Fourth Quarter 2017 Newsletter Commentary

Fourth Quarter 2017 Newsletter Commentary

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We are handling the current wave of disruptions the way we always have: by conducting intensive research to find skewed risk/reward opportunities in companies with resilient business franchises.

“New” always gets people’s attention. In 1999, Michael Lewis captured the seductive energy of the internet boom in his memorable book, “The New New Thing.” Today, the new thing is referred to as “disruption.” 2017 stock market returns reflect investors’ adoration of disruptors, as sentiment swung back powerfully to growth-style investing. Growth indices outperformed value in the U.S. by 17%, in emerging markets by 19%, in EAFE by 8%, and in Europe by “just” 5% (Figure 1).



Figure 1: Growth Outpaced Value by a Wide Margin in 2017 2017 Value Underperformance

Source: FTSE Russell, MSCI

Leading this disparity was the surge in stock prices of disruptors, many of which are in the U.S. and China, supported by the notion that these companies will displace incumbents in a fight-to-the-death battle. Investment pundits love a good acronym: in the U.S. we now have FANG MAN (Facebook, Apple, Netflix, Google; Microsoft, Amazon and Nvidia) which were up a cap weighted 46% in 2017, representing 23% of the Russell 1000’s overall gains and 13% of its market cap. In Asia we have the BATs (Baidu, Alibaba, and Tencent) which rose a cap weighted 96%, accounting for 18% of the MSCI Emerging Market index’s gain and now account for 8% of its market cap. Those subject to disruption have lagged, opening the door to clear-eyed analysis of risk and opportunity.

Assessing Disruption

Market sentiment aside, there is nothing new about the concept of disruption. Disrupted stocks have hit our investment screens ever since we opened our doors twenty-two years ago. The question is: are the disrupted companies going away? Of course, we don’t know the answer to that question. But we do know that disruption is difficult, and it doesn’t happen very often, even though it is regularly forecast.

For example, when low-cost Asian manufacturers came on the scene in the late 1990’s, western industrial companies were thought to be on the way to being “disrupted” out of business, yet they still retain their dominant positions today. On the other hand, digital cameras completely “disrupted” Kodak. How does one distinguish between the two?

The truth is, it is difficult. So, we resort to our tried- and-true approach – intensive research. If a stock is priced as if the disruption is a near-certainty, yet management has a credible plan to retain the business, we might choose to invest. If management is right, we can realize a significant upside. If management is wrong and the business erodes, well, that’s what the market expected anyway. Low initial valuation and slow decline of the existing franchise should allow an exit from the position with limited losses.

In Kodak’s case, management’s plan to contest digital photography was to enter the digital camera business. Yet Kodak had no manufacturing capability and no experience in the cut-throat world of digital consumer electronics basically, no edge. On that basis, Kodak seemed like gambling, and we passed on the investment. Meanwhile, we invested in western manufacturers that had a multitude of advantages they were able to exploit to thwart the competitive threat, including extensive global dealer and service networks, longstanding reputations for quality and reliability, and an ability to lower their own manufacturing costs by moving manufacturing offshore. Two completely different risk / reward profiles, and two completely different outcomes.

Our investment approach is to apply our bottom-up, intensive research process to expose client portfolios to skewed potential outcomes, where deep undervaluation, an identifiable path to earnings normalization, and downside protection provide the opportunity for significant upside with limited downside. Downside protection can take many forms, but some common characteristics include regulatory and scale advantages, the power of incumbency, and flexible cost structures that provide financial and operational resilience.

The Current State of Disruption

Consider the current environment. We examine four industries embedded in our portfolios facing the risk of disruption:

  • Money center banks, which have had to adapt to a slew of fintech disruptors;
  • Pharmaceutical supply chain, where the looming threat of Amazon has recently provoked controversy;
  • Technology, where incumbents continue their process of adapting to cloud computing; and
  • Advertising agencies, whose relevance has been questioned by investors in the age of Facebook and Google.

