Dear Fellow Investor,
Our equity Funds rose the first half of the year, including modest returns in the second quarter. Some outpaced their benchmarks, while others trailed. Our bond funds continued to find ways to earn some income in spite of continued (artificially) low interest rates. While our stock returns have been subpar in recent years, even if that were not the case, we would (as always) point readers to the longer-term results. Returns for all of our Funds over various intervals can be found on the performance table on our website (weitzinvestments.com).
Fund activities can be found by accessing the Quarterly Commentary link under each Fund’s section on our website. We have changed the format of our Quarterly Commentary to include reasoning behind portfolio changes rather than merely listing buys and sells, winners and losers. We hope this change will be helpful to shareholders.
Little has changed in our outlook as we cross the halfway mark of 2017. We continue to believe that stocks and bonds are expensive. The causes—central bank suppression of interest rates, the willingness of investors to “pay up” for earnings growth and excess corporate liquidity being used for share buybacks rather than capital spending—are not new, but the steady rise in the stock market without a meaningful correction has lasted an unusually long time. At the end of the quarter, there were some signs of price weakness in the tech sector leaders and upticks in bond yields, but it is probably premature to declare an end of the “bargain drought.”
Our Game Plan
Price distortions, including those caused by the growing popularity of indexing and ETFs, are making it hard to find investments at reasonable prices. This is annoying, but you pay us to “figure it out,” so complaining is not helpful. The question is, “What are we doing about it?”
Our “Holy Grail” is business value. If we can buy the stock of a growing business at a discount to the price that a smart business owner would pay for the whole company, our investment is very likely to be successful. The stocks that are “working” in this market are generally very good companies, but we believe that for many, stock prices are high enough that the odds are stacked against investors. Buying the best companies, regardless of price, worked—until it didn’t—with the “Nifty Fifty” in the 1970s, the tech/internet stocks of the late 1990s and the housing and mortgage-related financials in the mid-2000s.
To paraphrase Ben Graham, “Buying a great business at too high a price is a speculation.”
During this extended period of high valuations, the turnover in our stock funds has been low. We have added a few new stocks to our portfolios, but they tend to fall into the category of intermediate-term “trades” (as opposed to our preferred long-term “investments”). For example, DXC Technologies (DXC, Financial) is the successor to Computer Sciences Corporation (CSC), an undermanaged and somewhat troubled IT consulting company that brought in new management in 2012. The new CEO, Mike Lawrie, has considerable turnaround experience and by 2016 had CSC back on track. Earlier this year, CSC acquired Hewlett Packard’s Enterprise Services business (originally Ross Perot’s EDS). The plan is to use the same playbook Lawrie used with CSC to make the combined company more profitable. If they are reasonably successful over the next three to four years, we believe that DXC can earn $9-10 per share and sell at a modest 12-13 times earnings. This is not “home run” material, but it would represent a nice increase over today’s $76 per share. More importantly, achieving these gains is not dependent on low interest rates, a strengthening economy or technological breakthroughs.
Most of our assets are invested in companies we have owned for many years, but the companies themselves have not been standing still. Berkshire Hathaway (BRK.A, Financial) has been in our clients’ accounts continuously since 1976, but today’s Berkshire is very different from that of 40, 30, 20 or even 10 years ago. Recent headlines trumpet Berkshire’s $12 billion profit on its Bank of America (BAC, Financial) investment. In fact, that investment was made in 2011 when Buffett lent BAC a badly needed $5 billion. Berkshire received a convertible preferred stock with a 6% yield ($300 million per year) convertible into BAC shares worth over $17 billion today. Berkshire’s internal rate of return on this investment is about 18% per year.
Berkshire currently holds about $100 billion in cash available for future deals. Investments like BAC (and similar lifelines thrown to Goldman Sachs and General Electric (GE, Financial) in 2008) are rare and tend to arise in times of economic stress. Neither we nor Warren can predict when the next “deal” will present itself, but Warren and his investment team are both patient in waiting for great opportunities and bold in seizing them.
The various Liberty entities offer a variety of subscription-based cash flow generators. Liberty Global (LBTYA, Financial) is a large European cable company, which we think is very undervalued at $31 vs. our estimated value of $43. Its Latin American assets will soon be spun off into a separate company, and we expect the Liberty management to use the same consolidation “playbook” to build a valuable Latin American version of Liberty Global. Investors have been disappointed by the recent pace of quarterly progress at both Global and the Latin American subsidiary, LiLAC, but we believe that putting strong, subscription-based businesses in the hands of Liberty management is a great prescription for building business value.
Liberty’s ownership in SiriusXM (Liberty SiriusXM Group) dates back to 2009 and the depths of the Great Recession. Sirius was on the brink of bankruptcy and Liberty lent them about $400 million. The loan had a very high yield (and was repaid in under a year) but also included a “kicker” in the form of a virtually free option to acquire 40% of the company. That option was exercised and is now worth over $10 billion. Management is busily working on extracting full value from the Liberty holding company that owns its Sirius stake.
Cable TV and broadband internet providers are among our favorite types of businesses, and Charter Cable is the second-largest cable company in the U.S. Charter recently purchased Time Warner Cable and Bright House Networks and is integrating them into the Charter system. This process will take another two to three years, and when completed, Charter’s shares should be worth considerably more than the current $337. We do not own Charter directly, but we do own it indirectly through Liberty Broadband and Liberty Ventures.
Liberty Broadband is a pure play on Charter, holding about 0.3 shares of Charter for every Broadband share. Ventures is a holding company that owns Charter shares and Liberty Broadband shares. The shares of both Broadband and Ventures offer ways to buy Charter at a discount to its current price. If Charter’s value increases, we should be doubly rewarded as Liberty extracts full value for the Charter shares we have bought at a discount. Nothing is ever simple with Liberty and John Malone, but investors are generally very well-served.
The message in these investment vignettes is not that our stocks are terribly cheap. The weighted-average price-to-value of our portfolios is in the mid-upper 80% range—somewhat higher than usual. What gives us comfort, though, is that the businesses are solid and their values are growing. Their stock prices will not be immune from panicky market corrections, but if their prices fall, we will have a basis for stepping in and adding to our positions. The financial press is full of stories about the “death” of value investing—or even of any kind of active management. We still believe that it is more sensible to pick stocks based on valuation than on market capitalization, and we plan to stick to our investment philosophy.
Warren Buffett (Trades, Portfolio) likes to describe the stock market as analogous to a baseball game in which there is no umpire calling balls and strikes. The batter (investor) can stand at the plate and let pitches (stocks) go by indefinitely, “waiting for his pitch” (a bargain investment). Meanwhile, the fans in the stands are screaming, “Swing, you bum!” We may have been too picky at times, and the cash reserves we hold have come with an opportunity cost, but we believe in our investment process. We are not asleep at the plate—our on-deck list grows by the week. The raw material for triggering market volatility is in place, and we are looking forward to taking advantage of it. In the meantime, we are grateful for a patient group of shareholders with long-term perspectives.
Best regards,
Wally Weitz Brad Hinton
