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Fundamental Value had a solid quarter, returning 7.71% gross of fees, in line with the S&P 500 ETF’s return of 7.65%. This brings the portfolio’s annualized outperformance, after typical fees, to 5.4% since inception.1 
While the market soared in Q3, most of the market’s YTD returns evaporated in the beginning of Q4. This has not surprised us in the least. We have kept a material cash buffer of ~10% in FV in order to have dry powder to buy stocks at discounted prices should the market turn lower. We are sharpening our pencils on a number of potential new investments. Our largest positive contributor in the quarter was HCA Healthcare, which we wrote about in Q4 2017. HCA gained more than 35% in Q3, after their quarterly results showed profits growing about 7% compared to last year. This level of growth is typical for the company: patient volumes at HCA hospitals (excluding new facilities) have increased for 17 straight quarters. We think HCA will continue to grow, as the demographics in their core markets and strong negotiating position with insurance companies allow them to build hospital additions and outpatient centers at high returns on capital. When we purchased the stock in 2017, we paid about 13x trailing earnings, which we thought was a bargain. In fact, this was even cheaper than it appeared, as the combined effect of HCA’s growth and the corporate tax cut meant that our purchase price was only about nine times what HCA will earn in 2018. Today, the shares are about 50% higher than our cost, meaning that they again trade at a low-teens multiple of current earnings. And again we find this to be undervalued relative to the long-term prospects for the business. Our second largest positive contributor was Express Scripts (ESRX), which appreciated almost 25%. This was despite an attempt made by Carl Icahn to break up the company’s pending merger with Cigna. Icahn wrote a letter on August 7th explaining why Cigna shouldn’t buy ESRX, even claiming that the deal “may well become one of the worst blunders in corporate history.” In his letter, he trotted out a number of ideas that have been used to criticize ESRX and the PBM industry in the past, including regulatory risk, risks to pharmaceutical rebates, and the risk of a decline in profitability after the expiration of ESRX’s contract with Anthem. While we discussed our reasons for owning a stand-alone ESRX in our 3Q17 letter, the best response to Icahn’s points came from Glenview Capital, whose missive rebutted Icahn’s points so thoroughly that we were wincing by the end. The piece explains:
Unfortunately for Icahn’s ESRX short position, ISS and Glass Lewis, who advise institutional shareholders on votes of this nature, voiced their approval for the merger on August 10th. To his credit, Icahn made the quickest about-face of his investing career, abandoning his effort to scuttle the deal on August 13th. Shareholders overwhelmingly approved the deal on August 24th. The DoJ approved it in early September. While the merger is still in the final stages of closing, the share price of ESRX has appreciated substantially towards the ~$100 value of the merger to ESRX shareholders. We made no material trades in the quarter. This is a a first for the FV strategy--never before have we so fully executed on a strategy of thoughtful idleness. Of course, no rational investing strategy will produce trades in all time periods. Investment decisions ought to be based on a comparison of market prices to underlying business values, not on the schedule of the earth’s orbit around the sun or on the desire to simply do something. But then, what do we write about in a quarter devoid of portfolio changes? A short discussion of the value of patience is what we came up with. The human brain has spent precious few centuries evolving in the time of markets, portfolios, and compound interest, all of which reward patience. Rather, it developed in a dangerous, threat rich environment, where a quick reaction to new information costs little relative to the risk of getting eaten by a tiger. Man thus developed a tendency to act quickly: to be impatient. In securities markets, this bias towards action is not rational. After all, any form of trading involves costs, and good returns are not enough to justify a new investment--it must also outperform the position it is replacing. In addition, there are other biases which can compound action bias, such as the disposition effect and herding. These are exactly the sort of investor biases we seek to take advantage of to achieve market-beating returns in the FV strategy. Given the many bad reasons for acting, we might expect portfolio managers that can fight this urge to beat their peers. And in fact, lower-turnover mutual funds do outperform their more frequently trading competitors by 2.4% annually. We will continue waiting, only trading when we feel it improves the risk and return profile of the portfolio. 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. - Bireme Capital
1 Net calculations assume a 1.75% management fee. Fee structures and returns vary between clients. FV inception was 6/6/2016.
