The full article can also be found at the Horizon Kinetics' website.
For 2011, the Core Value strategy was down approximately 11% and, for the second consecutive year, has returned less than the broad stock market. It is not desirable and, one may take it for granted, not our wish to produce negative returns or to underperform the average equity. Nor have we over time. What is happening now? First, our portfolio does not look very much like the average equity fund. In order to perform very much like the market, a portfolio must look very much like it. In the 16-year history of Core Value, it has differed from the market by more than 10% points in 7 separate years, and by 5 percentage points or more in 12 separate years. This is considered to be a very large divergence. Core Value generally does not own what is popular, since that which is popular tends to be overpriced, which is why it did not contain technology or communications stocks in 1999 and 2000. And during the past 2 years it has not owned large-capitalization, major-index stocks since these likewise are overpriced. In this regard, we are in good company with many noted value-oriented managers who have also experienced negative returns this past year. Almost by definition, if one does not own what is popular, then one cannot be doing as well as that which is popularâuntil that condition changes.
It is important to understand the reasons why the sorts of companies in our portfolios are distinctly unpopular at this time, because we are now in a bubble phase. This is a topic we began to address in the prior quarterly review, one that has affected all sectors of the market. However one invests, one is well advised to understand the character of this particular bubble, since it also has important implications for the mainstream, index-associated portion of the equity markets, which has experienced increased volatility, increased correlations and valuation excesses. The balance of this letter will review elements of this bubble, why the trend creating it has begun to exhaust itself, and, of course, certain holdings in the portfolio.
First, though, it should be said that the performance of the strategy in 2011 is related to share price, a temporary phenomenon associated with the bubble, and not with the quality or intrinsic risk of the investments: as a group, these companies are quite profitable, maintain liquid balance sheets and are managed by owner-operators. These are highly successful individuals who are typically their companiesâ largest shareholders and their equity typically represents a large or dominant portion of their personal wealth, such that they have the greatest self-interest in the appreciation of those shares.
The performance cannot be due valuation: as a group, this is an extraordinarily discounted set of businesses. They can be readily demonstrated to provide superior financial returns to the broad equity market. Since they have few serious competitive threats, balance sheet or regulatory issues that might cause such price behavior, there must be some other factor at work.
Measuring the Indexation Phenomenon â the ETF-Driven Bubble
We previously wrote about the dramatic increase in assets invested in ETFs. For a sense of magnitude, since 1999, the number of ETFs has expanded from fewer than 100 to more than 1,100, even as the number of listed stocks in the U.S. has declined by one-third. This migration away from individual security selection was lent greater urgency by the 2008/2009 financial crisis: in the 3 years following 2007, the percentage of domestic equity mutual fund assets invested in index funds rose by 25% to 14.5%1 .
This seemingly modest market share greatly understates the extent of the shift to indexation. The flow of funds into ETFs has been over $1 trillion. Adding index mutual funds and assets that are indexed but in private accounts, the true figure is in the trillions of dollars. It also greatly understates their influence. For instance, the average daily turnover of both the SPDR S&P 500 ETF (ticker âSPYâ) and the iShares Russell 2000 ETF (âIWMâ), which is intended to measure the small-capitalization sector of the stock market) exceed 50% of their market capitalization; phrased differently, annual turnover is on the order of 12,000%, which is a historically unprecedented phenomenon and, frankly, astounding. The dollar value of all ETF shares traded now accounts for about 50% of total U.S. equity market trading2. For 2011, ETFs alone were responsible over $20 trillion of trading, which means that turnover for the entire group was 20x their $1 trillion of assets under management, or about 2,000%. This is a wave before which no amount of security selection talent can stand because, as discussed below, the funds flow is bifurcated in a very particular way that depresses the shares of some stocks as it inflates those of others.
Remaining for a moment with the topic of scale, weâll pose a question. What does it mean for investors when the liquidityâthe dollar volume of buying and sellingâof a derivative instrument such as an ETF is greater than that of its constituent parts? There is greater trading volume in the Russell 2000 ETF, for instance, than in many of the companies comprising it. It has been calculated that if IWM had to create a sufficient number of new units (provide liquidity) for the aggregate volume of short positions in IWM, it would take the ETF more than 180 days to buy all the component securities if it limits its buying to 10% of the average daily volume of each holding3. This extreme does not apply to the more liquid Russell 2000 holdings, and there are other mechanisms for providing liquidity in a continuous market, such as through derivatives, but clearly the daily liquidity needs of these large ETFs in creating new or destroying old units canât always be met in the open market.
Since the liquidity and daily trading volume of some of the largest ETFs now exceed the liquidity of the stocks that comprise the index, this phenomenon has reached a critical point: indexes, which are meant to measure the performance of, and provide exposure to, groups of stocks, have come to distort the prices of the stocks they are meant to measure â one of the great sorts of ironies that arise from bubble behavior. Paradoxically, the trauma of the 2008/2009 financial crisis, which instigated a surge by investors into these instruments as a tool to diversify their holdings in order to reduce overall portfolio volatility has, by the magnitude of these efforts, actually contributed to the increasingly lockstep movements among indexes. It has driven both correlations and volatility to levels last witnessed in 1929 (more of which later).
The Impact of the ETF Bubble on Valuation â The ETF Divide
ETFs donât merely purchase securities, they also donât purchase them. For the ETF creator it is critical to gather a very large volume of assets, since it is a very low-fee business. In turn, the scalability of any ETF, and therefore its profitability, is ultimately dependent upon the liquidity of its least liquid member, because that member will be the first security to generate a limitation in terms of the volume of assets that can be raised. There is only so much of that security that can be purchased. Therefore, ETF manufacturers choose to exclude companies with more modest market capitalizations or even large ones if they have limited share float. The valuation discrepancy across the ETF divideâthose companies that are included in major and multiple ETFs versus those that are excludedâis becoming so severe that the two groups are beginning to exhibit very different valuation and variability characteristics.
A simple illustration of the ETF valuation divide follows. It uses REITs, but the exercise could be repeated with virtually any other industry sector or even asset class. The first table below includes popular real estate equities. These companies are well managed and reasonably well financed. Included in the table is the number of ETFs for which each company is among the top ten individual holdings. Also included are the dividend yields and price-to-book ratios, two commonly used valuation metrics for this sector. While two of the companies can each be found in twenty ETFs, most number in the high teens, and one in this list, Health Care REIT, is in the top ten of only nine.
The second table lists some ânot-so-popularâ real estate equities, so termed because, generally speaking, they are not included in the top ten individual holdings of many (or any) ETFs. In those cases where they are present in the top ten, the ETF in question is very small and the company represents a relatively low weighting. One should not assume that a companyâs presence in an ETF means that it has attained a level of acceptance among investors; if the ETF itself has not gained acceptance, inclusion in that ETF does not represent acceptance. If one compares the two tables, one can see that the typical yield for the less popular REITs is twice that of a conventional, popular REIT, and the average price to book ratio is half. This is a very large discrepancy, one that would not, historically, have existed.
This valuation difference cannot be ascribed to qualitative factors such as balance sheet risk. This is commonly measured in real estate companies by debt-to-equity ratio. Real estate companies have been reducing their leverage for the past four years, and that's true of the popular and the non-popular REITs. The table on the following page shows the debt-to-equity ratios for the two groups as they existed at the end of September 2011. They are similar; neither group is very leveraged by these standards.
