Circle Of Competence Issue #13
DEPARTMENT OF GENERAL FINANCE
Phil Fisher's investment checklist which undoubtedly has served many investors well for over six decades. Definitely worth a read. And then reread.
For those of you who follow Buffett's every move and interview (like this nerd does), you will recognize this argument between Warren Buffett and Elon Musk as a classical misunderstanding of what the word 'MOAT' means. Buffett means a competitive advantage that allows one company to achieve superior profitability on invested capital over their competitors. Musk cares only about doing cool things with new tech, regardless of how much cash he burns. While he believes innovation is the only moat that matters, Buffett has been investing longer than Musk has been alive, and I wouldn't discount the ability of Buffett to adapt to new forms of moats - highly innovative companies being one of them (look at his investment in Apple)!
Interesting article on the difference between GAAP earnings in 2017/2018 and the actual cash flows (economic earnings) of the biggest 1,000 companies. This is a case in point as to why investors need to do their due diligence and get under the hood of companies' filings instead of taking reported GAAP numbers at face value.
Mortgage rates are rising, commercial rates are rising, and benchmark 10 year rates are rising. At the basics of valuation math are the numerator (cash flows) and the denominator (the discount rate). As rates (the denominator of said function) rise, valuations fall. It has been said that debt market lead equity markets - so what are bond markets saying at the moment? I make no predictions, nor do I care where rates go. But, Buffett always said the most important rate to know is the 10 year treasury because it gives a good idea of what types of returns can be had for little to no risk - and to value securities in light of this.
Who knew there were distressed investors for distressed private equity FUNDS? Interesting business model built around the specific situation where limited partners vote to oust their general partner (manager of their capital) but retain the fund's rights. Seems fairly messy to me, but perhaps these companies add real value by saving their partners' original investments versus realizing a permanent loss on their capital.
DEPARTMENT OF REAL ESTATE
This article dovetails nicely with the Sears article above. The disruption of brick and mortar retail is one of the biggest microeconomic trends in the age of Amazon and online retail. So, one must ask, what happens to all of the excess retail space? Conversion to (insert your vision here).
This is an interesting mini case study on IWG, which has a similar business model as WeWork, but is priced more like a real estate company than a tech company. It also has positive EBITDA, unlike WeWork. But my favorite line is at the end of the article and spells out the risks to WeWork's model of mismatching short-term assets (lease with WeWork's tenants) with long-term liabilities (lease with office owners):
"IWG's history, in turn, hints at what could turn out to be WeWork's biggest problem: Whirlwind expansion is very risky when it involves a commodity as cyclical and replicable as the office. Like IWG in 2000, WeWork more than doubled revenues last year.
A checkered history suggests short-term office space may have more potential for disruptive growth than sustainable profit."
I've followed Eddie Lampert's career and investments for a while now, and I do hope he can get through his woes at Sears and continue to invest his capital successfully, because it has been tough to watch a rising star take such a beating in the public markets like this. Sears now is auctioning off some of their profitable stores online in a sales and lease-back type transaction where the buyer simply buyers the physical asset and enters into a long-term lease with the selling company.
DEPARTMENT OF TECHNOLOGY AND STARTUPS
The Robots are coming. To medicine.
DEPARTMENT OF BOOKS
If you want to achieve anything in life, this book is a must read. I can't say enough about this short, but powerful work by Ray Dalio, the founder of Bridgewater Associates which has produced the most net profits of any hedge fund globally since its inception (almost $50B). He spells out his approach for getting exactly what he wants out of life, from idea conception to achieving your goal. The best part about this book is that its 'principles' are broadly applicable to just about any endeavor or field, even though Dalio applies them to business. Highly recommend also watching his video on 'how the economic machine works' because it is a great synopsis on long-term and short-term economic cycles.
DEPARTMENT OF PODCASTS
Wonderful episode on how to find underappreciated multifamily apartment opportunities with Andrew Cushman, a professional multifamily investor who has acquired over 1,800 apartment units over the past 6 years using outside investments. I particularly like how he breaks down the simple analysis he uses to understand where each potential deal stands relative to other properties in the market on a rent per square foot basis as well as relative to the median income trends. I would recommend this to anyone looking to learn more about the multifamily industry.
In this episode, Brandon Turner interviews Mark Hentemann, a writer and producer for the famous TV show, "Family Guy." Mark's favorite metric for comparing properties is the price per square foot, because it communicates exactly how much real estate he gets per dollar invested, vs. cap rates, which can be manipulated fairly easily in the multifamily valuation process. Funny, but highly educational, episode!
This is the second part of Preston Pysh and Stig Brodersen's interview with Jim Rickards, and it does not disappoint. Jim goes more in depth on his view that fixed supply monetary bases (cryptocurrencies) are doomed to failure because they are inherently deflationary vs. fiat currencies which are inherently inflationary. And when you have a deflationary currency, there isn't much of an incentive for a credit market to develop because when you borrow money, the real value of the debt GROWS over time vs. declines in an inflationary monetary system. He therefore concludes that since a credit market most likely will not flourish under such a fixed monetary system, that the 'use case' (case for using the currency) does not exist.