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FV slightly trailed the market in Q2, returning 3.3% before fees vs 3.6% for the SPDR S&P 500 ETF (SPY). This brings the portfolio’s annualized outperformance, after typical fees, to 6.1% since inception.1 
For the second quarter in a row, the largest negative contributor was Cogeco, as our investments in Cogeco Communications (CCA) and Cogeco Inc (CCA/CGO) declined 10-15%. We continue to think Cogeco is extremely cheap at <10x FCF for a locally dominant cable provider, as we laid out in our Q2 2017 letter. We bought more CCA this quarter, and it remains one of our largest positions. Despite the fall in the stock price, Wall Street EPS estimates for Cogeco Communications have been rising year to date, moving from 6.02 to 6.36 CAD for 2018.2 On June 29th, the shares fetched 64.68 CAD. 1 Net calculations assume a 1.75% management fee. Fee structures and returns vary between clients. FV inception was 6/6/2016. Bireme Capital LLC is a Registered Investment Advisor. 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. This piece is for informational purposes only. If not specified, quarter end values are used to calculate returns. 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 (and usually do) have positions in the securities mentioned.
Fundamental Value (FV) was down 1.05% in Q1, slightly trailing the -1.0% total return of the SPDR S&P 500 ETF (SPY). Since inception, FV has returned 22.7% annualized (net) vs 15.4% for SPY, an outperformance of 7.3% annually.
No stock in the portfolio had a more eventful quarter than Express Scripts (ESRX), which agreed on March 7th to be acquired by health insurer Cigna in a $67 billion dollar deal. The consideration to ESRX shareholders consists of $48.75 in cash and 0.2434 in Cigna stock. This amounted to $96 per ESRX share based on Cigna’s $194.25 stock price prior to the announcement.
Cigna’s stock, though, has declined to $171.65 since the deal was announced, underperforming its peers by about 10%. Most of this move occurred in the first day or two after the deal was announced, as investors apparently questioned the logic behind such a large purchase for the $41 billion insurance firm. The deal is worth about $90 to ESRX shareholders today. Somewhat surprisingly, ESRX traded lower for the quarter, finishing at $69 per share. It's currently priced for a >30% return should the deal close. There are risks to the deal, including antitrust risk and the risk that Cigna shareholders will vote against it. But to put this in perspective, deals requiring shareholder votes at the purchasing company are completed about 82% of the time, and that includes deals that fail due to antitrust challenges. Cigna/ESRX may appear to have a greater than average amount of antitrust risk. Health insurers can be clients of Pharmacy Benefit Managers (PBMs) like ESRX, making this the type of "vertical" integration that has recently come under increased scrutiny. In fact, the government is at this very moment midway through an attempt to break another vertical integration in AT&T/Time Warner. The DoJ lawsuit challenging that merger surprised many participants and appears to have made investors leery of all vertical deals, as demonstrated by ESRX’s large discount to the merger price. We do not think the government would have a compelling case if they chose to similarly challenge the ESRX deal. Often, when the government challenges vertical mergers, they attempt to show that the acquirer would withhold the acquiree's product in an attempt to sell their own upstream service. This was the argument put forward in the Time Warner (TWX) case: AT&T might attempt to push consumers to drop Dish satellite service and sign up for DirecTV by withholding TWX-owned channels like CNN and TNT from Dish. The corollary in the Express Scripts case would be if Cigna withheld Express Scripts PBM services from insurance companies that compete with Cigna. In the case of TWX, this sort of vertical foreclosure is plausible; after all, TWX does have exclusive content such as CNN and HBO that are important to carriers like Dish. But PBMs have no such exclusive intellectual property. All PBMs do pretty much the same thing, and compete on service, reputation, and price. Perhaps the government will object to the fact that the market will lose the sole “independent” PBM, with almost all others being aligned with health insurers or pharmacy networks. This may be true, but we feel it will be difficult to show that this would harm the consumer. After all, ESRX does not have anything close to 100% market share amongst health insurers, who would be heavily motivated to seek out an independent provider if they thought a competitor-owned PBM would harm their insurance customers. Cigna itself currently uses OptumRx for a large portion of its PBM function. OptumRx is owned by Cigna’s competitor UnitedHealth Group, a fact which does not seem to have harmed the relationship. There is even a history of health insurers starting PBMs from scratch. This includes ESRX’s largest