We also examine retailing, where we have limited exposure, as disruption is even more clear; downside protection is limited; and selectivity is key.

Large Banks are Evolving

The disruptive force in the banking industry is commonly known as fintech, which captures everything from blockchain technology to mobile transaction processing and peer-to-peer payment systems. Certainly, fintech has provided an explosion of user-friendly technologies that have made it easier to apply for a loan, transfer money, and manage a portfolio. Yet, despite the early hype of fintech displacing the major banks, it is the incumbent banks upon which fintech companies now rely for the backbone of their payment and settlement processes. The reason is obvious – the massive regulatory system that governs banking, not to mention the system’s complexity, has so far provided an almost insurmountable barrier to entry around the incumbent banking system.

The largest banks have been able to capitalize on their size and scale advantage to roll out state-of-the- art technology to a large and growing customer base. Investment in technology has emerged as a top management priority, which has included acquiring technology from the fintech companies. Rather than disrupting the banks, fintech has largely been an enhancer of their value proposition. Digital transformation also carries the potential to eliminate customer pain points, reimagine traditional banking services, and strengthen customer retention. Indeed, among millennials specifically, the four largest banking institutions have nearly 60% market share of primary checking/savings accounts compared to half that in the broad population (Figure 2); excellence in digital engagement is now firmly established as a key competitive advantage in financial services.

Figure 2: Money Center Banks Have Larger Deposit Share Among Millennials

Source: FTSE Russell, MSCI

It is impossible to predict how new and evolving technologies will impact these institutions in the future, however the bear case of slow erosion of market share as millennials start banking has not been realized, and the big banks’ scale and ability to use technology to improve the consumers experience and provide more secure mobile banking has led to an increase in share among the majors.

Pharmaceutical Supply Chain – Complexity and Value-Add

The main participants in the pharmaceutical supply chain are developers of new compounds, generic manufacturers, drug distributors, retail pharmacies, mail order pharmacies, payors, and pharmacy benefit managers. Investors most fear disruption in the distribution portion of the system, namely the drug distributors and retail pharmacies, as they are perceived as the most likely targets for Amazon. It is hard to predict if Amazon will enter any of these businesses, but an analysis of industry structure, profitability, and the business franchises is important to making a judgement.

In distribution, a three-player oligopoly (McKesson, AmerisourceBergen and Cardinal) accounts for 95% of the market. It is both a service business, as they help lower drug costs by sourcing generics for pharmacies, as well as a logistics business involving their extensive physical distribution capabilities. Regulation of the industry, their extensive service network, and overall value proposition to the pharmacies imply that the scope for disruption is limited. In addition, Amazon tends to seek out businesses that are ripe for margin compression. Drug distribution is a highly evolved industry, with efficient operations that operate at low margins, typically 2% to 4%, suggesting it is a lower probability target for Amazon. Whether there is an opportunity for Amazon to disintermediate the retail pharmacies remains to be seen. The trend is in the other direction; however, as prescription-by-mail penetration has trended down from 17% in 2010 to 12% today.

Software Companies Adapt to a Changing Landscape

Similar to banking, displacing embedded enterprise software is difficult. Two examples – Microsoft and Oracle – illustrate the point. Each provides mission-critical software in which companies worldwide have made massive investments over decades, making rapid erosion of their businesses a remote possibility. The real risk is missing out on the next phase of growth offered by new technologies. So, the question is, can these companies successfully navigate the transition to the cloud? In Microsoft’s case, the consensus is “yes;” Oracle appears to be on the way, but the jury is still out.