This circumstance feels much like the 1999-2000 bubble period, when blue-chip equities were discarded in favor of technology, internet, and telecommunications stocks. At least for a time. In the current version of that phenomenon, companies that were already constituents of major indexes continue to receive their proportionate share of fund inflows, even if they have poor fundamentals or are strategically challenged businesses, such as those subject to technological obsolescence by the ascendance of the smartphone, the tablet computer, or the increasingly free access to media content through such portable devices. It is the first time in history that the mode of investing in equities is done with complete disregard for the evaluation of the individual companies whose shares are being purchased. Accordingly, many of the S&P 100 companies trade at far higher valuations than they otherwise might.
As to other types of companies, such as the owner-operators, the inverse dynamic operates. The owner-operator companies, which constitute a major element of the Core Value strategy, are particularly prone to being on the wrong side of the ETF divide. Due to heavy inside ownership, they often have more limited float and are accorded correspondingly lower weights if they are in an index. Ironically, as an owner-operator company repurchases shares, typically an anti-dilutive action, their float decreases, as we discussed our third quarter commentary. This forces the ETF manufacturer to reduce the companyâs weight in the index, if it is in an index, which in turn requires share sales by any index-based holders. Thus, when well-regarded insiders buy, index-based investors must sell.
As well, many owner-operator companies are also multi-industry companies that do not qualify for the many sector-specific ETFs. As a consequence, they are among the most discounted of sectors, although they are not, of course, recognized as a sector. In the table below, a selection of holdings in Horizon Kineticsâ strategies is compared with selected major S&P 500 Index constituents, as to the number of ETFs in which they are among the top 10 holdings. Clearly, Horizon Kinetics holdings tend to be on the wrong side of the ETF divide (as they are intended to be).
The one exception in the table above (right), Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), was a top 10 holding of 20 ETFs as of December 27, 2011. There are a number of anomalies attached to this. It is worthy of note that Berkshire Hathaway is a major holding of the Financial Sector Select SPDR (XLF). In fact, as of January 13, 2012, Berkshire Hathaway is the second largest holding of XLF, the top 10 constituents of which include Wells Fargo (WFC, Financial), JP Morgan Chase (JPM, Financial), Citigroup (C, Financial), Bank of America (BAC, Financial), U.S. Bancorp (USB), and Goldman Sachs (GS, Financial). From the perspectives of balance sheet construction and risk, one of these things is not like the others; aside from not being a leveraged, spread-based business like a bank or investment bank, Berkshire Hathaway owns shares of Wells Fargo, which is the largest position in XLF, and of U.S. Bancorp and American Express, which are the sixth- and seventh-largest. Berkshire Hathaway also has interests in other major S&P 500 companies such as IBM, Johnson & Johnson and Kraft. It also wholly owns many companies, such as Mid-American Energy and Burlington Northern that are comparable to S&P 500 Index companies.
Yet, the irony here is that even though Berkshire is a major ETF constituent and although a large part of its balance sheet is comprised of S&P 500 type companies, Berkshire underperformed the S&P 500 Index by approximately 10% in 2011. There is a large short position in XLF, which, in turn, means that there is a short position in Berkshire Hathaway. As of December 30, 2011, the short interest in Berkshire Hathaway Class B shares was 12.4M shares, or 1.3% of the float. Historically, Berkshire Hathaway was owned mainly by long-term investors. However, as XLF is among the most actively traded ETFs, with average trading volume of 125 million shares a day, in principle the ownership of the ETF (and therefore the stocks underlying it) turns over 100% every 72 hours. This is perhaps another example of indexation, presumed to be measuring price movement and granting broad exposure, in fact impacting the price of the securities it is intended to measure.
The Seeds of the Bubble Reversal
This, then, is a form of bubble, if one definition is the flow of funds into a sector or securities irrespective of fundamental merit or valuation. When that continues for too long, excesses arise. It is inevitable. Like all bubbles, it will reverse. When? An external issue may be legislative. Many of the statistics cited in this letter are drawn from a recent presentation to the U.S. Senate Committee on Banking, Housing and Urban Affairs, the prepared remarks for which are entitled ETFs and the Present Danger to Capital Formation4. The concern is systemic risk; thatâs a nasty term nowadays.
Those hearings aside, this particular multi-trillion dollar wave of dysfunctional behavior appears to be exhausting itself. In conceptual terms, the rising correlations of equity securities globally must reduce the utility of indexation to index buyersâa major benefit of the variety of new indexes was the presumed benefit of alternative correlations in the service of reduced portfolio volatility. Concurrently, there is increasing pressure for fee compression amongst the index and ETF providers. If a product loses its utility to both the buyers and the sellers, then its business purpose becomes obsolete.
There are indicators that such a reversal is already in development. Hereâs one: BlackRock, which acquired iShares from Barclays as a benefit of the financial crisis, is the largest provider of ETFs. It has over $70 billion of assets merely in emerging markets based ETFs. Its fees are generally in the range of 35 to 70 basis points, and it has been managing some of these for a decade. But then along came Vanguard, which has been establishing, only in the last few years, ETFs for the same major indexes that represent significant assets at BlackRock. Vanguard charges 12 to 25 basis points for the very same product. And Vanguard is gathering assets rapidly. During the first 9 months of 2011, BlackRockâs MSCI Emerging Markets ETF experienced asset outflow of $10.9 billion even as Vanguardâs MSCI Emerging Masrkets ETF gained $7.2 billion. Fee compression on scores of billions of dollars of assets represents pure loss of pre-tax income to BlackRock. Itâs a serious problem. They would like to maintain their fees.
What are they doing? On September 1st, 2011, BlackRock filed for SEC permission to offer 13 actively managed ETFs that would not have to disclose their holdings daily. They already had permission to sell active ETFs that offer daily transparency. This would permit them to offer not merely exposure to a sector or batch of stocks, but the possibility of outperformingâand maintaining or raising their fees. If BlackRock is doing that, so must its competitors. Eaton Vance filed for the same exemptive relief shortly thereafter. How do you outperform an index? To state the obvious, if the notion is to maintain a fee structure by offering the possibility of outperforming an index, then one of the only avenues available is to select companies that are: 1) not in the index, and 2) offer the possibility of idiosyncratic returns, as, maybe, from stocks selling below book value or below NAV, or that have superior measures of business return yet are less expensive than the index. In other words, you select stocks which are on the wrong side of the ETF divide, the sorts of stocks we own. The wave of fund flows into indexation has been huge and of bubble proportions. When that wave reverses and comes coursing back, it will try to move through a universe of stocks with a limited market capitalization and limited float. The impact would be large, indeed. And it might not be long in coming.
Now, the current discounts are not a terrible circumstance from the point of view of a value investor who can acquire companies on the âwrong sideâ of the ETF divide. An investor desiring exposure to real estate equities, for instance, can purchase a real estate ETF, likely priced at a 3.5% yield and 2.5x book value, or a group of comparable non-indexed companies, such as the table of ânot-so-popularâ REITs, above, at a 7% yield and 1.25x book value. Venture into individual stock selection, instead of basket selection, and the valuations can be fractions, not multiples, of book value. The only catch is to wait, though as just discussed, the wait might not be all that long. One day, history will record yet another of those odd periods when investors could have purchased all manner of stocks at multi-decade low valuations, almost indiscriminately, but missed out in their enthusiasm for a particular passion of that era.
