Mon Sep 21 2015
Live Index (1445 articles)

The Kind of Companies I Am Comfortable Owning

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A relatively calm year took a turn in the past month, with the Standard & Poor’s 500 falling nearly 7% over that period; as a result, the Standard & Poor’s 500 is down about 5% for 2015. As an investor, I feel these periods are a great opportunity to stress test your portfolio – to see if you’re ready for more downside if it lies ahead. John Hussman(Trades, Portfolio) wrote an article a few weeks back titled “If You Need to Reduce Risk, Do It Now.” I agree: if volatility made you question your portfolio, now is the time to take a hard look at whether changes should be made.

I say that as if the timing has meaning, but this is really a general statement that applies in all periods: if you aren’t willing – or happy – to see a reduction in the value Mr. Market places on your current holdings, I’d argue that you need to make changes. Personally, I think this is an indication that (a) the security is expensive or (b) you don’t really understand what you’re investing in and will be shaken out by lower prices on their own; either way, it’s time for change.

Looking at my personal portfolio, I’m content with where I’m at. I’ve been largely inactive through the recent market turmoil, but I’m watching a handful of names closely in hope of further declines. I’m taking about positions I currently own, where I want to see recent losses continue; I think I’m safe in assuming that most market participants do not share my perspective. In this article, I’ll attempt to explain why I feel that way about the companies in question.

The first two names, Berkshire Hathaway (BRK.B) and Microsoft (MSFT), are my largest holdings. In both cases, lower quotations from Mr. Market present an opportunity to potentially improve per share intrinsic value through share repurchases. Importantly, these companies are willing – and capable – of buying back a substantial percentage of their own shares, regardless of short-term issues in China (or anywhere else in the world). For Microsoft specifically, I think it’s likely that the actual impact on its Chinese business (where an estimated 90% of PC’s run illegal copies of Windows) is less important than the opportunity to buy back billions of stock at more attractive prices; from that perspective, short-term weakness is a net positive for investors.

More broadly, this period has reinforced a belief that I’ve held for some time: companies that are not dependent upon the kindness of strangers are also the companies that can capitalize on periods of instability / volatility (by repurchasing their own shares, buying other companies at more attractive prices, etc). For the owners of businesses like Berkshire Hathaway and Microsoft, months like August bring reason to rejoice, no matter what Mr. Market says.

In my mind, master limited partnerships (MLPs) are on the other end of the spectrum; as an example, let’s look at Energy Transfer Partners (ETP). At the end of 2009, ETP had $ 6.2 billion in debt and 168 million common units outstanding. Five years later (year end 2014), ETP had $ 18.3 billion in long term debt and 333 million common units outstanding. Said differently, the amount of long-term debt had roughly tripled, the number of units outstanding had roughly doubled, and the amount of debt per common unit had increased roughly 50% (to $ 55 per unit). My understanding is that this is quite common at MLPs (though maybe not this extreme): from what I can tell, issuing units is akin to breathing for most MLPs.

At the start of the year, ETP was trading at $ 65 per unit; at Friday’s close, ETP traded hands at $ 45 per unit. As the numbers above indicate, management has often used ETP units as currency: in the past three years, they’ve generated more than $ 3.7 billion in financing cash flows from issuance of common units (equal to ~16% of the market cap at Friday’s close). The problem is that Mr. Market isn’t feeling as optimistic about ETP’s prospects today as he was nine months ago; the company must issue 40% more units than they needed to on Jan. 1 to generate the same amount of money. Said differently, the cost of using equity as a way to fund the company’s expansion has become much more expensive. At the same time, the company is sitting on a mountain of debt: interest expenses were $ 860 million in 2014 (and are on pace to exceed $ 1.2 billion in 2015), compared to $ 394 million five years ago. The prospect of higher interest rates over time – and rising borrowing costs – is also a consideration for unitholders; the company has historically been dependent upon debt and equity markets. That doesn’t mean the world is about to end – but it does mean that, if others start to think that the world is coming to an end, it could materially impact ETP.

