Private Equity Masquerade

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“Investors should remember that excitement and expenses are their enemies.”

- Charlie Munger

March 10, 2017 was the 8th anniversary of the bull market in stocks that began in 2009. While the economic recovery from that same period has been labeled many things including “muddle-through”, “new-normal”, or other various metaphors suggesting anemia, the stock market recovery has been quite the opposite. From the bottom, the S&P 500 has gained a whopping 271%, while small and mid-cap stock indices have increased 307%. Buy-and-hold investors have more than tripled their money and experienced an 18-19% return per year over the last eight.

Considering the magnitude and duration of this bull market, it is remarkable how broadly unrecognized it remains. As of this writing, a sentiment survey among individual investors shows that only 30% feel the stock market will be higher in the next 6 months, whereas 46.5% believe it will be lower (with the balance being neutral).1 These bullish readings are 8.5% below historical averages, whereas the bearish readings are 16% higher! We see a similar risk-averse story when looking at the $50 trillion of “cash on the sidelines”, and we know that there is $2 trillion less in stocks today than in 2007 and $2.5 trillion more in bonds! It seems that more than eight years after financial Armageddon ended, investors are still wondering if another one may be just around the corner.

With that as our psychological backdrop, it may be easy to understand the attraction to alternative investments, private-equity, and other seemingly noncorrelated assets. A look at the asset allocation decisions among institutional endowment funds shows a greater than 50% weight in “Alternative Strategies” compared to below 20% just 15 years ago. As for domestic equities, these same institutions have sold and diminished their average weightings every year throughout this bull market. Private companies such as Uber or Airbnb have achieved private market capitalization levels of $68 billion and $30 billion, respectively, before going public. There is simply too much private money looking for a home. More importantly for public equity investors, it may point to some valuation bubbles that we view as outright dangerous. We want to stay far away from private equity activities that may be hiding or masquerading inside of some publicly traded stocks. Endeavors which attain these halo valuation-multiples have historically and inevitably found the gravitational pull back towards earth.

Amazon may be the poster child in this realm. Having been public for more than 20 years, it has become one of only five companies in the U.S. boasting a market capitalization of more than $400 billion, yet is still broadly thought of as a startup company. In 2016, Amazon posted an overall profit of $2.4 billion even though the cloud division (AWS) contributed $3.1 billion in operating profit. What this means is that the sum-total of all non-AWS businesses lost money. Meanwhile, shipping costs are eating them alive, swelling to $7.2 billion. But Amazon’s CEO appears more occupied with his vision of getting “millions of people living and working in space” and declaring a need for a “space-faring civilization” than returning profits to shareholders.

Amazon is certainly not alone. Google changed the name of its company to Alphabet explicitly because it wants the world to view it not just as a search engine, but rather as an entity capable of disrupting a whole host of traditional businesses through the “alpha bets” it takes in venture capital investments. Other than the piles of fun found in attempting to “create” innovation, there’s a serious investment problem here: all non-Google sales last year amounted to $809 million vs. $100 billion for all of Alphabet. Those activities contributed $3.6 billion in losses. In just the last year, Alphabet has jettisoned its satellite-imaging unit, its solar-powered drone division, its “Project Wing” drone delivery program, its robotics division, and its modular/cheap smartphone efforts. It’s finding these moonshot investments have developed into craters.

At Smead Capital Management, we are attracted to businesses that remain true to their roots, building upon the core competencies and value propositions that made them successful to begin with. We applaud management team moves to reinforce company moats, and are discouraged if we see distracting engagements that take the focus elsewhere. While the concept of innovation may sound exciting, disruptive, and futuristic, we generally don’t think capital is well spent on such moonshots. This is especially true if the economic need involved is already being met.

The kind of ventures we like might include Alaska Airlines (ALK) recent acquisition of the Virgin America. This broadens Alaska’s footprint, while consolidating industry capacity (think bigger “moat”!), making way for Alaska to be a dominant West Coast franchise. It paid a very fair price which may add to Alaska’s forward earnings immediately. Similarly, we applaud Lennar’s (LEN) recent acquisition of WCI Communities. This adds 13,700 lots and 55 active communities to LEN’s already entrenched East segment, and deepens its share of homebuilding in Florida to nearly 10% of the market. The recent success shown by Amgen due to its consistent R&D spending represents another prime example. It recently announced data from clinical trials of its new cholesterol drug Repatha, which demonstrated its ability to meaningfully lower LDL cholesterol with strong safety and tolerance profiles. This builds on Amgen’s already powerful moat, and introduces a new line of medicines that it can develop into many more therapies and indications. We never know the outcome of such things, but when ventures like these pay off, they give leverage and breadth to moats already in existence in a way few competitors can mimic.

John Kenneth Galbraith, in his work A Short History of Financial Euphoria, gives us another way to think about today’s landscape. He reminds us that “when there is a claim of unique opportunity based on special foresight, all sensible people should circle the wagons; it is the time for caution.” In this spirit, we will restate the idea that maniacal overcapitalization of expensive private and public securities should be avoided. When such “claims of unique opportunity” are regurgitated to you by your barber or Uber driver, you know it’s time to use caution.

We thank you for your continued investment and support.

Warm Regards,
Tony Scherrer, CFA

1Source: American Association of Individual Investors

The information contained in this missive represents Smead Capital Management's opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Tony Scherrer, CFA, Director of Research, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

© 2017 Smead Capital Management, Inc. All rights reserved.

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