Holdings Review
This section will focus on three companies: one new, and two existing positions. The existing ones were chosen for us by dint of popular vote; one because the share price has declined sharply, the other because the share price has risen sharply. Specific questions have been asked about each, but there are really two underlying questions, which really are the same question: 1) why havenât the Sears Holdings shares been sold, since it is such an abysmally poor retailer and the shares are down so much?, and 2) why havenât the MasterCard shares been sold, since although the operations are great, the shares are up so much? I suppose there is an even simpler underlying question: will you hold Sears until the shares sink toward zero, and will you hold the Master Card until you lose the large gain? Or, plainer still, why donât you sell the losers before they go down, and sell your winners while you still canâyou know, trade, man!
Sears Holdings (SHLD, Financial)
Everyone knows Sears, no one likes it. I mean it; Iâve met no one outside of Horizon Kinetics who likes Sears. Nearly every person in this country of driving age has had an opportunity to be dismayed by the shopping experience (there are probably a few square feet of Sears floor space for every U.S. household). As an aside, let it be stated that we donât love or even like Sears either; it is an investment and is judged on its investment merits. It is one of many investments, nothing more, nothing less. There has been much said and written about the company, some of it scathing, some witty, all of it negative. And, applied to Sears as a retail store business, it is all true; virtually every successive management decision over the course of six years has been either naĂŻve, misguided, incompetent, or arrogantâif Sears is viewed as a department store company. This includes the initial decision to curtail the advertising budget, the reduction of inventories, the reduction in sales staff, the disinvestment in the physical infrastructure, and the succession of chief executive officers, the latest with not a bit of prior retailing experience. While Sears has spent billions on share repurchases, its competitors like Target spent billions on store reformatting and refurbishment. As one retail analyst scoffed, âcustomers donât care about the price of the stock; they care about the price on the shelf.â Valued on its retail sales and operating income, Sears stock is a decidedly unappealing sight.
Yet, if viewed as a real estate company, virtually every management decision has been logical. This was the initial investment thesis when the position was established: that the ultimate value of the real estate was worth more than the market capitalization of the company, and that the realization of that value would be a long-term prospect, since it appeared that the controlling shareholder, Eddie Lampert, was intent on first maximizing the cash flow available from the retail business. Indeed, since 1996, the repurchase of shares has increased the amount of real estate owned per share by over 50%, which is no small matter. If Sears has been engaged in a long-term end game of capitalizing the real estate, then there would necessarily have to come a time when the stores would begin to reach a point of diminishing returns. Eight years after Mr. Lampert became chairman, this appears to be happening to at least some of the stores, and those are being closed; they are not being supported with additional spending. What might seem to be a manifestation of failure, and of an uglier and uglier picture as a retailer, is simply one step in a long end game as a realtor. If I were the controlling shareholder of Sears, I might do the same; so might you. In fact, the original thesis cannot be fulfilled unless the stores are eventually sold, and they are unlikely to be sold if they are highly profitable. Unfortunately, if some become unprofitable and are sold, we are asked why we purchased the stock of a failing retailer.
The retailing environment is far poorer today than it was several years ago, and no doubt poorer than Mr. Lampert could have anticipated at the beginning of this process, and that certainly affects the clearing price of retailing real estate. So what is the clearing price? We cannot really know without the sort of inside knowledge that the CEO or Chairman has. Nevertheless, a variety of sources tend to confirm that a rough average price for mall-type real estate, to build or buy, is roughly $225 per square foot, although individual values can be less than one-half or more than twice that figure. Of the roughly 4,000 Sears stores, some 800 are owned, and these encompass roughly 93 million square feet. If, merely for momentary consideration, these are worth $200 per square foot, then this real estate is worth $18 billion, or $168 per share; at only $100 per square foot, the per-share value would be $85. If one subtracts both the companyâs net debt and capital lease obligations (net of cash) and pension and post-retirement liability obligations of $33 per share, then the net value of the real estate is $52 per share. Moreover, the balance sheet has been arranged such that it will not be until 2016 that the first major debt maturities and credit line expirations take place. Thus, there will be a good four years for retailing and housing (Sears sells the white goodsârefrigerators, washing machines and dishwashers)âto recover, for capitalization rates to improve, and for optionality to be realized within this enormous real estate portfolio. Aside from the owned stores there is reason to believe that there are many long-term, below-market leases among the 3,000-plus leased stores. These, too, have value as real estate. As does the companyâs 2 million square feet of owned office space at its headquarters in the Hoffman Estates suburb of Chicago. There are other assets, too. Aside from whatever values are attached to the brands that it owns (for example, Craftsman tools, Kenmore, Landâs End and DieHard car batteries), Sears is also a major internet presence: it was listed as the 7th largest internet retailer in 2011 by Internet Retailer, directly behind Walmart.com.
We will certainly continue to evaluate events as they unfold and monitor this holding. To date, though, the basis for this investment still operates. As an end note, on January 9th, 10th, and 11th, which were days during which the Sears stock traded at its lowest share price since 2004, Mr. Lampert increased his personal holdings of Sears by over 5.4 million shares priced at some $162 million. At the January 13th closing price of $33.56, his total shareholdings are worth more than $750 million.
MasterCard (MA, Financial)
MasterCard shares were purchased in Core Value as a 1% position in July 2008 at a price of approximately $281, when the balance sheet included $1.4 billion of obligations under a legal settlement with the U.S. Department of Justice. Analysts gave considerable weight to this issue as a risk. By January 2009, the shares had declined by over 55%, far more than the broad market. The initial purchase price was equivalent to a P/E of 26x 2008 earnings (excluding the impact of a $1.6 billion litigation charge that caused a net reported loss), and 25x 2009 earnings. In February 2009, when the shares were approximately $158, we increased the position by 150%. We would characterize both the initial as well as the subsequent purchase as value-based. Hereâs why.
MasterCard and Visa (V, Financial) function as a virtual duopoly in providing the transaction processing infrastructure for credit cards, charging a variety of fees for each transaction. Part of the competitive barrier to entry is the enormous cumulative investments they have made over the decades. This affords some pricing power, and their returns on invested capital are among the highest one can find among publicly traded companies. It is also a high fixed-cost, low marginal cost businessâthe marginal cost of an incremental transaction is quite small, such that an increase in transaction volumes can result in expanding profit margins. At the time of the first purchase, this phenomenon was readily observable. As well, MasterCard, which had its IPO in 2006, manifested much lower profit margins than Visa, and there was no obvious structural reason why its profitability could not converge toward that of Visa; absent any other operating dynamics, such convergence alone would add a lot to MasterCardâs profitability.
An additional qualitative strength of the MasterCard business was that over one-quarter of revenues in 2009 derived from what might broadly be described as emerging markets, and those revenues were expanding at double-digit annual rates even as the companyâs major developed markets, the U.S. and Europe, contracted or grew modestly. Penetration rates in emerging markets are low and the ultimate expansion potential significant.
Accordingly, based upon an expectation of normalized profitability a few years forward, anticipating the effacement of the litigation liabilities, the advancement of revenues through overseas growth, and the scale and efficiency benefits of that growth, we considered MasterCard, which was otherwise debt-free, to be an undervalued, not overvalued, stock of extraordinarily high quality. As one measure of business quality, the companyâs return on average equity in 2009 was 53%; its return on assets, at 21%, exceeded most companiesâ ROE.