customer, Anthem, which is in the process of launching its own PBM service and cutting ESRX out of the contract completely. Whether the DoJ challenges this deal remains to be seen. We plan to hold the stock for now, barring a dramatic appreciation towards the deal price. The largest negative contributor in the quarter was a name we highlighted in a previous letter, Cogeco Communications. Cogeco declined about 20% for the quarter after posting admittedly mediocre profit growth from the core business. However, they continue to gain broadband share in their markets, management is still guiding to low single-digit profit growth, and the shares trade at less than 10 times free cash flow. We continue to believe this massive discount to the overall market is unwarranted. We added to our stake in the company, and it is now one of our largest positions. We made one sale during the quarter, letting go of National Presto Industries (NPK), a diversified manufacturer of ammunition, electrical appliances and (until recently) adult diapers. We owned NPK for many years. We thought highly of management's conservative nature and focus on the business as opposed to impressing Wall Street. The CEO, MaryJo Cohen, is a second-generation manager with a large amount of skin in the game due to her 24% stake. While NPK has multiple segments and a multitude of products, the defense segment generates 90% of its profits. Within this segment, historically >50% of sales came from a single contract to produce 40mm grenade ammunition. Unfortunately, a recent change to the way this contract is awarded (the removal of the small business requirement) makes it much more likely that this contract will eventually be lost to a larger rival. In fact, there have already been contracts for next-generation 40mm training rounds awarded to two competitors, including the behemoth General Dynamics. With the playing field leveled and competitors already starting to make inroads, we felt it was time to part ways with this investment. We sold the stock for about 14x PE (after backing out net cash), which we felt was a full multiple given the risks. We made one purchase in the quarter, of a strip-center focused REIT called Kite Realty. Kite, headquartered in Indianapolis, is a $1.2B market cap firm that was started in 1960 as a drywall, painting, and construction company. They have concentrations in Indiana and Florida, and own 117 properties with 23.3m square feet of leasable space. The stock is down 32% over the last year, causing it to trade at an 8.4% dividend yield and 12.5x EBITDA. This is a nine-year low in valuation. We have been looking for a way to invest in retail for years. We've looked at department stores, apparel retailers, and malls, all in an effort to bet against the Amazon-induced panic surrounding physical retail. By and large, we’ve found that investor pessimism was well founded, and up until now our only investment on this theme has been Walmart. But in Kite, we believe we have found the intersection of negative sentiment, cheap valuation, and good business prospects that we look for. Sentiment and valuation levels are obvious -- you don’t often get to purchase REITs at 7x cash flow from operations. Yet, the business is stable, and occupancy rates are at a fairly high 94% averaged across the portfolio. This is in large part because their tenants are stable. Their largest customers are firms like TJ Maxx, Publix, and Ross, firms with solid business plans and positive same store sales. This is unlike the mall companies, which are dominated by struggling apparel retailers that are beginning to question the $30-40 per square foot rents of the enclosed malls (vs the $15 or so they might pay at Kite’s properties). Another important metric is releasing spreads -- this is the difference between the prices on outgoing and incoming leases. At Kite, this number has been a positive 7-10% for the last 8 quarters, in stark contrast to some of the mall operators that are generating double-digit negative releasing spreads. We are not the only ones that have noticed the value in the stock, as four Kite insiders purchased a total of over 110,000 shares in the first quarter. We started purchasing shares of Kite at around $15 per share, similar to where they stand today. 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. - Bireme Capital Bireme Capital LLC is a Registered Investment Advisor. 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. This piece is for informational purposes only. If not specified, quarter end values are used to calculate returns. 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 (and usually do) have positions in the securities mentioned.
Fundamental Value had an exceptional quarter, up 10.7% gross vs the S&P 500 which was up 6.8%. For the year, FV finished with a 28.2% gross return vs the S&P’s 21.7%. The positive relative results were notable given the material cash balance carried throughout the year and the fact that traditional value indices underperformed in 2017, a headwind for our strategy which tends to favor such stocks.
