Importance of social roles/ efficiency

Why has social role / efficiency become such an important component of my investment thought process?

Well all companies exist for a reason. Their relevance is determined by the role they play in society.

Being the most efficient producer is one such role, value accretive product creation is potential another and credit risk arbitrage, aggregation of scale and even asset accumulation are examples of social roles.

Unless we know what value our firm creates in society, it's hard to establish the longevity of our companies.

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My Facebook investment

Facebook, overhyped social media giant or undervalued media titan? Margins and growth rates tell the story. Time too gives us perspective.

Check out the margins:

Facebook
85% gross margin
45% op income margin
50% growth rate

Vs

Google 65% gross, 25% op;
Tencent 65% gross, 35% op
and; Ali Baba 65% gross, 35% op.

It is consistent across Facebook and Google that they have overhead cost at about ~40% of total revenue, and ~30% across Tencent and Ali Baba. Nothing concrete here but I will go with the hunch that this overhead % reflect more about the operating environment each group of companies are in.

It is the COGS of 15% for FB vs 35% for the rest that really caught my eye. Standard COGS for these companies include server costs and traffic acquisition cost. Basically, this refers to any cost involved in directing traffic to Facebook. Most of the cost here are standard components and it is the traffic acquisition cost that makes Facebook really interesting.

Unlike Google that had to pay a lot of money to acquire traffic through its various ad networks, Facebook has not need to do so, not yet at least though the management had plans to enter into the space.

With its rapid growth rate and high margins as compared to Google's plus a bottom line is almost at Google's level, investors must ask why. What is it that gives Facebook such high levels of profit efficiency?

My take is the way both companies acquire traffic. Facebook is a closed social media ecosystem that draws people directly onto it. Hence it does not have to pay for traffic. On the other hand, Google is a sprawling web giant that has to cast out its web bigger and bigger each day in order to sustain its grip on the internet. With Google's open ecosystem approach, I will put my money on it being the bigger cousin eventually. However I'd like to think that Facebook will be the much more profitable company given its hopefully self sustaining closed ecosystem.

It's even more remarkable if you consoder the fact that unlike Google, Facebook has yet to come under any major antitrust cases.

So yeah, that's why I think Facebook is undervalued

Update: I saw an advert by MCCYS with a remarkable level of engagement and intimacy created through the personalised contents and comments. This reinforced my conviction that Facebook is undervalued.

Investing in companies that increases Social Efficiency

Colgate, with its oral care business units, improves oral hygiene for a small cost today to improve our standard of living

Costco, supply chain efficiency reduces cost of consumption for customers, making both investors and customers better off at the same time.

3G Capital companies are all beasts of efficiency. In general society is better off because they are able to deliver same or better quality products with a much lower cost structure.

Verisign. It’s a monopoly but it performs an absolutely critical role in the internet driven world by serving as a registry for domain names.

Berkshire Hathaway’s group of companies 

  • Geico, low expense ratio increases payout for consumers while at the same time ensuring greater profitably for investors
  • Regulated Utilities type of companies like BHE and BNSF. Berkshire Hathaway’s iron clad capital sufficiency reduces the cost of borrowing for its capital intensive subsidiaries. This ultimately translates into lower utility cost for end consumers.

Investing in companies with the right culture and environment

A thought came to me as I was looking through my portfolio companies. An often overlooked factor in investments is the company culture. Most investors take a quantitative approach to their investments. There’s nothing wrong with such a method of valuation, but for long term investors, paying a higher price for quality might pay off in the long run. 

To give an analogy, and a Warren Buffett one in fact. Imagine you are trying to buy a gift for your girlfriend. You have 2 choices, a unpolished diamond, or a used brinestone. Both are undervalued but of course the unpolished diamond is still relatively more expensive. Which will you choose? Of course you will choose the unpolished diamond. It’s hard to imagine a scenario where your girlfriend will be happy with a brinestone regardless of what you do with it.

Relating this to investments, it is critical, even as we look out for under valued companies, that we identify the diamonds among the brinestones. These are the companies that will produce long term outperformance.

So what are examples of quality?

  • Passionate management team 
  • Strong cost orientation
  • Cost efficiency
  • Meritocratic structure
  • Lean structure
  • Performance driven
  • Ownership mentality

Some of my favourite groups of  companies include those affiliated to John Malone, 3G Capital and Berkshire Hathaway.

Trade on negative sentiments – only

I last added on to my position in mid April at the peak of the previous market cycle. Big mistake. The market went down afterwards and that’s my first experience of “Sell in May and go away”.

Lesson learnt. What we buy matters but when we buy them matters too. It’s hard to keep a full bladder and that that’s discipline to manage and control. 

A new resolution for me thus is to only buy when the market is fear, on dips and and on peaks.

Thoughts of my portfolio

I just bought more of QSR, LBTYA, SRG and KHC. Except for SRG, these are all ‘platform companies’ that relies heavily on M&A as a pillar of growth. 

In addition to the above, there’s also LBRDA, LILA, BUD, AME, AXTA and ST. All are ‘platform companies’. Broadly speaking, I can group them into:

  • Telecommunications 
  • Consumer goods
  • Industrials

In an era of stagnated growth, what’s better than to create value through leverage and the reduction of cost? All companies are managed by top management with strong track records, especially John Malone and 3G Capital.