As of year-end 2011, MasterCard closed at $372. Having risen by about a third from the initial purchase price in a flat market, and by about two-thirds in 2011, also in a flat market, we are being asked whether this position should have been sold or whether it ought not to be sold. Why, exactly, havenât we sold it? Perhaps we will. There is an ongoing need in the portfolio for sources of funds to acquire some of the very well-managed businesses that, being on the wrong side of the ETF divide, trade near or below book value or at double-digit earnings yields (single-digit P/E ratios). But due process is in order before the rope is brought out.
First, through operating profits, MasterCard effaced substantially all $1.4 billion of its litigation settlements liabilities by year-end 2010; the balance was paid off in 2011. Not being a business that requires substantial ongoing capital expenditures, net income, now in the $2.5 billion range, is approximately equal to free cash flow. Having dispensed with its only substantive liability, and since the business does not require much reinvestment, the two basic uses for its free cash flow (other than for acquiring other businesses, which are hardly likely to be as profitable), are to pay dividends or to repurchase shares. Since the ROE in the first 9 months of 2011 was roughly 45%, repurchase of shares is, on its face, a financially high-return investment. The company has begun to repurchase shares; this amounted to $1.1 billion during the first 9 months of 2011.
As to the balance sheet, cash now exceeds total liabilities. Operationally, revenues during the first 9 months of 2011 were 22% higher than in the prior-year period, and net income 31% higher; earnings-per-share, a result of the share repurchases, were 34% higher. The net margin expansion dynamic described above has continued, as displayed below:
Wall Street analystsâ consensus earnings for 2012 are $21.72 per share, which is consistent with a 36.5% net margin on sales that are 12%+ higher than in 2011. On this basis, the shares trade at 17.2x this yearâs expected earnings. This is similar enough to the third quarterâs run-rate annual income, which would be $22.52 per share. On this measure, the shares are far less expensive than when they were first purchased.
There is now a new facet to earnings growth. At a P/E of 17x, the company could repurchase about 1/17 of its shares annually, and without resorting to borrowing (although that would also be accretive). This would add an additional 5.9% per year to the earnings progress of the basic business. This could go on for a very long time.
Some find the benefits of share repurchases on this order, which can require many years to become effective, difficult to appreciate. An exercise with more immediacy would be to presume that the company shifts to a dividend payout strategy. If the company were to distribute 75% of its earnings (per consensus estimates), yet still retain some $700 million annually for other purposes, the dividend would be about $16.30. What dividend yield would the investing public desire/require from MasterCard? The S&P 500 Index dividend yield is 2.2%. One can hardly suggest that MasterCard, based upon the most basic metrics of revenue expansion rate, return on equity, and balance sheet characteristics, is not far superior to the average S&P 500 Index company. If MasterCard, in this exercise, were to yield 2.2%, the shares would trade at $741; at the current MasterCard share price of $372, it trades at a 4.4% yield.
This speaks to the valuation question. It is clear that MasterCard trades at a higher P/E ratio than that of the S&P 500 Index. It is clear that MasterCard is a far superior company, with remarkably high returns on invested capital, and a valuation that could be supported by absolute measures such as dividend yield. It presents a certain valuation/quality/return profile. There are, as well, companies that trade at deep discounts to the S&P 500 Index and which are also demonstrably superior companies, and thus present an alternative valuation/quality/return profile. The choices of what to purchase, what to sell, and what to retain will be made, as always, on the basis of incomplete and imperfect information that is made available to portfolio managers, as always with the aim of improving the portfolioâit will always seem like a good idea at the time.
Air Lease Corp. (AL, Financial)
Air Lease is the second coming of Steven Udvar-Hazy. In 1973, Mr. Udvar-Hazy co-founded what became International Lease Finance Corp. (âILFCâ), and in doing so established a new industry: leasing commercial aircraft to airline companies. He was successful both in concept and execution. ILFC, which is the worldâs largest aircraft lessor, was sold to American International Group (âAIGâ) in 1990 for $1.3 billion. Mr. Udvar-Hazy remained CEO of ILFC until 2009, and retired from AIG in February 2010. By April 2011, he had engineered the IPO of a new aircraft lessor, Air Lease, bringing with him ILFCâs senior officers, who had worked for him there since 2002.
The basis for this new venture appears to be the reluctance of AIG to invest in the business. The two largest aircraft lessors are owned by diversified financial companies, the 2nd being GE Capital, which, like other major finance companies, is shrinking its balance sheets. Yet, this is occurring at what seems to be an opportune moment to allocate additional capital to the business:
âËâ On a secular basis, airlines continue to increase their use of leasing. The proportion of aircraft fleets leased was about 0% in 1973, about 20% 25 years later in 1998, and 35% 12 years later in 2010. Leasing permits airlines to deploy their insufficient capital elsewhere, to more readily expand and diversify their fleets, and is a particularly helpful mechanism for new, rapidly expanding low-cost airlines such as abound in emerging economies.
âËâ The airline industry is expanding. Historically, passenger traffic has increased on a 1:1 basis with world GDP growth, but most of that growth has been coming from emerging economies. Asia/Pacific traffic, for instance, which was 17% of world traffic in 1990, was 29% in 2010. Therefore, market size expansion in the next decade should be greater than in the decade prior.
âËâ As mentioned, some of the largest aircraft lessors, like ILFC, are policy constrained with regard to expanding their capital base.
âËâ The cost of capital, which is to say interest rates, has never been as low.
Accordingly, Mr. Udvar-Hazy is entering a market that is growing in overall size, for which penetration of this particular service is also expanding, in which major competitors are constrained, and for which expansion capital is cheap. Certainly, he knows how to build such a business.
The worldwide commercial aircraft inventory is a far more stable figure than one might infer, given the cyclicality in passenger traffic. Inventory has trended up even during downturns, as orders placed during a preceding cyclical upturn in traffic are ultimately delivered. Borrowing from ILFCâs financial statements for reference, revenues and earnings of that company increased sequentially between 2005 and 2009, even through the financial crisis and the decline in passenger traffic during 2008 and 2009. Neither, compared with most finance companies, do aircraft lessors use a great deal of leverage; ILFCâs debt to equity ratio in 2009 was 3.5x, and its interest coverage ratio was also 3.5x.
Leases are typically net leases, under terms that require the lessee to pay all operating expenses, including insurance and maintenance, and to return the aircraft in a condition that conforms to a detailed set of qualitative criteria.
With $2.2 billion of equity capital raised in the IPO and a prior private placement, and $1.8 billion of borrowings, Air Lease has so far acquired $3.4 billion of planes, which numbered 79 as of September 30th. It has contracted to purchase another 126 aircraft between year-end 2011 and 2015, plus another 95 thereafter. It is in an early expansion phase.
As to valuation, current earnings cannot be used; they are not yet at normalized levels, since the current balance sheet can support a greater amount of operating assets than are yet in place. However, our position was established at only about 5% to 10% above book value and about 20% below the stockâs closing price on the day of its IPO last April.
DISCLAIMER
Past performance is not indicative of future returns. This information should not be used as a general guide to investing or as a source of any specific investment recommendations, and makes no implied or expressed recommendations concerning the manner in which an account should or would be handled, as appropriate investment strategies depend upon specific investment guidelines and objectives. This is not an offer to sell or a solicitation to invest.
This information is intended solely to report on investment strategies as reported by Horizon Kinetics LLC. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. Under no circumstances does the information contained within represent a recommendation to buy, hold or sell any security, and it should not be assumed that the securities transactions or holdings discussed were or will prove to be profitable.
No part of this material may be: a) copied, photocopied, or duplicated in any form, by any means; or b) redistributed without Horizon Kineticsâ prior written consent.
