Investment Style: Large-Cap Value
The Value Fund’s Institutional Class returned +6.47% in the first calendar quarter, compared to +6.07% for the S&P 500 and +6.03% for the Russell 1000. For the fiscal year ended March 31, 2017, the Value Fund’s Institutional Class returned +10.06%, compared to +17.17% for the S&P 500 and +17.43% for the Russell 1000.
Fiscal Year Contributors
Liberty Broadband’s principal asset consists of its interest in Charter Communications. Shares of Charter, and cable companies broadly, have performed well in the wake of the U.S. election. Although much remains to be seen, investors generally believe that regulatory pressures will ease as a result of a presumably more “industry friendly” Federal Communications Commission (FCC) as well as a Justice Department that may look more favorably on further industry consolidation. We have invested in Liberty Broadband because we like the operating strategy at Charter, and while regulatory relief would certainly be a benefit, it’s not an explicit part of our investment thesis. Liberty Broadband shares trade at a discount to their underlying Charter investment due to the added complexity of Liberty’s involvement.
We are confident Liberty Broadband’s management will ultimately collapse this discount, thereby making Liberty Broadband a cheaper opportunity to invest in Charter’s future.
Liberty SiriusXM (LSXMA, Financial) is a tracking stock, with its principal asset being Liberty Media’s 67% ownership of satellite radio operator SiriusXM. Thanks to the continued strength of new car sales in the U.S., SiriusXM has enjoyed very robust operating results in recent quarters, as 75% of all new cars sold feature a satellite radio built directly into the dashboard. New car buyers are offered a free trial of the service and typically convert to paying subscribers at a healthy rate. Recently, SiriusXM has opened a new channel for customer growth by partnering with used car dealers as well as service providers to offer trial subscriptions. Although we don’t anticipate these trials will convert at the same rate as those associated with new car sales, we believe it provides an excellent opportunity to remarket to existing car radios as well as lessen the company’s reliance on the cyclical new car market. Shares of Liberty SiriusXM mirrored most of SiriusXM stock price gain of the prior twelve months but still trades at a discount to our intrinsic value of standalone SiriusXM.
Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial)0 is a conglomerate holding company owning subsidiaries engaged in a number of business activities. Shares benefited from optimism that a combination of higher interest rates, lower taxes and increased domestic activity would increase earnings at Berkshire’s insurance and industrial businesses. We believe Berkshire will compound wealth for its shareholders for the foreseeable future.
Fiscal Year Detractors
QVC Group (QVCA, Financial) is a tracking stock issued by Liberty Interactive which includes subsidiaries QVC, zulily and its interest in HSN. QVC Group operates an American television network and also operates televised and online shopping experiences in other countries. In the third calendar quarter of 2016, shares of QVC Group fell after management indicated that its QVC U.S. business had experienced a significant sales headwind. QVC’s U.S. business, which had not seen a decline since the Great Recession, saw sales fall nearly 6% in the third quarter and 7% in the fourth quarter, as several categories simultaneously slowed. Importantly, we don’t view these issues as a sign of the QVC model suddenly being broken, and management has indicated sales results have begun to stabilize. QVC’s customer retention and loyalty remain strong, as does viewership of their network. Furthermore, the international businesses appear unaffected by the current U.S.-centric slowdown. Although the decline in QVC shares has been disappointing, management has taken advantage by accelerating their share repurchase to foster per share value growth.
Endo International is a specialty healthcare company engaged in developing, manufacturing, marketing and distributing branded pharmaceutical and generic products and medical devices. Endo experienced significantly worse-than-anticipated erosion at Qualitest, its legacy generic drug platform. The competitive environment changed quickly, and we were slow to recognize it. After conversations with both management and a couple of the larger drug buying consortiums, we could not gain comfort in the durability of Endo’s now lower earnings base. The company’s balance sheet and potential legal obligations (liabilities relating to the company’s legacy vaginal mesh products) left less room for error given growth challenges on the branded side of Endo’s business. Considering the erosion in our investment thesis, questions about management’s ability to identify and navigate risk, and a growing list of unknowns surrounding the business, we elected to close our position in the second calendar quarter of 2016 and refocus our capital in more attractive opportunities.
Allergan is a global specialty pharmaceutical company focusing on the development, manufacturing, marketing and distribution of brand name, biosimilar and over-the-counter pharmaceutical products. Allergan shares finished 2016 on a higher note, following an otherwise challenging year. While revenues and earnings were shy of expectations and drug price regulation dominated headlines throughout much of the past year, the health of Allergan’s core underlying growth drivers gave us confidence to continue buying shares at increasingly attractive discounts during the fourth calendar quarter. Encouragingly, recent operating results have come in ahead of internal forecasts, and the company’s initial outlook for 2017 exceeded our expectations. Growth across Allergan’s therapeutic segment looks healthy, with the global aesthetics franchise demonstrating notable strength. Headwinds from legislative and regulatory developments continue to bear monitoring,
Quarterly Contributors
Liberty Broadband’s principal asset consists of its interest in Charter Communications. In late January, rumors broke that Verizon Communications had made an informal acquisition offer to Charter Communications, sending both Charter and Liberty Broadband shares higher. We acknowledge that such a combination makes strategic sense for Verizon as it searches for an efficient means to deploy 5G wireless technology (which will require very dense, wired networks). However, we suspect shareholders can reap greater value from Charter continuing to integrate its Time Warner Cable and Bright House Networks acquisitions on a stand- alone basis. That said, we believe management will pursue the right course (stand-alone or M&A) that will maximize long-term shareholder value.
