, and your ability to stomach mark-to-market volatility in your investments. It's not clear that we will see ANY travel demand in 2020, let alone "normal demand." It's not clear that things will be "normal" even in 2021. We simply don't know. What I believe is that we will get back there, in time. And I believe that DESP shareholders today will be the beneficiaries.

Disclosures: I am long shares of DESP in my own account and the Antrim Investment Research portfolio, of which I am the sole beneficiary. Neither Antrim or myself have any professional relationship with Despegar or any other company mentioned in this blog, and I am not being compensated for its publication.

Investment Philosophy: Thinking Outside the Style Box

Investors simply love to group stocks and companies together. By industry, by sector, by market cap (large, small, mega, mid, or even micro), and most insidiously, by style. Anyone who's ever tried to look into a mutual fund manager or even watched a few hours of CNBC will be familiar with the distinction between "value" investors, and "growth" investors. And conceptually, we understand that the value guys will buy anything that presents itself as a bargain, even if it's a security of objectively lower quality, while the growth guys are true believers who worship at the altar of "quality" and don't mind paying a premium for a share in a better company and a better management team. But the thing I've learned in over a decade of institutional equity investing is that the value guys and the growth guys (the good ones anyway) are both doing the exact same thing. They are looking for underappreciated assets. They just approach the opportunity set from different directions.

The "Growth" guys believe that the market has a hard time fully valuing a high growth business with a great management team, because the multiples on current earnings seem high, and it's hard to predict what the next big thing might be. They back the best horses, and they let them run. The value guys, by way of contrast, start with companies trading at low multiples and revel in low expectations that can be easily exceeded by even mediocre managers and businesses, having started with the belief that it's easier to determine what's irrationally out of favor than it is to divine the future of a business, or industry, or the economy as a whole. And when you have two different approaches, you get two different investment processes and two different investment portfolios, but ideally they're both full of underappreciated assets.

I'm a value investor. That's just how my brain works. It made sense to me when I was reading books about investing in college, and it made sense to me when I went to work for a value 7manager after I graduated. But I don't go in for all the nonsense that I hear value managers saying on TV and in the opinion columns. What I hear a lot of is managers saying that for most of the last decade, "growth" has outperformed "value" and that their portfolios stood no chance at success in the short run (the last 7 years or so). They seem to be saying, "all of these low multiple stocks must go up eventually," but they are not saying, "I've done the work to determine that this company doesn't deserve its low multiple, and this is an underappreciated asset." Companies in industries like Oil & Gas exploration, for example, look cheap. Maybe they are, but they face real, visible headwinds on the demand side from the advent and improvement of alternative energy sources. It's not enough to note that the multiple is cheap without doing more work. And it's irresponsible to blame portfolio under performance entirely on the "FANGs," (Facebook, Amazon, Netflix, and Google), which few value investors own.

Indeed, I am about to make the case that one of the most obvious values in the market today is one of those very stocks, and that value investors who aren't willing to look at a high P/E stock to determine whether or not it's cheap aren't really doing their jobs. The subject of today's blog post on thinking outside of the style box is: Facebook (Facebook, Inc. 190.78 -8.08 -4.06%).

In the interest of full disclosure - I am long facebook in Antrim's portfolio, and it's my largest position. In what can only be classified as a near term illustration of my good luck, I have an average cost basis in FB shares of $140.79, having fortuitously taken advantage of what I believed to be a severe mis-pricing during intra-day market volatility in mid-March. But I hope to be a FB shareholder for a long time, and I'll explain why as concisely as I can.

