The universe I can’t play in [i.e., small companies] has become more attractive than the universe I can play in [large companies]. I have to look for elephants. It maybe that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in.” – Warren Buffett (Trades, Portfolio)
This is our first investor letter for the Boyar’s Orphaned Equity Strategy. Before we discuss our performance and investment outlook, we thought it would be helpful to recap why we decided to introduce the strategy.
The Opportunity
The U.S. stock market has been largely driven by money flowing into passive strategies. U.S. equity assets managed via passive strategies have increased from ~10% in the late 1990s to nearly 40% today. We believe that today’s investment environment, where investors are piling into high-flying technology companies, is eerily reminiscent of the dotcom bubble. In addition, the sell-side investment research community has been reducing its coverage of small/midcap companies (and as a result of recent regulatory developments, we believe the research coverage of these companies will likely continue to decline). Togethers with stocks outside of the major indices, these stocks have become “orphaned.” As a result, many companies sell at levels significantly below what we perceive to be their intrinsic or private market value. We believe that a concentrated portfolio of “orphaned” equities should generate superior long-term results.
Our Strategy
The Strategy seeks to invest in catalyst-driven companies that have one or more of the following characteristics:
- Excluded from most major indices with low levels of “passive” ownership as indiscriminate buying of shares by index funds can artificially inflate a company’s value. In addition, if a stock is not included in one of the major indices, it has fewer “forced buyers” which could lead to potential undervalued situations which we would seek to take advantage of.
- Have complex ownership structures as investors tend to shy away from companies that are difficult to analyze which can cause a company to sell below its intrinsic value.
- Have low levels of hedge fund ownership or minimal sell-side coverage as these companies are poorly followed by the investment community and allow us to utilize our in-house research capabilities to uncover mispriced equities.
- Controlled by founders we believe to be good partners with “skin in the game” as they manage their businesses for long-term operational success and not simply to beat quarterly earnings.
- Are out of favor by sell-side analysts as these analysts can often tell you everything there is to know about a given company, except when to buy its stock. We have found that investing in companies that are currently exiled by analysts could lead to some very profitable results.
- Are undergoing corporation actions as many larger funds’ investment mandates force them to sell the stocks of spun-off companies regardless of the spun-off entities’ investment merits. This can cause the share price of these stocks to reach artificially low levels. We are not constrained by such mandates.
- Reside in out of favor industries as often, analysts will become overly pessimistic about a particular industry. This can cause shares of companies with solid long-term prospects to sell at low valuations simply due to their association with a particular industry. We strive to take advantage of these situations by purchasing shares in high-quality companies at bargain-basement prices.
We believe these overlooked areas of the market offer a unique opportunity for outsized long-term returns.
Performance
The Boyar’s Orphaned Equity Strategy has an absolute return mandate and we do not believe it will correlate well with any major index. While we are not focused on short-term returns and think we should be judged over a 3-5-year period, our initial results were quite satisfactory. From May 14, 2018 (when we started investing) despite an average cash position of ~54%, we returned 1.7% outpacing both the S&P 500 and the Russell 1000 for the 2nd quarter. Our high cash position led us to trail the Russell 2000.
Current Investment Position
As of the writing of this letter, the strategy has an ~38% cash position. While we are not market timers, we are price sensitive and are looking for the best possible entry points. Facebook’s (which we do not own) recent 20% drop in the wake of providing a disappointing outlook reaffirms our view that stocks can swing wildly even over a short period of time and the most prudent course of action is to both invest slowly and maintain a reasonable amount of dry powder to take advantage of market dislocations.
MSG Networks Investment Rationale
The Strategy took a position in MSG Networks Inc. (MSGN, Financial) which is in the out of favor media industry and is controlled by the Dolan family who despite their negative reputation on Wall Street have been great partners to invest alongside with over the years.