As an example, does it makes sense to start projects funded (at least partly) by issuing ETP units anymore? Projected returns that made economic sense at $ 65 per unit might not work at $ 45 per unit. And if enough new projects are shelved, how will ETP continue increasing distributions going forward? In the case of ETP, the distribution coverage ratio is already under pressure. Finally, if ETP can’t grow the distribution over time, will the market push the unit price even lower? If Mr. Market doesn’t change his dour mood, we might find out the answers soon enough; I’m not smart enough to answer these questions, but I would be thinking about this if I owned ETP units.

That was a long discussion, so let me quickly summarize why I don’t mind – and even hope for – lower prices at Berkshire Hathaway and Microsoft: they have the ability to withstand and capitalize upon short term instability / volatility of any kind. The fact that I’m likely to benefit from short term macroeconomic weakness around the world or from fear in the broader stock market makes enduring lower account values in the near term more bearable.

The third company that I’m happy to see fall further – Walmart (WMT) – receives solid marks on the criteria mentioned above (check out the most recent 10 quarters to see how management began capitalizing on a lower stock price in the last month of the quarter through repurchases).

Personally, I think Walmart is making intelligent long-term investments in its business. I believe the company is building an ecommerce network that very few competitors in the U.S. will be able to match; there’s reason to believe Walmart and Amazon (NASDAQ:AMZN) will continue to strengthen their lead over the remainder of the field in the coming years. In my opinion, Mr. Market is fully penalizing Walmart for the investments that they’re making in building out their network (the operating loss will exceed $ 1 billion this year by my math), while simultaneously assuming no long-term benefit from this spend; my work leads me to believe that this is a flawed conclusion.

In addition, Walmart is pushing ahead with the transition to Neighborhood Markets, the next evolution in the company’s business model. Meanwhile, comps at the company’s Supercenters have strengthened in recent periods; this will be a key factor in returning margins to historic levels. As it relates to employee wages, I think the reaction (based on the commentary I’ve read) has exhibited what Howard Marks (Trades, Portfolio) calls “first level thinking” – in this case, “costs are going up, EPS will decline, sell”. And while that’s a sound conclusion for what will happen in the coming quarters (and if that matches your holding period), I think it fails to consider what’s likely to happen in the coming years, including (a) a rising minimum wage nationwide, (b) Walmart’s impact on wages at other companies, (c) the benefit of being more selective on new hires, (d) potential improvements in employee retention, morale, shrinkage, etc, (e) the impact rising wages will have on spending among Walmart’s core customer base, and (f) other levers Walmart can pull to improve their margins.

Most of this is of little or no importance to the majority of market participants; they are only concerned with the stock price in the near term. For them, the math is simple: “costs are going up, EPS will decline, sell”. As I noted above, I’m happy to see them do so: a falling stock price allows me to invest in Walmart more cheaply, and allows the company to repurchase a larger number of shares without increasing the amount of money being spent. Walmart doesn’t need to rely on the kindness of strangers to run their business: the share count will continue to decline year after year after year. If you own this business, you should hope they can do this as cheaply as possible. Hopefully Mr. Market is kind enough to help on this in the months and years ahead.

Conclusion

As I noted above, I view the recent volatility in the market as a test. If stock price declines (without any change in fundamentals) worry me, that’s a problem; and if a large decline in the stock price (say, 25%) isn’t enough to entice me to buy more, that’s worrisome as well.

The seas appear to have calmed (for now) from what we saw at the end of August; instead of breathing a sigh of relief, it’s time to ensure you’re adequately prepared for the next storm.

If a 7% decline was enough to shake your resolve, imagine how you’ll feel if the S&P 500 is down 17% – or 27% – at year end. Investors should always prepare themselves for what lies ahead; price action alone must not be the impetus for your decision-making.

If you are not willing to accept the vicissitudes of the market – or individual holdings – with equanimity, do something now before it is too late.

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