For 2011, the Core Value strategy was down approximately 11% and, for the second consecutive year, has returned less than the broad stock market. It is not desirable and, one may take it for granted, not our wish to produce negative returns or to underperform the average equity. Nor have we over time. What is happening now? First, our portfolio does not look very much like the average equity fund. In order to perform very much like the market, a portfolio must look very much like it. In the 16-year history of Core Value, it has differed from the market by more than 10% points in 7 separate years, and by 5 percentage points or more in 12 separate years. This is considered to be a very large divergence. Core Value generally does not own what is popular, since that which is popular tends to be overpriced, which is why it did not contain technology or communications stocks in 1999 and 2000. And during the past 2 years it has not owned large-capitalization, major-index stocks since these likewise are overpriced. In this regard, we are in good company with many noted value-oriented managers who have also experienced negative returns this past year. Almost by definition, if one does not own what is popular, then one cannot be doing as well as that which is popularâuntil that condition changes.
It is important to understand the reasons why the sorts of companies in our portfolios are distinctly unpopular at this time, because we are now in a bubble phase. This is a topic we began to address in the prior quarterly review, one that has affected all sectors of the market. However one invests, one is well advised to understand the character of this particular bubble, since it also has important implications for the mainstream, index-associated portion of the equity markets, which has experienced increased volatility, increased correlations and valuation excesses. The balance of this letter will review elements of this bubble, why the trend creating it has begun to exhaust itself, and, of course, certain holdings in the portfolio.
First, though, it should be said that the performance of the strategy in 2011 is related to share price, a temporary phenomenon associated with the bubble, and not with the quality or intrinsic risk of the investments: as a group, these companies are quite profitable, maintain liquid balance sheets and are managed by owner-operators. These are highly successful individuals who are typically their companiesâ largest shareholders and their equity typically represents a large or dominant portion of their personal wealth, such that they have the greatest self-interest in the appreciation of those shares.
The performance cannot be due valuation: as a group, this is an extraordinarily discounted set of businesses. They can be readily demonstrated to provide superior financial returns to the broad equity market. Since they have few serious competitive threats, balance sheet or regulatory issues that might cause such price behavior, there must be some other factor at work.
Measuring the Indexation Phenomenon â the ETF-Driven Bubble
We previously wrote about the dramatic increase in assets invested in ETFs. For a sense of magnitude, since 1999, the number of ETFs has expanded from fewer than 100 to more than 1,100, even as the number of listed stocks in the U.S. has declined by one-third. This migration away from individual security selection was lent greater urgency by the 2008/2009 financial crisis: in the 3 years following 2007, the percentage of domestic equity mutual fund assets invested in index funds rose by 25% to 14.5%1 .
This seemingly modest market share greatly understates the extent of the shift to indexation. The flow of funds into ETFs has been over $1 trillion. Adding index mutual funds and assets that are indexed but in private accounts, the true figure is in the trillions of dollars. It also greatly understates their influence. For instance, the average daily turnover of both the SPDR S&P 500 ETF (ticker âSPYâ) and the iShares Russell 2000 ETF (âIWMâ), which is intended to measure the small-capitalization sector of the stock market) exceed 50% of their market capitalization; phrased differently, annual turnover is on the order of 12,000%, which is a historically unprecedented phenomenon and, frankly, astounding. The dollar value of all ETF shares traded now accounts for about 50% of total U.S. equity market trading2. For 2011, ETFs alone were responsible over $20 trillion of trading, which means that turnover for the entire group was 20x their $1 trillion of assets under management, or about 2,000%. This is a wave before which no amount of security selection talent can stand because, as discussed below, the funds flow is bifurcated in a very particular way that depresses the shares of some stocks as it inflates those of others.
Remaining for a moment with the topic of scale, weâll pose a question. What does it mean for investors when the liquidityâthe dollar volume of buying and sellingâof a derivative instrument such as an ETF is greater than that of its constituent parts? There is greater trading volume in the Russell 2000 ETF, for instance, than in many of the companies comprising it. It has been calculated that if IWM had to create a sufficient number of new units (provide liquidity) for the aggregate volume of short positions in IWM, it would take the ETF more than 180 days to buy all the component securities if it limits its buying to 10% of the average daily volume of each holding3. This extreme does not apply to the more liquid Russell 2000 holdings, and there are other mechanisms for providing liquidity in a continuous market, such as through derivatives, but clearly the daily liquidity needs of these large ETFs in creating new or destroying old units canât always be met in the open market.
Since the liquidity and daily trading volume of some of the largest ETFs now exceed the liquidity of the stocks that comprise the index, this phenomenon has reached a critical point: indexes, which are meant to measure the performance of, and provide exposure to, groups of stocks, have come to distort the prices of the stocks they are meant to measure â one of the great sorts of ironies that arise from bubble behavior. Paradoxically, the trauma of the 2008/2009 financial crisis, which instigated a surge by investors into these instruments as a tool to diversify their holdings in order to reduce overall portfolio volatility has, by the magnitude of these efforts, actually contributed to the increasingly lockstep movements among indexes. It has driven both correlations and volatility to levels last witnessed in 1929 (more of which later).
The Impact of the ETF Bubble on Valuation â The ETF Divide
ETFs donât merely purchase securities, they also donât purchase them. For the ETF creator it is critical to gather a very large volume of assets, since it is a very low-fee business. In turn, the scalability of any ETF, and therefore its profitability, is ultimately dependent upon the liquidity of its least liquid member, because that member will be the first security to generate a limitation in terms of the volume of assets that can be raised. There is only so much of that security that can be purchased. Therefore, ETF manufacturers choose to exclude companies with more modest market capitalizations or even large ones if they have limited share float. The valuation discrepancy across the ETF divideâthose companies that are included in major and multiple ETFs versus those that are excludedâis becoming so severe that the two groups are beginning to exhibit very different valuation and variability characteristics.
A simple illustration of the ETF valuation divide follows. It uses REITs, but the exercise could be repeated with virtually any other industry sector or even asset class. The first table below includes popular real estate equities. These companies are well managed and reasonably well financed. Included in the table is the number of ETFs for which each company is among the top ten individual holdings. Also included are the dividend yields and price-to-book ratios, two commonly used valuation metrics for this sector. While two of the companies can each be found in twenty ETFs, most number in the high teens, and one in this list, Health Care REIT, is in the top ten of only nine.
The second table lists some ânot-so-popularâ real estate equities, so termed because, generally speaking, they are not included in the top ten individual holdings of many (or any) ETFs. In those cases where they are present in the top ten, the ETF in question is very small and the company represents a relatively low weighting. One should not assume that a companyâs presence in an ETF means that it has attained a level of acceptance among investors; if the ETF itself has not gained acceptance, inclusion in that ETF does not represent acceptance. If one compares the two tables, one can see that the typical yield for the less popular REITs is twice that of a conventional, popular REIT, and the average price to book ratio is half. This is a very large discrepancy, one that would not, historically, have existed.
This valuation difference cannot be ascribed to qualitative factors such as balance sheet risk. This is commonly measured in real estate companies by debt-to-equity ratio. Real estate companies have been reducing their leverage for the past four years, and that's true of the popular and the non-popular REITs. The table on the following page shows the debt-to-equity ratios for the two groups as they existed at the end of September 2011. They are similar; neither group is very leveraged by these standards.