That said, I am concerned about the impact of raising interest rates. Right now, although these companies enjoy stable and predictable cash flow, they are all highly leveraged and higher interest rates will be a major dampener of their growth. 

Fortunately, their respective access to capital appears to be in good shape. QSR and KHC has the further backing of Berkshire Hathaway with its mighty cash pile. For the John Malone companies, the proper hedging instruments (fixed i/r) are also in place. This helps them to avoid surprises. 

All seems well then. But the risk is getting a little too high for me to stomach. Only BRK.B and AAPL are ‘safe’ in my portfolio, plus my cash holdings, and they make up 35% of it. But that will not do. It’s time to deleverage, and reallocate my portfolio to companies that will benefit from the raising interest rates. More of BRK.B, cash and maybe WFC then. 

LBTYA: Liberty GlobalĀ 

Bought more of LBTYA at 34.7.

EV/EBITDA ratio of 8.34, below the US cable tv average of 11.31 and its 10 year historical median of 9.53. (Kindly note that I did not examine if there’s any one off income.) 

My benchmark isn’t quite accurate as Liberty operates in the Eurozone but it will do since I am managing my own portfolio. There’s also more to why I am buying LBTYA than valuation 

It’s hard to value John Malone’s companies as they are always unorthodox in their practices. That said, his preference is for his companies to be valued by the cash they generate. The cable cowboy was after all the first person to use EBITDA and his track record showed that he does know how to use it to its fullest effects.

His strategies are multi-fold – leverage stable predictable cash flow, financial engineering, tax shield, and stock buybacks – to accelerate the growth of his companies. Truth be told, no one quite knows what’s going on with his companies. 

So why am I buying into his company? 1) relatively cheap valuation, 2) tailwind for telecommunications and 3) John Malone and his team of world class operators! 

I can go on and on about the alignment of interest between management and shareholders, the unique moat created by a series of other John Malone companies but what’s important are the 3 points above. 

Check out the book Outsiders if you haven’t and you’ll know why I think John Malone is a world class operator.

Portfolio (Apr 2017)

Breakdown of Portfolio on Apr 2017:
Key Changes: Sold Hutchison Port Trust and Liberty Media, and took up positions in John Malone’s Liberty Broadband, Sensata and a new group of companies by 3G Capital.

Companies managed by 3G Capital follows the same formula that has proven to deliver market beating performance. 1) Strong Capital Allocation capabilities 2) management obsession with cost and 3) stable predicatable cash generating businesses.

Warren Buffett: 20%

  • Berkshire Hathaway (BRK.B)

John Malone: 25.9%

  • Liberty Global (LBTYA)
  • Liberty Global LiLac (LILA)
  • Liberty Broadband (LBRDA)
  • Liberty Media SirusXM (LSXMK)

3G Capital: 12.2%

  • AB Imbev (BUD)
  • Kraft Heinz (KHC)
  • Restaurent Brands International (QSR)

Others: 22.8%

  • Apple (AAPL)
  • Ametek (AME)
  • Axalta (AXTA)
  • Seritage Growth Properties (SRG)
  • Sensata (ST)
  • Asia Pay TV Trust (S7OU)

Cash Position at 19.1%

It is critical to win with your customers and suppliers.

It’s crucial to find a company that wins with its customers and suppliers. Otherwise it runs in the risk of incurring wrath from them.

If customers turns against you, you run the risk of depriving yourself of income streams. Look at Valeant and potentially Transdigm. They acquire companies that own monopolistic products and jack up the prices of the products after the acquisition. This corroborates with Citron Research view in its short report. 

If your supplier turns against you, your cogs might increase, or you get lousier credit terms, or worse, you are held hostage if they refuse to supply you.

At the end of the day increasing your profit margins just because you can builds your company on a shaky platform.

QSR: Restaurent Brands International

Bought QSR at 56.41.

It is hard to value QSR properly. Based on traditional metrics like PE ratio, QSR is overvalued (PE Ratio at 39, PB 7.78, PFCF 22)

Given the company’s unique operating model as an heavily leveraged acquisition platform, I have eventually reached at EV EBITDA to value the company 12.43, which is lower than the Global Restaurent industry median of 13.12. The metrics is used as it is a capital neutral valuation metric and it suggests that QSR is fairly valued.

With 1) a strong culture of capital allocation, 2) the cost obsession of its management 3) meritocratic, performance driven and ownership centric management and 4) the Operator Owner model led by 3G Capital, QSR has the makings of a good company that is shareholder friendly.

Fundamentally, QSR has an asset light operating model that generates annuity from its Burger King business. However, acquisitions might change its operating model – Tim Hortons operations is more asset intensive at the moment. Nonetheless, as a whole the company generates substantial and reliable cash flow that can be leveraged to fund further acquisitions.

Finally, there remains tremendous room for QSR to grow its business. Global Rev 603bn vs QSR Rev 4bn in 2016.

https://www.ibisworld.com/industry/global/global-fast-food-restaurants.html