Fundamental Value 1Q19 Quarterly Letter

The first quarter of 2019 was one of Fundamental Value's largest gains since inception, returning 11.5% net versus a gain of 13.5% for the S&P 500. For the S&P, this was merely a reversal of losses created in the fourth quarter, when the market dropped -13.5%. Since FV only dropped -9.4% in Q4, we've come out 2.9% ahead during this 6 month period.

Since inception, FV has gained 18.4% annually net of fees, beating the market by 5.2% per year. A hypothetical investment of $100,000 in FV at inception would have turned into $168,000 at the end of Q1, compared to $132,000 if invested in the SPY ETF.¹

Market commentary

It is hard to believe that just a few shorts months ago we were talking about the historically bad year that was 2018. Since then, indexes have rapidly bounced back to set new all-time highs. The S&P 500 enjoyed its best quarter in a decade, and its best first quarter in two decades. Thus, we are back to warning about markets that are priced for perfection.

The table below shows some simple financial metrics that we hope will help demonstrate why we think future returns to many assets will be disappointing. In this table are yields on equity, bonds and cash, along with risk premiums and GDP growth. Pay particular attention to the percentile column, which compares today’s value to the historical range. Lower values are worse.²


Interest rates are lower than average: investors will earn less interest on cash and bonds. Equity yields are lower: a dollar invested in the stock market buys less earnings and dividends. Risk premiums are lower: investors are less handsomely compensated for taking incremental risk. Potential GDP growth is lower: investors will get less of a boost from overall economic strength.

Investors can quibble with the relevance or calculation of many of these data points. Likely, some data points understate the problem; some exaggerate it. But taken together, they paint a consistent picture of an inauspicious time to invest. That’s not to say that some markets and securities won’t continue to perform strongly. But investment selection will need to be done in a much more discriminating fashion.

Unfortunately, the behavior of most investors has been anything but discriminating. Investors have continued unabated in their push towards passive investing, showing a willingness to buy all securities regardless of valuation.

In contrast, Fundamental Value holds a highly concentrated portfolio of high-conviction ideas. Through deep, bottom-up analysis of individual securities, we attempt to find pockets of attractive return opportunities for our clients, even in an expensive market. (For more on our philosophy of exploiting cognitive biases to generate alpha, see here.)

FV is less than 90% invested today, and has been since inception. Despite this handicap, FV has outperformed the S&P 500 by 5.2% annually since inception. This 10%+ cash cushion minimizes the impact of market drawdowns, and leaves us with dry powder to put to work should we find more attractive investment opportunities.

As we find individual securities with more or less attractive risk-adjusted return characteristics, we expect our cash allocation to change. In particular, we hope to find many more great investments in the event of any market weakness.

A final note: it is important to recognize that our valuation concerns are independent of any of the risks du jour. Our projections for low returns are not predicated on a trade war, or hawkish monetary policy, or slowing earnings growth, or political instability. Lower returns are embedded because of rich valuations; should any of these idiosyncratic risks materialize, that will merely worsen our expectations.

Portfolio commentary

We made a few trades in the quarter. First, we sold Apple. This may come as a surprise to clients who have read our previous letters. Just a few months ago, we highlighted our resolve to continue as Apple shareholders, despite the company's weak iPhone guidance and the general deterioration of the Chinese smartphone market.

What changed? The price of the stock. From the time we re-underwrote our investment in early January, Apple shares have appreciated more than 30%. Since we published a piece on the company in April 2017, the stock has generated a 44.2% total return compared to 28.7% for the S&P 500. This is a tremendous rise for such a large company, and has materially impacted the valuation.

While we are sad to let go of such a great company, we are concerned that Apple will see less growth -- or even a decline -- in sales over the next few years, largely due to slower developed-market iPhone replacement rates.

We still think that the services segment will grow, as we described last quarter. However, this business is not without risks. For example, Apple’s 30% fee on app store transactions -- one of the major ways that the services segment generates sales -- has begun to cause a small revolt. This was first highlighted by Netflix’s move away from app store sales in Dec 2018, and was brought further into focus by Spotify’s recent antitrust filing against the company.

At a PE of 16.5x (roughly 15x net of distributable cash), we felt we were merely being adequately compensated for the risks involved. We prefer to be dramatically overcompensated, and thus we closed the position towards the end of the quarter.

Our investment in 21st Century Fox also came to an end in the first quarter. The merger with Disney fully monetized the value of the hidden assets we highlighted in our Q3 2017 letter. The price of our final share sales, at around $50, was nearly double our average price.

We initiated one long position in the quarter, Booking Holdings (BKNG), the leading online travel agent (OTA) in the world.

Essentially an asset-light online marketplace for hotels, Booking is the sole way to book many worldwide accommodations. It charges a roughly 15% fee for this service. This simple model has resulted in massive revenue growth, with net sales expanding from $2 billion to nearly $15 billion and EBITDA up 14x over the last decade. This growth has not required much capital, with the company’s $6 billion of EBITDA generated by less than $20 billion of invested capital.

Despite Booking's historical growth and returns on capital, its strong network effects, and Euromonitor-projected market share gains for the OTA segment overall, BKNG trades at a modest 16x 2019 free cash flow. We see a much longer growth runway for Booking than Apple, despite Booking trading at only a slightly higher valuation.

We think that US investors may be biased against an investment in BKNG due to a lack of familiarity with the Booking.com brand, which is headquartered in Europe and does the majority of its business there as well. It did not help that the company's name until early 2018 was "The Priceline Group, " a reference to the company’s well-known but financially irrelevant hotel auction brand. We think this is an example of investors falling prey to the “availability heuristic,” one of the cognitive biases we seek to exploit in the Fundamental Value portfolio.

We initiated a roughly 10% position in Booking Holdings for our clients.

For those that want to learn more about our investment process, we recently wrote a blog post about our position in Facebook, which you can read here.

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

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¹ Net calculations assume a 1.75% management fee. Fee structures and returns vary between clients. FV inception was 6/6/2016.
² Data from Bloomberg and Federal Reserve as of 5/31/2018. Productivity and population growth are five-year trailing averages. Equity yields use the S&P 500 Index, with price data through 5/31/19 and earnings data through 12/31/18.

• “Earnings yield” uses trailing 12 month earnings.
• “Shiller earnings yield” is the inverse of the cyclically adjusted PE ratio as created by Robert Shiller, which produces a smoother earnings stream by averaging inflation-adjusted earnings over the last 10 years.
• “Baa 30y yield” uses Moody’s Baa Long-Term Corporate Bond Yield Average Index.
• “BBB spread” is the option-adjusted spread between the yield of BBB-rated corporate bonds and the corresponding Treasury yield, obtained from FRED.
• “High yield spread” is the option-adjusted spread between the yield of below-investment-grade corporate bonds and the corresponding Treasury yield, obtained from FRED.
• “Potential GDP growth” is the CBO’s estimate of the inflation-adjusted growth the economy would produce with a high rate of use of its capital and labor resources.

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Bireme Capital LLC is an SEC 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.

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. Changes in investment strategies, contributions or withdrawals may cause the performance 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. SPY ETF performance includes expenses as well as reinvested dividends. For current performance information, please contact us at (813) 603-2615.