This circumstance feels much like the 1999-2000 bubble period, when blue-chip equities were discarded in favor of technology, internet, and telecommunications stocks. At least for a time. In the current version of that phenomenon, companies that were already constituents of major indexes continue to receive their proportionate share of fund inflows, even if they have poor fundamentals or are strategically challenged businesses, such as those subject to technological obsolescence by the ascendance of the smartphone, the tablet computer, or the increasingly free access to media content through such portable devices. It is the first time in history that the mode of investing in equities is done with complete disregard for the evaluation of the individual companies whose shares are being purchased. Accordingly, many of the S&P 100 companies trade at far higher valuations than they otherwise might.
As to other types of companies, such as the owner-operators, the inverse dynamic operates. The owner-operator companies, which constitute a major element of the Core Value strategy, are particularly prone to being on the wrong side of the ETF divide. Due to heavy inside ownership, they often have more limited float and are accorded correspondingly lower weights if they are in an index. Ironically, as an owner-operator company repurchases shares, typically an anti-dilutive action, their float decreases, as we discussed our third quarter commentary. This forces the ETF manufacturer to reduce the companyâs weight in the index, if it is in an index, which in turn requires share sales by any index-based holders. Thus, when well-regarded insiders buy, index-based investors must sell.
As well, many owner-operator companies are also multi-industry companies that do not qualify for the many sector-specific ETFs. As a consequence, they are among the most discounted of sectors, although they are not, of course, recognized as a sector. In the table below, a selection of holdings in Horizon Kineticsâ strategies is compared with selected major S&P 500 Index constituents, as to the number of ETFs in which they are among the top 10 holdings. Clearly, Horizon Kinetics holdings tend to be on the wrong side of the ETF divide (as they are intended to be).
The one exception in the table above (right), Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), was a top 10 holding of 20 ETFs as of December 27, 2011. There are a number of anomalies attached to this. It is worthy of note that Berkshire Hathaway is a major holding of the Financial Sector Select SPDR (XLF). In fact, as of January 13, 2012, Berkshire Hathaway is the second largest holding of XLF, the top 10 constituents of which include Wells Fargo (WFC, Financial), JP Morgan Chase (JPM, Financial), Citigroup (C, Financial), Bank of America (BAC, Financial), U.S. Bancorp (USB), and Goldman Sachs (GS, Financial). From the perspectives of balance sheet construction and risk, one of these things is not like the others; aside from not being a leveraged, spread-based business like a bank or investment bank, Berkshire Hathaway owns shares of Wells Fargo, which is the largest position in XLF, and of U.S. Bancorp and American Express, which are the sixth- and seventh-largest. Berkshire Hathaway also has interests in other major S&P 500 companies such as IBM, Johnson & Johnson and Kraft. It also wholly owns many companies, such as Mid-American Energy and Burlington Northern that are comparable to S&P 500 Index companies.
Yet, the irony here is that even though Berkshire is a major ETF constituent and although a large part of its balance sheet is comprised of S&P 500 type companies, Berkshire underperformed the S&P 500 Index by approximately 10% in 2011. There is a large short position in XLF, which, in turn, means that there is a short position in Berkshire Hathaway. As of December 30, 2011, the short interest in Berkshire Hathaway Class B shares was 12.4M shares, or 1.3% of the float. Historically, Berkshire Hathaway was owned mainly by long-term investors. However, as XLF is among the most actively traded ETFs, with average trading volume of 125 million shares a day, in principle the ownership of the ETF (and therefore the stocks underlying it) turns over 100% every 72 hours. This is perhaps another example of indexation, presumed to be measuring price movement and granting broad exposure, in fact impacting the price of the securities it is intended to measure.
The Seeds of the Bubble Reversal
This, then, is a form of bubble, if one definition is the flow of funds into a sector or securities irrespective of fundamental merit or valuation. When that continues for too long, excesses arise. It is inevitable. Like all bubbles, it will reverse. When? An external issue may be legislative. Many of the statistics cited in this letter are drawn from a recent presentation to the U.S. Senate Committee on Banking, Housing and Urban Affairs, the prepared remarks for which are entitled ETFs and the Present Danger to Capital Formation4. The concern is systemic risk; thatâs a nasty term nowadays.
Those hearings aside, this particular multi-trillion dollar wave of dysfunctional behavior appears to be exhausting itself. In conceptual terms, the rising correlations of equity securities globally must reduce the utility of indexation to index buyersâa major benefit of the variety of new indexes was the presumed benefit of alternative correlations in the service of reduced portfolio volatility. Concurrently, there is increasing pressure for fee compression amongst the index and ETF providers. If a product loses its utility to both the buyers and the sellers, then its business purpose becomes obsolete.
There are indicators that such a reversal is already in development. Hereâs one: BlackRock, which acquired iShares from Barclays as a benefit of the financial crisis, is the largest provider of ETFs. It has over $70 billion of assets merely in emerging markets based ETFs. Its fees are generally in the range of 35 to 70 basis points, and it has been managing some of these for a decade. But then along came Vanguard, which has been establishing, only in the last few years, ETFs for the same major indexes that represent significant assets at BlackRock. Vanguard charges 12 to 25 basis points for the very same product. And Vanguard is gathering assets rapidly. During the first 9 months of 2011, BlackRockâs MSCI Emerging Markets ETF experienced asset outflow of $10.9 billion even as Vanguardâs MSCI Emerging Masrkets ETF gained $7.2 billion. Fee compression on scores of billions of dollars of assets represents pure loss of pre-tax income to BlackRock. Itâs a serious problem. They would like to maintain their fees.
What are they doing? On September 1st, 2011, BlackRock filed for SEC permission to offer 13 actively managed ETFs that would not have to disclose their holdings daily. They already had permission to sell active ETFs that offer daily transparency. This would permit them to offer not merely exposure to a sector or batch of stocks, but the possibility of outperformingâand maintaining or raising their fees. If BlackRock is doing that, so must its competitors. Eaton Vance filed for the same exemptive relief shortly thereafter. How do you outperform an index? To state the obvious, if the notion is to maintain a fee structure by offering the possibility of outperforming an index, then one of the only avenues available is to select companies that are: 1) not in the index, and 2) offer the possibility of idiosyncratic returns, as, maybe, from stocks selling below book value or below NAV, or that have superior measures of business return yet are less expensive than the index. In other words, you select stocks which are on the wrong side of the ETF divide, the sorts of stocks we own. The wave of fund flows into indexation has been huge and of bubble proportions. When that wave reverses and comes coursing back, it will try to move through a universe of stocks with a limited market capitalization and limited float. The impact would be large, indeed. And it might not be long in coming.
Now, the current discounts are not a terrible circumstance from the point of view of a value investor who can acquire companies on the âwrong sideâ of the ETF divide. An investor desiring exposure to real estate equities, for instance, can purchase a real estate ETF, likely priced at a 3.5% yield and 2.5x book value, or a group of comparable non-indexed companies, such as the table of ânot-so-popularâ REITs, above, at a 7% yield and 1.25x book value. Venture into individual stock selection, instead of basket selection, and the valuations can be fractions, not multiples, of book value. The only catch is to wait, though as just discussed, the wait might not be all that long. One day, history will record yet another of those odd periods when investors could have purchased all manner of stocks at multi-decade low valuations, almost indiscriminately, but missed out in their enthusiasm for a particular passion of that era.