Facebook is unquestionably a "growth" company in the sense that, over the past three years, they've grown operating income at a compound annual growth rate of 25%, on the back of 37% revenue growth, and they trade at a nominally high multiple - around 25x trailing earnings, and generate a fully levered, trailing free cash flow yield on enterprise value of just over 5%. But my contention is that at today's price, Facebook is trading at a bargain valuation. And the simple reason is that it is a near certainty (nothing is truly certain) that FB will continue to grow at near these rates over the next 5 to 7 years, well above the overall market, and regardless of the depth or length of recession that we are likely already in the midst of as a result of the Covid-19 pandemic. If you believe that, you should be running to the front of the line to buy FB shares yielding 5% on enterprise value and trading at a mere 1x PEG ratio vs last year's net income. Maybe I'll be able to convince you it's true with one datapoint from their Q4 earnings presentation:

In Q4 of last year, Facebook had 1.6B daily active users, 190M of which were located in the U.S. and Canada (roughly 11.4% of their user base). But Facebook generated, on average, $41 of revenue per user in the U.S. and Canada, which amounted to almost 49% of their revenue. In the rest of the world, FB hasn't yet monetized its user base to the same degree. Europe is closest at $13 in average revenue per user, but there's a long way to go before Facebook is generating $41 per year off of each of their 294M daily active European users.

That's it. That's all you need to understand. By the time that Facebook has monetized its user base, globally, to the same extent it has in the U.S., it's revenue base will be over 4x the size of where it is today. That's 5 years of ongoing 35% annual revenue growth that FB has in their pocket, so to speak. All they need to do is successfully execute in the Rest of the World the playbook that they have put in place in the U.S., and I understand there are differences in those markets from a regulatory perspective, and there are investments in cyber-security and privacy that need to be made. I know that ad revenue growth slows during a recession. But I also know that Facebook engages their users, and there is absolutely no reason to believe that engagement is almost 75% less attractive to European advertisers than it is to U.S. based marketers.

We haven't even talked about Instagram, which could grow into an excellent source of e-Commerce revenue for the company as merchandisers harness the power of Instagram as a visually enticing platform for shoppers. I haven't mentioned messenger or WhatsApp, which are home to Facebook payments and chatbots that can sell you anything from insurance to tennis shoes. At today's prices, you don't need to value those nascent business lines (which are too small to be broken out separately in FB financial reporting), in order to value FB.

That's how I define a bargain valuation, and I would challenge you to do the same. If the market has come up with some reason (ESG, user privacy, GDPR, recession) to undervalue a "growth" company trading at a reasonable, or even "high" multiple, that may be a better value than a "value" stock trading at a nominally low multiple of book or earnings.

Disclosure: I am long FB in Antrim's proprietary portfolio as well as my own personal retirement accounts. Neither Antrim nor myself has any business relationship with FB or any other company mentioned in this blog post.

Investment Philosophy: The Local Rock Pit

Investment Philosophy: The Local Rock Pit

In Chapter 8 of his book, One Up on Wall Street, Peter Lynch imagines a company with all of the characteristics that make for a perfect stock. Some of these characteristics (“There’s something depressing about it,” for example) feel quaint, though accessible. Others hint at technical glitches with the efficiency of the stock market’s price discovery process, like: “It’s a Spinoff” (Spin-offs are notorious for outperforming the market, for a whole host of reasons that will no doubt be the subject of future blog posts). All of his characteristics, however, are getting at the same thing: there has to be a reason that all those smart people on Wall Street haven’t discovered this fantastic opportunity and snatched it up for themselves, otherwise, you’re wrong, and you haven’t met the perfect stock.

But that doesn’t mean that there aren’t basic economic and business concepts that occasionally confuse the savviest of us.

Here’s a thought exercise: Would you rather own Walt Disney, Co., or a local rock pit?

The answer is Disney, obviously. This is my first blog post, I wasn’t going to ask a hard question. So why does Peter Lynch, formerly “America’s number-one money manager” according to the dust jacket of his own book, write, in Chapter 8: “I’d much rather own a local rock pit than own Twentieth Century Fox”? He’s obviously being a bit hyperbolic, but he’s trying to make a point about something economists might call, “competitive barriers to entry,” about which you, and I, and Peter might say, “it’s got a niche.” The owner of the local rock pit sells dirt, literally, which is used, in aggregate, as a construction and building material. Fox, on the other hand, is one of the most successful American film studios. It’s easy, conceptually, to shovel dirt. It’s a sight harder to manage the theatrical release of Ad Astra. But that doesn’t mean that Twentieth Century Fox doesn’t face competition. On the contrary, Warner Bros., Sony Pictures, Universal, and Paramount would have a bone to pick if you were to suggest as much.

