Fundamental Value had a solid quarter, returning 4.2% on a gross basis. This return slightly trailed the S&P’s 4.4%, and brought gross returns to 35.3% and 22.5% for FV and the S&P 500 respectively since FV’s inception in June 2016.
The quarter included a few notable trades.
We trimmed our stake in some of our largest positions -- Apple, Samsung, and Berkshire Hathaway -- as they had all appreciated significantly in the preceding year. We continue to believe in their stories and still have material investments in each of them.
We entirely sold out of Humana, Inc., one of our best performing investments to date. When we made this investment last year (at about $156 per share), we felt the quality of Humana’s business was overshadowed by the pending failure of its merger with Aetna. We thought that once the merger fog was lifted, investor attention would return to Humana’s focus on the fast-growing Medicare Advantage segment of the health insurance industry.
Events played out in a manner consistent with our thesis: the merger was called off on 2/14/2017, yet the stock returned about 50% from our time of purchase. However, given the appreciation in the stock, and our increasing concerns around the long-term health of their Medicare Advantage market position, we decided to liquidate this investment for clients.
With the funds from the reduced or exited positions, we made significant additions to two names: Express Scripts and 21st Century Fox.
Express Scripts (ESRX) is a company that manages the drug prescription approval and payment process for health plans, companies, and some government entities. In this role they are called the Pharmacy Benefits Manager (PBM). They pool the negotiating power of their customers and seek pricing concessions directly from the drug manufacturers or wholesalers, allowing clients to achieve better pricing than if they negotiated on their own. They also use their expertise to exclude some drugs from coverage—usually drugs for which there are cheaper or better alternatives. Finally, they are somewhat vertically integrated, operating a large mail order pharmacy called Accredo.
We believe the opportunity exists to buy ESRX at a discount to intrinsic value due to a dispute with one of their largest customers, Anthem. This conflict came fully to light in early 2016, when Anthem initiated a lawsuit that claimed $3B in annual overcharging by ESRX. ESRX’s stock price quickly fell from $85 to $65 and has yet to recover, despite the company posting consistently higher EBITDA and earnings since. In fact, with trailing free cash flow (FCF) per share above $6 at the time, this means that the multiple on the stock has collapsed from a healthy ~14x to just over 10x. Since then FCF has expanded and the stock price has declined further, creating a FCF multiple of about 8.5x at the end of the quarter.
Recently ESRX disclosed exactly how much EBITDA they make from their contract with Anthem, which expires 12/31/2019. At about 31% of total EBITDA, their profits on the Anthem business are material. However, we feel that a loss of the Anthem business is more than priced into the stock, and calculate they will earn about $4.50 per share in 2021 when Anthem has fully exited the relationship. At that point the core ESRX business, which grew EBITDA 6% last year, would trade at a still-discounted 13x multiple. We think ESRX is priced for above-market returns.
Twenty-First Century Fox
Twenty-First Century Fox (21CF) is a media conglomerate whose main businesses include: 20th Century Fox Movie and TV Production, FOX Broadcasting, Fox News, Fox Sports (FS1, FS2, and Regional Sports channels such as the YES Network), FX, FXX, SKY TV (European Satellite TV), STAR TV (Indian Satellite TV), National Geographic, and a 30% stake in Hulu.
Over the long term, 21CF has seen substantial growth, as their focus on news and sports has proven prescient. Since 2004, Operating Income has grown from $2B to $6.6B, or a 9.8% annual rate. They consistently garner increasing revenues per subscriber from the cable companies that resell their TV channels, and their current contracts (per company guidance) indicate this ought to continue in the future.
The company also has some substantial assets that are “hidden” from cursory analysis, in the sense that they do not contribute much to current earnings (or even contribute losses). The most valuable is their ownership of a dominant satellite TV provider in India: Star. Star India is the country’s largest provider of pay TV services, reaching 650m people per month. This translates to substantial revenue, and as recently as two weeks ago CEO Lachlan Murdoch commented that they are “very confident” that Star India can do $1B of profit by 2020. At that point the business would be worth $20B if it garners the 20x EBITDA multiple the market currently places on their main competitor, Zee Entertainment. This equates to greater than $10 per FOXA share, a material amount relative to the $26.4 price at the end of the quarter.
We think the value of 21CF’s hidden assets implies that we are paying about 6-8x earnings for the core media business. This is a multiple we are very happy to pay for 21CF’s best-in-class media assets. 21CF is currently our largest position.
New position: Old Republic International
We made one new investment in the quarter, in an insurance company called Old Republic. Old Republic provides several distinct types of insurance: title, worker’s compensation, commercial auto, and others. In their title insurance business, they are the third or fourth largest provider in an oligopoly market that is just starting to fully recover from the Great Recession.
The other insurance lines have consistently performed better than the overall insurance industry -- generating large amounts of cash, or “float”, for Old Republic to invest at zero cost to the company. This money cannot be paid out to shareholders, as it must be held to (eventually) satisfy their insurance obligations, but Old Republic is allowed to harvest the investment income in the meantime. Old Republic has $12.8B of float, comprising cash, investment grade bonds, and equities, which generates over $300m per year of interest income.
Old Republic trades at about 1.1x book value or <13x earnings, a significant discount to the market and its peers. The book value multiple is particularly low since title insurance has lower capital requirements than other lines of insurance and generates high returns on equity. We think earnings in the title business should continue to improve as they have since 2009, with the excesses and mistakes of the real estate bubble continuing to fade into the background.
We can articulate a couple of reasons why this opportunity might exist. For one, Wall Street has largely ignored Old Republic, which has very limited sell-side research coverage. This is probably because management eschews one-on-one meetings with analysts and investors, preferring to do their talking solely on quarterly conference calls. There may also be some confusion around the company’s historical results, which appear extremely volatile due to the presence of a large mortgage guaranty insurance line prior to the financial crisis. With that business in run-off and generating a small amount of income, ORI ought to make consistent and growing profits going forward.
We are grateful for your business and your trust, and a special thank you to those who have referred friends and family. There is no greater compliment.
 For a further discussion of this idea, see our post on sumzero.com (membership required for access).
Bireme is a registered investment advisor. This post is for informational purposes only, and comprises excerpts from our original letter emailed to clients in October 2017. While Bireme believes the sources of its information to be reliable, it makes no assurances to that effect. Bireme is also under no obligation to update this post should circumstances change. Nothing in this post should be construed as investment advice, and it is not an offer to sell or buy any security. Bireme clients may have positions in the securities mentioned.
Advisory fees and other important disclosures are described in Part 2 of Bireme’s Form ADV. The performance described above is the performance on a dollar weighted average of the securities in all Bireme accounts invested in the FV portfolio from inception 6/6/2016 through 9/30/2017. Changes in investment strategies, contributions or withdrawals may cause the performance results of your portfolio to differ materially from the performance displayed. Different types of investments involve varying degrees of risk and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. It is not possible to invest directly in an index. Index performance does not reflect charges and expenses and is not based on actual advisory client assets. Index performance does include the reinvestment of dividends and other distributions. For current performance information, please contact us at (813) 603-2615. Bireme Capital LLC is a Registered Investment Advisor in the Commonwealth of Pennsylvania and the State of Connecticut. Registration does not constitute an endorsement of the firm nor does it indicate that the advisor has attained a particular level of skill or ability.