Holdings Review
This section will focus on three companies: one new, and two existing positions. The existing ones were chosen for us by dint of popular vote; one because the share price has declined sharply, the other because the share price has risen sharply. Specific questions have been asked about each, but there are really two underlying questions, which really are the same question: 1) why havenât the Sears Holdings shares been sold, since it is such an abysmally poor retailer and the shares are down so much?, and 2) why havenât the MasterCard shares been sold, since although the operations are great, the shares are up so much? I suppose there is an even simpler underlying question: will you hold Sears until the shares sink toward zero, and will you hold the Master Card until you lose the large gain? Or, plainer still, why donât you sell the losers before they go down, and sell your winners while you still canâyou know, trade, man!
Sears Holdings (SHLD, Financial)
Everyone knows Sears, no one likes it. I mean it; Iâve met no one outside of Horizon Kinetics who likes Sears. Nearly every person in this country of driving age has had an opportunity to be dismayed by the shopping experience (there are probably a few square feet of Sears floor space for every U.S. household). As an aside, let it be stated that we donât love or even like Sears either; it is an investment and is judged on its investment merits. It is one of many investments, nothing more, nothing less. There has been much said and written about the company, some of it scathing, some witty, all of it negative. And, applied to Sears as a retail store business, it is all true; virtually every successive management decision over the course of six years has been either naĂŻve, misguided, incompetent, or arrogantâif Sears is viewed as a department store company. This includes the initial decision to curtail the advertising budget, the reduction of inventories, the reduction in sales staff, the disinvestment in the physical infrastructure, and the succession of chief executive officers, the latest with not a bit of prior retailing experience. While Sears has spent billions on share repurchases, its competitors like Target spent billions on store reformatting and refurbishment. As one retail analyst scoffed, âcustomers donât care about the price of the stock; they care about the price on the shelf.â Valued on its retail sales and operating income, Sears stock is a decidedly unappealing sight.
Yet, if viewed as a real estate company, virtually every management decision has been logical. This was the initial investment thesis when the position was established: that the ultimate value of the real estate was worth more than the market capitalization of the company, and that the realization of that value would be a long-term prospect, since it appeared that the controlling shareholder, Eddie Lampert, was intent on first maximizing the cash flow available from the retail business. Indeed, since 1996, the repurchase of shares has increased the amount of real estate owned per share by over 50%, which is no small matter. If Sears has been engaged in a long-term end game of capitalizing the real estate, then there would necessarily have to come a time when the stores would begin to reach a point of diminishing returns. Eight years after Mr. Lampert became chairman, this appears to be happening to at least some of the stores, and those are being closed; they are not being supported with additional spending. What might seem to be a manifestation of failure, and of an uglier and uglier picture as a retailer, is simply one step in a long end game as a realtor. If I were the controlling shareholder of Sears, I might do the same; so might you. In fact, the original thesis cannot be fulfilled unless the stores are eventually sold, and they are unlikely to be sold if they are highly profitable. Unfortunately, if some become unprofitable and are sold, we are asked why we purchased the stock of a failing retailer.
The retailing environment is far poorer today than it was several years ago, and no doubt poorer than Mr. Lampert could have anticipated at the beginning of this process, and that certainly affects the clearing price of retailing real estate. So what is the clearing price? We cannot really know without the sort of inside knowledge that the CEO or Chairman has. Nevertheless, a variety of sources tend to confirm that a rough average price for mall-type real estate, to build or buy, is roughly $225 per square foot, although individual values can be less than one-half or more than twice that figure. Of the roughly 4,000 Sears stores, some 800 are owned, and these encompass roughly 93 million square feet. If, merely for momentary consideration, these are worth $200 per square foot, then this real estate is worth $18 billion, or $168 per share; at only $100 per square foot, the per-share value would be $85. If one subtracts both the companyâs net debt and capital lease obligations (net of cash) and pension and post-retirement liability obligations of $33 per share, then the net value of the real estate is $52 per share. Moreover, the balance sheet has been arranged such that it will not be until 2016 that the first major debt maturities and credit line expirations take place. Thus, there will be a good four years for retailing and housing (Sears sells the white goodsârefrigerators, washing machines and dishwashers)âto recover, for capitalization rates to improve, and for optionality to be realized within this enormous real estate portfolio. Aside from the owned stores there is reason to believe that there are many long-term, below-market leases among the 3,000-plus leased stores. These, too, have value as real estate. As does the companyâs 2 million square feet of owned office space at its headquarters in the Hoffman Estates suburb of Chicago. There are other assets, too. Aside from whatever values are attached to the brands that it owns (for example, Craftsman tools, Kenmore, Landâs End and DieHard car batteries), Sears is also a major internet presence: it was listed as the 7th largest internet retailer in 2011 by Internet Retailer, directly behind Walmart.com.
We will certainly continue to evaluate events as they unfold and monitor this holding. To date, though, the basis for this investment still operates. As an end note, on January 9th, 10th, and 11th, which were days during which the Sears stock traded at its lowest share price since 2004, Mr. Lampert increased his personal holdings of Sears by over 5.4 million shares priced at some $162 million. At the January 13th closing price of $33.56, his total shareholdings are worth more than $750 million.
MasterCard (MA, Financial)
MasterCard shares were purchased in Core Value as a 1% position in July 2008 at a price of approximately $281, when the balance sheet included $1.4 billion of obligations under a legal settlement with the U.S. Department of Justice. Analysts gave considerable weight to this issue as a risk. By January 2009, the shares had declined by over 55%, far more than the broad market. The initial purchase price was equivalent to a P/E of 26x 2008 earnings (excluding the impact of a $1.6 billion litigation charge that caused a net reported loss), and 25x 2009 earnings. In February 2009, when the shares were approximately $158, we increased the position by 150%. We would characterize both the initial as well as the subsequent purchase as value-based. Hereâs why.
MasterCard and Visa (V, Financial) function as a virtual duopoly in providing the transaction processing infrastructure for credit cards, charging a variety of fees for each transaction. Part of the competitive barrier to entry is the enormous cumulative investments they have made over the decades. This affords some pricing power, and their returns on invested capital are among the highest one can find among publicly traded companies. It is also a high fixed-cost, low marginal cost businessâthe marginal cost of an incremental transaction is quite small, such that an increase in transaction volumes can result in expanding profit margins. At the time of the first purchase, this phenomenon was readily observable. As well, MasterCard, which had its IPO in 2006, manifested much lower profit margins than Visa, and there was no obvious structural reason why its profitability could not converge toward that of Visa; absent any other operating dynamics, such convergence alone would add a lot to MasterCardâs profitability.
An additional qualitative strength of the MasterCard business was that over one-quarter of revenues in 2009 derived from what might broadly be described as emerging markets, and those revenues were expanding at double-digit annual rates even as the companyâs major developed markets, the U.S. and Europe, contracted or grew modestly. Penetration rates in emerging markets are low and the ultimate expansion potential significant.
Accordingly, based upon an expectation of normalized profitability a few years forward, anticipating the effacement of the litigation liabilities, the advancement of revenues through overseas growth, and the scale and efficiency benefits of that growth, we considered MasterCard, which was otherwise debt-free, to be an undervalued, not overvalued, stock of extraordinarily high quality. As one measure of business quality, the companyâs return on average equity in 2009 was 53%; its return on assets, at 21%, exceeded most companiesâ ROE.