MSGN operates two highly profitable regional sports networks (RSNs). These RSNs both serve approximately 7.1 million subscribers (the vast majority in the NYC Metro area) and are the local broadcast homes of 10 professional sports teams, including the NY Knicks and NY Rangers. Over the past 10 years, the flagship MSG Network has won 152 Emmys, more than any other single station in the region. Shares of MSGN, have been somewhat volatile over the past couple of years, though earlier this calendar year they were trading at an all-time high of nearly $26 a share. However, amid disappointing video subscriber trends reported by many of the major U.S. pay-TV distributors, in conjunction with 1Q 2018 earnings releases, a slight reversal in MSGN’s generally improving subscriber trends, a downgrade by a long-time bullish sell-side firm in April 2018, and disappointing advertising revenues in the wake of poor performance by the Knicks and Rangers this past season, shares declined by nearly 30% from their recent highs.
In our view, the selloff represents an overreaction and an excellent opportunity to own a highly profitable business (49% adjusted operating income margins)1 that has minimal capital requirements (capex/revenue: <1%) and that generates an enormous amount of free cash flow thanks to its outsized FCF conversion (FY 2017 FCF/EBITDA: 58%). The December 2017 Tax Cut and Jobs Act will be a boon to MSGN’s FCF-generating abilities, as the Company has historically been a full tax payer at the federal level. Effective January 1, 2018, MSGN anticipates at least a 20% reduction in cash taxes relative to what would have been paid under the prior law. At current levels, MSGN trades at an absurdly low 8.0x our FY 2019 FCF projection. (FY 2019 will be the first full fiscal year of benefits under the new tax law.)
In addition to the new benefits provided by the new tax law, a number of attractive growth opportunities should benefit MSGN’s results in the coming years. These include incremental advertising opportunities facilitated by MSG GO (streaming platform), new distribution from multiple virtual multichannel video programming distributors (vMVPDs) thanks to recent agreements with DirecTV Now and FuboTV, new programming initiatives targeted at millennial consumers, and the legalization of sports gambling, which could meaningfully boost revenue through increased viewership (potential for higher affiliate fees and advertising revenues) and attract a new base of advertisers (casinos, online betting platforms, etc.).
Although valuation multiples of cable networks have compressed in recent years, RSNs have generally been immune to many of the adverse trends impacting traditional media companies. Sports programming is one of the last major media genres that still commands large audiences, and this programming is still uniformly viewed live (no one watches the Super Bowl on Monday morning!), a situation which is increasingly attractive for advertisers as the media landscape has fractured.
Further reinforcing our view of the continued appeal of RSNs is Disney’s initial bid for certain Fox assets valued the RSNs at 12.5x EBITDA though this value is likely much higher following a recent bidding war, which has seen Disney increase their price for the Fox assets by 36% based on their most recent bid (June 2018).
The poor performance of the Knicks and Rangers has been a drag on recent results. However, the outlook for the Knicks and Rangers is encouraging, with both teams recently having appointed new head coaches and the Knicks set to see their star player (Kristaps Porzingis), who went down with a season-ending injury during the 2017/2018 season, return for the upcoming season. The increased media rights fees associated with NHL digital distribution and a new agreement for the Buffalo Sabres have adversely impacted direct operating costs (up 7.8% during the first 9 months of FY 2018). However, these costs are expected to moderate beginning in the next fiscal year, and we believe that MSGN should be able to offset a good portion of these increases in the coming years as affiliate fee agreements with its distributors in upstate NY, when these agreements come up for renewal. (The ratings of the Sabres are typically among the highest in the NHL.)
Applying a discounted (relative to precedent industry transactions) 10x multiple to our estimate of MSGN’s FY 2020 EBITDA multiple, we estimate MSGN’s intrinsic value to be $36 a share, representing ~57% upside from current levels. We believe that there is a good chance that the valuation discount narrows in the coming years, and we note that Chairman Dolan elected to receive stock options in lieu of restricted stock for a portion of his compensation in the past 2 fiscal years. In our view, MSGN would be a good strategic fit for a number of larger media players, many of which are currently preoccupied with larger M&A, and we therefore would not be surprised if MSGN were to find itself a target in the coming years. We would also not rule out the possibility of a management buyout or private equity interest. Media mogul John Malone has opined in recent years that a great deal of money can be made in cash generative businesses that have flat/declining growth (e.g., ESPN) by adopting an appropriate capital structure. Malone has also talked about the attractiveness of regional sports networks and stated that RSN’s could be appealing for one of his controlled companies. In our view, the important 2-year spinoff milestone, which lapsed in October 2017, could provide the impetus for an acquisition of MSGN (note: MSGN was structured as the parent, but there still could have been adverse implications if a sale occurred within the two-year window). The Dolans could also consider reuniting MSGN with MSG if the valuation disconnect persists, and we would note that MSG is still flush with cash ($1.2 billion), although a portion of that cash is likely earmarked for that company’s venue expansion initiatives.