He also goes into detail about his new company, Meraglim, which uses deep learning applied in novel ways to predict where macroeconomic variables will be in the next six to twelve months. It seems to me to be a sort of "Palantir for Finance." I have to admit, when I heard him speak on what the company actually does, I was skeptical. However, after learning more about the various branches of science and new data he was applying neural networks to, I am not so skeptical as I am curious. Highly recommend listening to this episode for his analytical views on cryptos as well as his work in AI and deep learning applied to financial markets.
DEPARTMENT OF LETTERS
Highlighted Company - Evercore Partners
This week, I read through all of Evercore Partner's annual shareholder letters and took a look at their 10-k's dating back to their IPO in 2006. Here are some general thoughts I had about the business.
To start, Evercore is comprised of two lines of business:
- Global Advisory and Investment Banking. Within this line of business, they establish client relationships and fulfill client needs with regards to various types of corporate events such as M&A, recapitalizations, restructurings.
- Investment Management. Within this branch of Evercore, they have an institutional equities platform for institutional investors, a wealth management platform, an equities research platform, and a middle market private equity arm which raises and deploys capital into middle market transactions.
It is also clear that the co-founders of the firm are well-connected star players in the finance industry:
- Roger Altman, former US Deputy Treasury Secretary and Vice Chairman of Blackstone
- Austin Beutner, former General Partner of Blackstone (retired from company now)
The founders' vision was to start an advisory firm free from conflicts of interest that are rampant in the banking worlds. They also founded the asset management side of their business, which includes wealth management, institutional equities management, and Evercore Capital Partners (invests in private middle market companies where operational changes could be made to add value).
They have attracted many powerful and well-connected financiers over the years with sizable cash and stock awards, which is normally not particularly enticing to existing shareholders. However, what is interesting is that their goal has been to use the firm's profits to buy back 100% of the amount of shares issued to new bankers they bring in to fully balance out the dilutive effects of issuing new shares to new bankers. Just in the last 5 years alone they have returned $225M in dividends and $900M in share buybacks - over $1B in capital - to shareholders. While shares outstanding have grown in 2006 from 13M to 45M currently, they have only issued a net 7M over the past five years due to the level of buybacks. In addition to their share issuing and buyback strategy, they have also increased their dividend by 11% annually since 2006 and compounded free cash flow by 30% over the past 5 years.
Over the past ten years, they have advised on many of the largest deals of each year, consistently ranked number one in the independent advisory category, and consistently ranked between sixth and twelfth in global transaction volume for all investment banks (bulge bracket banks included). This illustrates the growing strength of their brand, and it seems to me that their strategy of using shares to attract top banking talent is beginning to pay true dividends to both management and shareholders. I am not sure to what degree each played a role in the success of the firm, but I believe the two pillars that the firm was built on were building their network by recruiting top tier bankers and the independence of their advisory practice (i.e. no underwriting of securities, just plain old advice). By doing both well, they have continued to grow fee paying clients each year with the exception of 2008 during the great recession and thus have grown transaction volume and fees by several times over.
As with every company, there are risks to their business. In my mind, the main risks center around reputation risk (their relationships to their clients are their lifeblood and essential for sourcing fee-paying transactions) and the cyclical nature of the investment banking business. Where does the business go from here? It all depends on 1) the talent and relationships that Evercore continues to attract and 2) the market for advisory services, which has shown to be highly correlated to general economic and financial market performance (in 2008, their top line declined significantly, but recovered well in 2009 due to a lot of restructuring business and a rebound in deal activity). There is also the risk that the fundamentals of the business deteriorate for reasons above while management continues to pay out large bonuses in cash and stock and thus lessen their ability to buy back shares and current shareholders get diluted.
In addition to the risks inherent in the business, the question that plagued me when reading their reports was simply "is their performance just a function of overall deal volume over the past decade?" To see if this might have been the case, I decided to look at the fundamentals of a few of their independent advisory competitors and how they performed over the past 10 years. My hypothesis was that if each performed somewhat in line with Evercore, then their performance was more due to riding a deal volume wave rather than company-specific advantages. I chose Moelis & Co., Greenhill & Co., Houlihan Lokey, Inc., and Lazard as my group of comps. Interestingly, Greenhill has a negative shareholder return over the past 5-7 years and Lazard returned significantly less than the S&P over the past 7-10 years. However, Moelis and Houlihan Lokey are new to the public markets in the last 3-4 years and have both shown significant growth their in top line, earnings, and free cash flow since their financials have been publicly available. However, neither of these has the track record comparable to Evercore in the public markets, which muddies the water a bit. It seems to me that perhaps the answer to my question may be both - yes, the performance has been due to the deal volume increasing over the past decade, but also due to their ability to source the deals, recruit star bankers, and build a practice on successful execution.
Bottom line, if you had bought Evercore Partners at its IPO in 2006 at $21 per share, you would have a roughly 18% compounded return on your money, without counting the roughly $9 in dividends per share collected over the same period, as of 5/21/18.
Will Evercore continue to be able to execute on its vision to become the world's most elite independent investment banking group? I would love to hear your feedback!
Do your own research into the company mentioned above. This is not a recommendation to buy the company's shares or take any action in the securities of the above company, but merely an overview of their operations.
What are you reading this week? Drop me a line and let's connect or tweet at @competence_co. Have a great week!