As of year-end 2011, MasterCard closed at $372. Having risen by about a third from the initial purchase price in a flat market, and by about two-thirds in 2011, also in a flat market, we are being asked whether this position should have been sold or whether it ought not to be sold. Why, exactly, havenât we sold it? Perhaps we will. There is an ongoing need in the portfolio for sources of funds to acquire some of the very well-managed businesses that, being on the wrong side of the ETF divide, trade near or below book value or at double-digit earnings yields (single-digit P/E ratios). But due process is in order before the rope is brought out.
First, through operating profits, MasterCard effaced substantially all $1.4 billion of its litigation settlements liabilities by year-end 2010; the balance was paid off in 2011. Not being a business that requires substantial ongoing capital expenditures, net income, now in the $2.5 billion range, is approximately equal to free cash flow. Having dispensed with its only substantive liability, and since the business does not require much reinvestment, the two basic uses for its free cash flow (other than for acquiring other businesses, which are hardly likely to be as profitable), are to pay dividends or to repurchase shares. Since the ROE in the first 9 months of 2011 was roughly 45%, repurchase of shares is, on its face, a financially high-return investment. The company has begun to repurchase shares; this amounted to $1.1 billion during the first 9 months of 2011.
As to the balance sheet, cash now exceeds total liabilities. Operationally, revenues during the first 9 months of 2011 were 22% higher than in the prior-year period, and net income 31% higher; earnings-per-share, a result of the share repurchases, were 34% higher. The net margin expansion dynamic described above has continued, as displayed below:
Wall Street analystsâ consensus earnings for 2012 are $21.72 per share, which is consistent with a 36.5% net margin on sales that are 12%+ higher than in 2011. On this basis, the shares trade at 17.2x this yearâs expected earnings. This is similar enough to the third quarterâs run-rate annual income, which would be $22.52 per share. On this measure, the shares are far less expensive than when they were first purchased.
There is now a new facet to earnings growth. At a P/E of 17x, the company could repurchase about 1/17 of its shares annually, and without resorting to borrowing (although that would also be accretive). This would add an additional 5.9% per year to the earnings progress of the basic business. This could go on for a very long time.
Some find the benefits of share repurchases on this order, which can require many years to become effective, difficult to appreciate. An exercise with more immediacy would be to presume that the company shifts to a dividend payout strategy. If the company were to distribute 75% of its earnings (per consensus estimates), yet still retain some $700 million annually for other purposes, the dividend would be about $16.30. What dividend yield would the investing public desire/require from MasterCard? The S&P 500 Index dividend yield is 2.2%. One can hardly suggest that MasterCard, based upon the most basic metrics of revenue expansion rate, return on equity, and balance sheet characteristics, is not far superior to the average S&P 500 Index company. If MasterCard, in this exercise, were to yield 2.2%, the shares would trade at $741; at the current MasterCard share price of $372, it trades at a 4.4% yield.
This speaks to the valuation question. It is clear that MasterCard trades at a higher P/E ratio than that of the S&P 500 Index. It is clear that MasterCard is a far superior company, with remarkably high returns on invested capital, and a valuation that could be supported by absolute measures such as dividend yield. It presents a certain valuation/quality/return profile. There are, as well, companies that trade at deep discounts to the S&P 500 Index and which are also demonstrably superior companies, and thus present an alternative valuation/quality/return profile. The choices of what to purchase, what to sell, and what to retain will be made, as always, on the basis of incomplete and imperfect information that is made available to portfolio managers, as always with the aim of improving the portfolioâit will always seem like a good idea at the time.
Air Lease Corp. (AL, Financial)
Air Lease is the second coming of Steven Udvar-Hazy. In 1973, Mr. Udvar-Hazy co-founded what became International Lease Finance Corp. (âILFCâ), and in doing so established a new industry: leasing commercial aircraft to airline companies. He was successful both in concept and execution. ILFC, which is the worldâs largest aircraft lessor, was sold to American International Group (âAIGâ) in 1990 for $1.3 billion. Mr. Udvar-Hazy remained CEO of ILFC until 2009, and retired from AIG in February 2010. By April 2011, he had engineered the IPO of a new aircraft lessor, Air Lease, bringing with him ILFCâs senior officers, who had worked for him there since 2002.
The basis for this new venture appears to be the reluctance of AIG to invest in the business. The two largest aircraft lessors are owned by diversified financial companies, the 2nd being GE Capital, which, like other major finance companies, is shrinking its balance sheets. Yet, this is occurring at what seems to be an opportune moment to allocate additional capital to the business:
âËâ On a secular basis, airlines continue to increase their use of leasing. The proportion of aircraft fleets leased was about 0% in 1973, about 20% 25 years later in 1998, and 35% 12 years later in 2010. Leasing permits airlines to deploy their insufficient capital elsewhere, to more readily expand and diversify their fleets, and is a particularly helpful mechanism for new, rapidly expanding low-cost airlines such as abound in emerging economies.
âËâ The airline industry is expanding. Historically, passenger traffic has increased on a 1:1 basis with world GDP growth, but most of that growth has been coming from emerging economies. Asia/Pacific traffic, for instance, which was 17% of world traffic in 1990, was 29% in 2010. Therefore, market size expansion in the next decade should be greater than in the decade prior.
âËâ As mentioned, some of the largest aircraft lessors, like ILFC, are policy constrained with regard to expanding their capital base.
âËâ The cost of capital, which is to say interest rates, has never been as low.
Accordingly, Mr. Udvar-Hazy is entering a market that is growing in overall size, for which penetration of this particular service is also expanding, in which major competitors are constrained, and for which expansion capital is cheap. Certainly, he knows how to build such a business.
The worldwide commercial aircraft inventory is a far more stable figure than one might infer, given the cyclicality in passenger traffic. Inventory has trended up even during downturns, as orders placed during a preceding cyclical upturn in traffic are ultimately delivered. Borrowing from ILFCâs financial statements for reference, revenues and earnings of that company increased sequentially between 2005 and 2009, even through the financial crisis and the decline in passenger traffic during 2008 and 2009. Neither, compared with most finance companies, do aircraft lessors use a great deal of leverage; ILFCâs debt to equity ratio in 2009 was 3.5x, and its interest coverage ratio was also 3.5x.
Leases are typically net leases, under terms that require the lessee to pay all operating expenses, including insurance and maintenance, and to return the aircraft in a condition that conforms to a detailed set of qualitative criteria.
With $2.2 billion of equity capital raised in the IPO and a prior private placement, and $1.8 billion of borrowings, Air Lease has so far acquired $3.4 billion of planes, which numbered 79 as of September 30th. It has contracted to purchase another 126 aircraft between year-end 2011 and 2015, plus another 95 thereafter. It is in an early expansion phase.
As to valuation, current earnings cannot be used; they are not yet at normalized levels, since the current balance sheet can support a greater amount of operating assets than are yet in place. However, our position was established at only about 5% to 10% above book value and about 20% below the stockâs closing price on the day of its IPO last April.
DISCLAIMER
Past performance is not indicative of future returns. This information should not be used as a general guide to investing or as a source of any specific investment recommendations, and makes no implied or expressed recommendations concerning the manner in which an account should or would be handled, as appropriate investment strategies depend upon specific investment guidelines and objectives. This is not an offer to sell or a solicitation to invest.
This information is intended solely to report on investment strategies as reported by Horizon Kinetics LLC. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. Under no circumstances does the information contained within represent a recommendation to buy, hold or sell any security, and it should not be assumed that the securities transactions or holdings discussed were or will prove to be profitable.
No part of this material may be: a) copied, photocopied, or duplicated in any form, by any means; or b) redistributed without Horizon Kineticsâ prior written consent.