A Look Back at the First Half of 2018
Stocks were all over the map during the first half of 2018, with January a precursor of the stock market volatility we have experienced since then. You may recall that the Dow Jones Industrial Average reached an all-time high on January 26, but only one week later, the index had fallen ~4%. The S&P 500, despite having ended the 2nd quarter with a 2.65% gain had at one point, declined by ~10% from its 2018 high. From a historical perspective, this intra-year drop is not unusual: according to JP Morgan Asset Management, the average intra-year decline for the S&P 500 since 1980 has been 13.8%.
The market’s volatility was caused by many factors, including the potential for a trade war, which many pundits predict would negatively impact the economy. There is some evidence of such an impact already, as a number of CEOs report tempering capital expenditures until they can determine the magnitude of the situation. Uncertainty about the future direction of interest rates also played havoc with the stock market. The 10-year Treasury started the 2nd quarter yielding ~2.75% and was yielding ~3.12% by mid-May. However, approximately two weeks later, it was back to 2.76%, and it ended the quarter at 2.85%.
A rising interest-rate environment negatively impacts the multiple that investors will pay for stocks. Investors (all else being equal) will pay a lower multiple when the 10-year Treasury yields 3% than when it yields 1%. The S&P 500 currently sells for about 16.5x forward earnings (the multiple) versus a year ago, when it sold for 23.8x. With S&P profits expected to increase by about 20% in 2018, an argument can be made that the stock market is reasonably valued. However, now that the multiple has contracted from ~23x to ~16.5x, we see an outside chance of a multiple expansion over the short term (barring an all-out trade war).
While people may be nervous about investing in the stock market in a rising interest-rate environment, it is worth noting that according to JP Morgan Asset Management, since 1983, when the yield of the 10-year Treasury was below 5% (it is currently ~2.94%), increasing interest rates have historically been associated with rising stock prices. So, if history is any guide, we have a long way to go in terms of rate hikes before stock market performance is negatively impacted.
Mega cap technology stocks are still doing the heavy lifting when it comes to generating stock market returns (as measured by the S&P 500). David Kostin, chief U.S. equity strategist at Goldman Sachs, estimates that more than 100% of the S&P 500’s total return of 2.65% in the first half of 2018 is attributable to just 10 equities. Amazon alone was responsible for roughly 36% of the benchmark gauge’s advance. Amazon, Microsoft, Apple, and Netflix in the aggregate accounted for 84% of the index’s gain.
The narrowness of stock market leadership, however, has us concerned. History has shown that for a stock market advance to continue, the leadership cannot be limited to a small number of companies. Furthermore, the current leaders are among the most expensive when measured by their P/E ratio. Amazon, for example, sells for a whopping 109x forward earnings, and Netflix sells for 99x next year’s earnings.
Equally concerning, according to John Authers’s July 18th article in the Financial Times (citing Bianco research), if Microsoft were added to the FAANG grouping of stocks and these companies were their own sector, these six companies would comprise 17% of the S&P 500 in terms of market capitalization and would be the largest sector in the S&P 500. In the same article, (citing research by Michael Batnick), Authers reported that the market capitalization of the five biggest companies in the S&P 500 currently equals the market cap of the smallest 282 S&P 500 companies.