Despite the market’s increasingly rich valuation, we continue to find stocks we believe will generate high single-digit to low double-digit returns. This leaves us optimistic for the returns of FV going forward, despite our expectation of less than five percent returns for the US stock market as a whole. During the quarter, we made two significant trades, taking one new position and exiting one position. HCA Healthcare The lone position we initiated was a company called HCA Healthcare, one of the largest hospital operators in the country. In 2017, this for-profit operator’s 177 acute care hospitals and 250+ outpatient facilities generated over $43 billion in revenue and adjusted earnings per share of about $6.70. This means the stock, which we began purchasing around $86, is quite cheap at <13 times trailing earnings. HCA is a great business. On a profitability and returns basis it stands apart from its peers, with ~19% EBITDA margins and 16% returns on capital. As a reference point, S&P 500 companies average a ~7% return on capital. HCA does not hurt for growth, either, having doubled revenue and profits since coming public in 2009. It has generated this growth both through acquisitions and building new facilities, and emerged with top two market share in nearly all of its core markets. This makes HCA hospitals and outpatient facilities indispensable to insurance companies in those locales. With increased negotiating leverage comes higher reimbursement rates and larger profits for HCA hospitals relative to their for-profit or non-profit peers. In the end, HCA’s smaller competitors risk getting caught in a cycle of lower reimbursement rates, less money to reinvest, lower quality care, and less relevance to insurers. Many of them have attempted to battle HCA’s scale through mergers, but this has just saddled them with debt. Some are now trying to deleverage by selling assets. This benefits HCA, which has become the natural industry consolidator due to their immense financial resources and ability to tuck acquisitions into their existing networks. Tenet Healthcare’s former CEO said it best when he explained why they sold their Houston hospitals to HCA: “So we had four hospitals in Houston. They were just so far apart that they weren't exactly a network but they sit beautifully within HCA's network. So this is an example where there was a great acquisition for HCA and it was a great sale for us. And they have tremendous synergies in folding that into their system.” Despite HCA’s unique advantages, the market seems to unfairly paint all for-profit hospitals with the same brush, valuing them at 10-11x EBIT and 12-13x PE. This is much cheaper than the overall market and probably justified for the lower-quality operators. But we think this creates an opportunity to invest in HCA at a large discount to intrinsic value. HCA is a top five position in Fundamental Value as of this writing. Biglari Holdings We sold out of Biglari Holdings (BH) in the fourth quarter. Originally called Steak ‘n Shake, Biglari Holdings was solely a restaurant company from its founding in the 1930s until Sardar Biglari got involved in 2007. Biglari, a hedge fund manager at the time, waited a year before launching a proxy challenge that resulted in his taking over the company. He then abruptly stopped opening new restaurants, preferring instead to invest the cash flow outside the core business. He has had success with these investments, the largest of which is BH’s 20% stake in Cracker Barrel. These shares were purchased mostly in 2011, and have grown in value as CBRL’s stock price has risen from $50 to $175. Yet despite these successes, BH stock always traded at a large discount to its apparent value. Most market participants said this was due to the eccentricities and maneuverings of Biglari, who exhibited a blinding ego, sharp mind, and willingness to ignore smaller shareholders. In the end, fears of Biglari were well founded. He managed to secure a lavish pay package, change the company name to his own, and, most egregious of all, vote firm-owned Treasury shares in his own favor to fend off a proxy challenger in 2015. Despite our concerns, we always thought the discount implied by the market and Biglari’s undeniably strong investing track record were more than enough to compensate for his shenanigans. What finally changed our mind was the deterioration of the Steak ‘n Shake business, which saw comparable traffic down 4.5% for the first 9 months of 2017 and a decline in profits from $30m to a mere $1m before taxes. With the core restaurant business in a tailspin, we decided the discount was both smaller and more appropriate than we had previously assumed. We sold the shares at around $340 per share, generating a loss of about 15% on our investment. This was an example of our sell discipline, which emphasizes rational analysis of our investments which have declined in value. It is not easy admitting you are wrong, and research shows that this creates a bias amongst investors called the disposition effect. This analytical flaw causes an irrational desire to hold on to losers in the hopes of eventually booking a gain. We work hard not to fall prey to this bias, and re-examine our thesis any time a company’s share price declines materially. If nothing has changed, we may increase the size of our position, as we did for 21st Century Fox and Express Scripts in the third quarter. But sometimes we conclude that our thesis was wrong. In those cases we sell, as we did with Biglari Holdings. Thank You As always, 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. -Bireme Capital Bireme Capital LLC is a Registered Investment Advisor. 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. This piece is for informational purposes only. If not specified, quarter end values are used to calculate returns. 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 (and usually do) have positions in the securities mentioned. 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 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 [1]. 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. -Bireme Capital 1 For a further discussion of this idea, see our post on sumzero.com (membership required for access). Bireme Capital LLC is a Registered Investment Advisor. 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. This piece is for informational purposes only. If not specified, quarter end values are used to calculate returns. 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 (and usually do) have positions in the securities mentioned. |