But then, what about the local rock pit? After all, anyone can do it.

It turns out that in the vast majority of cases, localities have one, and only one, rock pit. Rocks are heavy, so it’s difficult to carry them long distances. So if you want rocks, you kinda gotta go to the local pit. That’s their niche. It may not be glamorous, but it’s a niche. And it means that as long as there are people who want rocks, there’s a job for the guy who owns the rock pit. That’s why Peter Lynch says he’d rather own the pit.

But to get back to the topic at hand — which is the philosophy of investment management — I would submit to you, dear reader, that even the cumulative, distributed genius of Wall Street professionals and the wisdom of crowds is no match for the occasional tendency to mistake something impressive for something rare, and that Wall Street’s vaunted, efficient price discovery mechanism sometimes — well — goofs.

Take a modern marvel of creativity and engineering, the Tesla (TSLA 168.47 -3.50 -2.04%) Model S. “Built for speed and endurance, with ludicrous acceleration, unparalleled performance, and a sleek aesthetic,” if you had asked Tesla to describe it themselves, that is. But really, it’s a great car. I want one, I don’t have one. Tesla, however, is not the local rock pit. Tesla is an auto manufacturer (among other things, but for the purpose of this discussion, we need only concern ourselves with their primary raison d’etre, which is to build cars). And as an auto manufacturer, they face some global competition. In particular, I am thinking of: General Motors, Ford, Fiat/Chrysler, Honda, and Toyota. I’m thinking about those five, because they are publicly traded on the NYSE, and because they are the five manufacturers with the largest market share in the United States as of January 8th of this year. These companies collectively represent over 2/3 of the domestic auto OEM industry. Tesla is dead last, with 1.1%. Now - that’s fine. Ferrari doesn’t have a huge market share either, and who wouldn’t want a Ferrari? But here’s what I find curious:

Tesla is the fourth largest by total enterprise value. They are a larger company by virtue of their equity valuation than Fiat/Chrysler and Honda combined. These are firms that are 10 times the size of Tesla by market share, and they are smaller by market cap. Does that mean that Wall Street has goofed? Have the geniuses running the world’s money lost their minds? I have my suspicions. But this is not where our analysis ends. This is where it begins.

The investor’s task, and the job of the equity analyst, is to identify a potential inefficiency (Tesla’s market cap doesn’t match their market share) and then determine why the market has put Tesla in this position. It’s to figure out if Tesla has a real niche that provides sustainable barriers to entry and foretells exorbitant future sales success and profitability, or if they are “merely” making a really cool car.

If you thought to actually buy shares of TSLA at this price, you would have to reasonably explain why it doesn’t matter that TSLA has never been profitable. You might want to know how, over the past year, Tesla generated nearly $900M of cash flow through “working capital.” You would have to assume that TSLA sales will quintuple, at least, just to justify its market cap in the upper echelons of the competitive automotive manufacturing industry, and you’d want to be able to justify your assumption. It’s not enough to know that Tesla has done something impressive. The equity analyst seeks to determine whether or not Tesla has done something that can’t be replicated. They seek to determine whether or not there are defining characteristics of Tesla’s success that are not appreciated by other market participants. And they seek to determine whether or not Tesla will ultimately live up to the other analysts’ expectations.

I’d rather just own the rock pit.

Disclosure: I have no positions in any of the stocks mentioned herein, and no plans to initiate a position in any of those stocks in the next 72 hours. I have no business relationship with any company mentioned in this post, and I am not being compensated for its publication.

This is a blog post, and it is not intended as a recommendation to buy or sell any of the securities to which it refers.

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