Microsoft was viewed as a prime victim for disruption when its Windows and Office franchises came under assault from cloud and mobile computing. But Microsoft Office has been around for over thirty years, with literally millions of years of time invested in spreadsheets and applications that run on these programs. Even if managements around the world make a concerted effort to replace Office with another cloud-based solution, it would likely take decades for the process to play out. Windows operating systems also power most cloud servers, a fact mostly overlooked by investors. To address the cloud threat, Microsoft moved from licensing Office to a cloud-based subscription model (Office 365), causing a short-term dip in revenues, but creating a strong and recurring income stream. Microsoft’s cash flow has grown at a 10% annual rate over the past three years, as the company has become the world’s second largest cloud provider, resulting in a re-rating of the stock as it became a “cloud play.”

Oracle has likewise been perceived as a victim of the cloud. The enterprise software, services, and database company has been criticized as slow to develop cloud-based solutions to service its global client base. This capability is now in place, and Oracle is successfully migrating clients to the cloud (Figure 3), while attracting new customers, albeit at a pace which is still a little disappointing to the market. We expect that inordinately high switching costs will afford Oracle the time to complete its customers’ transition to the cloud and support the case for its long-term earnings power, similar to the path Microsoft followed. In the event this process is not ultimately successful, we expect Oracle’s entrenched position and valuation to provide downside protection.

Figure 3: Oracle is Successfully Migrating Customers to the Cloud Revenue (Non-GAAP, $mm)*

Source: Company reports
* fiscal year ended May 31

Advertising Agencies' Role in a Digital World

Investors fear that the traditional agency model is threatened by new digital advertising channels (e.g., Google and Facebook), as advertising becomes more targeted and efficient. The question is whether advertising spend will decline over the long-term. The historical evidence for a decline, however, is scant. Over the last 100 years, advertising spending as a percent of GDP has remained in a tight band, even with the advent of new media over that period. Although a decline is possible, it is also possible that companies maintain or even increase spending, as they benefit from improved targeting. Despite all the current upheaval, the major agencies have posted positive revenue growth over the last three years.

Because of this uncertainty, it is more difficult to invest in any one type of media (TV, print, etc.), as there is no protection against a wholesale shift in spending. But we believe the advertising agencies are well positioned to provide the advice their clients need in a world of growing complexity, while also having flexible cost structures that can adjust to new realities.

Retail – Center of the Storm

Many retail businesses do not meet our criteria for downside protection, as their businesses have high leverage in the form of property leases and fixed operating expenses, limited or no barriers to entry, and are particularly vulnerable to the disruptive strengths of Amazon which, in 2016, sold an estimated $227 billion of goods while capturing over 70% of incremental e-commerce sales. The research question is what, from the existing retailers, can Amazon realistically disrupt. When we look closely at retail industry dynamics, we observe that the e-commerce model lends itself to high value items where shipping costs are low relative to the value of the article, such as consumer electronic goods, books, and apparel. On the other hand, the cost of shipping multiple, relatively low cost, fast moving, often bulky items (e.g., groceries) argues against the success of a full e-commerce model. In grocery, incumbents have expanded into the click-and-collect model to counter the Amazon threat, offering convenience the consumer wants without high delivery cost. We believe the risk / reward is better in grocery, and we have invested in Wal-Mart in the U.S., as well as Tesco and Sainsbury in the U.K.

Summary

Our approach to dealing with disruption can be summed up in three words: research, research, research. We seek to understand the strength of the underlying business franchise and a company’s ability to ward off potential disruptors. Of course, it is never possible to know the eventual outcome up-front, but by skewing the risk / reward profile in our favor, it is possible to expose our portfolios to investments where we see the downside case as being largely reflected in a company’s current valuation, with significant upside should the business successfully adapt to disruption.



DISCLOSURES

Past performance is no guarantee of future results. The historical returns of the specific portfolio securities mentioned in this commentary are not necessarily indicative of their future performance or the performance of any of our current or future investment strategies. The investment return and principal value of an investment will fluctuate over time.

The specific portfolio securities discussed in this commentary were selected for inclusion based on their ability to help you understand our investment process. They do not represent all of the securities purchased, sold or recommended for our client accounts during any particular period, and it should not be assumed that investments in such securities were, or will be, profitable.