Liberty Global is the largest international cable company, with operations in 14 countries providing video, broadband Internet, fixed-line telephone and mobile services to its customers. Liberty Global’s shares were strong in the first calendar quarter and made up some of the ground that had been lost during the prior year. The company’s quarterly results were solid, but shares have likely been driven upward as speculation of deals in the media industry has heated up of late, including revived speculation of a potential Vodafone transaction. We view Liberty Global as a standalone provider of broadband and Pay-TV services as an attractive opportunity, and although a potential acquisition by Vodafone may create value for shareholders, our investment thesis is not dependent on such an event.
Allergan is a global specialty pharmaceutical company focusing on the development, manufacturing, marketing and distribution of brand name, biosimilar and over-the-counter pharmaceutical products. Allergan’s stock rebounded as the company reported stronger-than-expected fourth quarter results following a string of disappointing quarters. The company’s initial outlook for 2017 came in ahead of our forecasts, with strong growth across six of its seven therapeutic areas expected to result in high single- digit revenue growth and high teens adjusted cash earnings per share growth. Allergan closed its $2.9 billion acquisition of LifeCell in February and also announced an agreement to acquire body sculpting device manufacturer ZELTIQ Aesthetics for $2.5 billion. If ZELTIQ shareholders approve the merger, Allergan will add two durable assets to its aesthetics portfolio that together should generate roughly $1.0 billion in annual sales with attractive organic growth profiles. We continue to believe Allergan shares have attractive upside potential from current prices.
Quarterly Detractors
Range Resources is an independent producer of natural gas and natural gas liquids (NGLs) based in Fort Worth, Texas, with operations in the Marcellus shale and emerging Terryville field. Range Resources stock weakened during the first quarter as mild winter weather once again put downward pressure on natural gas prices. The company’s higher-than-projected 2017 drilling budget and 20% 2018 production growth target likely also raised fears that Range’s balance sheet could once again deteriorate in the event of a prolonged downturn in gas prices. March supply/demand was kinder than January and February, however, leaving
natural gas storage levels in better shape entering injection season than a year ago (approximately 20% lower). Longer-term demand fundamentals for gas remain attractive, and improving oil prices together with international transport capacity have provided a spark for natural gas liquids prices that should benefit Range’s cash flow. We believe Range shares are undervalued, assuming mid-cycle natural gas prices of $2.75 or higher.
TransDigm Group is a designer, producer and supplier of engineered aircraft components for use on commercial and military aircraft. The prospect of rising interest rates and accusations of rigged/fake bids from a critical short report pressured TransDigm’s stock during January. The company’s levered balance sheet, while married with historically consistent cash flows, increases the company’s sensitivity to potential declines in profitability. In his first several weeks in office, President Trump targeted the cost of specific programs at several of TransDigm’s larger peers. While it remains to be seen what, if any, lasting impact this scrutiny will have on growth and cash flow, with TransDigm’s shares close to our estimate of intrinsic value, we elected to close our position in the stock with a nice gain.
United Parcel Service (UPS) is a package delivery company and a provider of supply chain management solutions. Over the past several years, the growth of e-commerce has created challenges for UPS during its peak holiday shipping season. While the market can not quite decide whether the onslaught of less profitable residential delivery volume is beneficial, UPS has announced plans to significantly accelerate capital spending in anticipation of even more residential delivery volume. Investors’ lack of faith in management’s intended path led to this most recent sell off. We believe the company’s efforts toward a more streamlined holiday shipping experience will bear fruit in time, and we expect the company’s stock price will eventually reflect this stepped-up commitment to its customers.
New Holdings
Dollar Tree operates a network of approximately 14,400 discount variety stores under the Dollar Tree, Dollar Tree Canada and Family Dollar brands. The legacy Dollar Tree concept is the last remaining true dollar store, where every item is a dollar. Its balanced offering of consumables (food and toilet paper) and more discretionary items (toys, stationery and party supplies) has generated consistently attractive financial results, with same store sales rising 22 of the past 23 years. Family Dollar, acquired for $8.8 billion in 2015, focuses more heavily on basic necessities such as diapers, food and paper products at prices between $1 and $10. Dollar Tree is early in the process of improving Family Dollar’s operating results, executing what we believe is a credible plan toward closing the gap in financial performance that exists with its nearest competitor Dollar General. Dollar stores’ unique combination of low prices and convenience continues to resonate with low- and middle-class consumers, providing attractive future store growth opportunities and durable excess cash flow. Portfolio Manager Dave Perkins profiles Dollar Tree in more detail in this quarter’s Analyst Corner.
Eliminated Holdings
Motorola Solutions was sold for a gain as the stock reached our estimate of intrinsic value.