Everyone seems to be jumping on the high-flying technology stock bandwagon. According to Jeff Cox of CNBC.com, fund managers who responded to the July Bank of America/Merrill Lynch fund managers survey (which polls 231 professional money managers who manage a total of $663 billion in assets to find out what they are buying/selling as well as their views on the market) identified the FAANG+BAT trade (this refers to a basket of popular technology stocks, including Facebook, Apple, Amazon, Alphabet, Netflix, Baidu, Alibaba, and Tencent) as the most popular trade for the sixth consecutive month. This bet has paid off handsomely, as the FAANG stocks alone have advanced by over 40% through mid-July.
However, we doubt that the managers placing these trades are patient long-term investors (and we suspect that many, not wanting to underperform their benchmark, are buying these stocks simply because they are increasing in price) and anticipate that they will sell their shares at the first sign of trouble. We saw a sneak peak of what could occur on July 16th, when Netflix reported disappointing earnings and its stock dropped 14% in after-hours trading (the stock has since recovered a small portion of its loses). In addition, on July 25 Facebook provided disappointing sales and profitability forecasts and the stock plunged more than 20% in after-hours trading. Whether these were one-off events, or a preview of more trouble is impossible to say for certain, but our best guess is that at some point, investors in many of these high-flyers will lose a great deal of money.
Could the Passive Equity Investing Rally Be Breaking?
In the U.S., passive investing has gone from ~10% of all equity assets to ~40% since the late 1990s. But could that trend be reversing? And what would that mean for U.S. equities? According to Morningstar, the first half of 2018 saw a 44% reduction in inflows into U.S. passive investment vehicles from the prior year. Of particular interest, BlackRock (the world’s largest money manager and a major provider of passive investing products) saw institutional investors withdraw $21 billion from passive stock funds but experienced $7 billion of inflows into passive bond funds. This trend was not limited to professional investors, as retail investors withdrew $1.6 billion from BlackRock’s passive stock funds and increased their exposure to passive bond funds by $6 billion. This reaction could be a sign that investors are getting nervous and embracing the perceived safety of bonds. If this trend away from passive equity investing continues, it could create significant selling pressure on “popular” stocks that are components of major indexes and ETFs.
Some Value Investors Are Changing Their Stripes (But We Won’t)
It has been a lonely time for value investors. The Russell 1000 value index has underperformed its growth counterpart for 10 of the past 11 years, according to Michael Wursthorn’s June 4 article in the Wall Street Journal.
This result has naturally led some pundits to declare value investing dead, arguing that value investing principles are not suited for this new technology-driven age (almost identical pronouncements were made in 1999/2000). This view has led some value investors to embrace the stocks of high-multiple-growth companies, like Amazon or Netflix—with even Warren Buffett (Trades, Portfolio) owning Apple shares. We give Mr. Buffett a pass, however: with a cash hoard of over $100 billion to deploy, his investible universe is much smaller than that of most investors, and Apple arguably does have some traditional value characteristics. While it has been painful for us to watch high-flying growth stocks like Amazon gain 56% this year, we have no plans to change the investment style that has served us so well for so long. At some point (hopefully sooner rather than later), value investing will come back into vogue, and many of the value investors who abandoned their style to keep up with a benchmark will regret their decision.
Past performance is no guarantee of future results. Investing in equities and fixed income involves risk, including the possible loss of principal. This material is intended as a broad overview of Boyar Asset Management’s, philosophy and process and is subject to change without notice. Account holdings and characteristics may vary since investment objectives, tax considerations and other factors differ from account to account. The statistical and other information contained in this letter has been obtained from sources we deem to be reliable, but we cannot guarantee its entire accuracy or completeness. The information presented is not intended to be an offer to sell or the solicitation of an offer to purchase any security or investment product. This presentation may not be published or re-distributed without the prior written consent of Boyar Asset Management Inc. Investors should bear in mind that past performance of any investments described herein are for illustrative purposes only and are not necessarily indicative of future results. This presentation may contain, or may be deemed to contain, “forward-looking” statements, which are statements other than statements of historical facts. By their nature, forward-looking statements involve risks and uncertainties because they relate to events and depend on circumstances that may or may not occur in the future. The future of investment results of the investments described herein may vary from the results expressed in, or implied by, any forward-looking statements included in this presentation, possibly to a material degree. Boyar Asset Management owns shares of Madison Square Garden Networks.
