Fundamental Value had a solid quarter, essentially flat against a loss of -4.6% for the S&P 500. Our short positions made the difference. Our average short name was down -17% and the short book contributed 5.5% to the quarter’s return. FV has compounded at 24.7% net of fees since inception in 2016, outperforming the S&P 500 by 8.6% annually.1
After disappointing Q1 guidance, the market gods have given us a tantalizing opportunity to buy Netflix stock at nearly a 50% discount from its peak. Investors seem to be extrapolating a one-quarter lull in subscriber growth into a multi-year issue, but we think Netflix will continue growing both users and ARPU for years to come.
As a result of the drop, Netflix stock price is unchanged from Q4 of 2019. This is despite the company generating an estimated $5.5b of GAAP net income in 2022, up from $1.2b in 2019. The stock trades at a ~33x PE ratio today. This is atypically high for our investing style, but we do not think it is commensurate with Netflix’s quality as a company. This is the cheapest valuation NFLX has seen since 2011, when all of its profits were generated by the DVD-by-mail segment. The current price will look progressively cheaper over time: we conservatively estimate that the company will earn more than $30 per share by 2028 and generate billions of free cash flow along the way.
A surprising purchase
Our letters over the past two years have contained an unceasing drumbeat of bubble warnings and excoriations of the speculative frenzy in growth names. Thus, long-time readers will doubtless find themselves confused to see us buying a canonical growth stock that, while historically cheap, nonetheless trades at over 30x earnings.
We took a substantial position in Facebook this week after it fell to less than $200 per share.
It is not our first go-round with the company. We originally bought the stock in 2018. At that time, we thought it was strange that such a high-quality company had fallen to less than 20x earnings. In our 4Q18 letter, we wrote:
We have watched Facebook from afar for some time. We have long been impressed at the pace they have grown the business, with revenues increasing from $5 billion to about $55 billion over the past six years. That growth has fallen to the bottom line as well, with profits multiplying from $1 billion to $20 billion.
This analysis turned out to be accurate.
Fundamental Value had its best year ever in 2021, returning 48.5% net of fees vs 28.7% for the S&P 500. The strategy has now compounded at 25.9% net of fees since inception in June of 2016, beating the market by 800 bps annually over more than half a decade. While this level of absolute returns is unlikely to be sustainable, we are as confident as ever in our ability to significantly outperform a still richly-valued equity market.1
Fundamental Value was up 9.1% net of fees in the third quarter, handily eclipsing the S&P 500’s return of 0.6%. FV has had a spectacular first three quarters of the year, returning 38.6% net vs 15.9% for the S&P. FV has now generated a net return of 25.6% annualized since inception in 2016, outperforming the S&P by 9.2% annually.1
Fundamental Value returned 27.0% net of fees for the first half of 2021, handily besting the S&P 500’s 15.2% gain. The strategy has now returned 24.9% annualized since inception, outperforming the S&P 500’s 17.2% return by 7.7% annually.1
At less than 6.5x earnings, Imperial Brands -- a UK tobacco firm -- is one of the cheapest stocks we have ever seen for a company with consistent profits. The stock has declined by about 50% since 2017 despite flat EBITDA and profit figures. We believe this is due to Imperial’s underwhelming operational performance combined with the market's infatuation with growth and ESG stocks, two themes which do not include Imperial.
We think investors excluding Imperial on these grounds are falling prey to social conformity bias, which means they are simply aping their peers. At Bireme Capital, this is exactly the type of mistake that we seek to exploit in our Fundamental Value strategy.
In contrast to our investor peers that see a no-growth, unsavory business, we see a company with stable cash flows, beloved brands, and high returns on capital, not to mention the ridiculously cheap earnings multiple. Due to the company’s 8.5% dividend yield, we expect Imperial’s stock to provide satisfactory investment returns regardless of where the stock trades in the short term.
Cogeco Cable is an undervalued Canadian cable company, with shares of Cogeco Inc. trading at about 10x free cash flow and 7x EBITDA. For these multiples you get a company with a near-monopoly on high-speed internet in its Canadian footprint as well as significant exposure to US cable customers.
Cogeco has more than doubled sales, EBITDA, and FCF since 2008, all without growing the share count.
Long term, a strategic buyer is likely to purchase these assets at a significant premium, as Altice and Rogers attempted in the summer of 2020.
After struggling during much of 2020, Fundamental Value enjoyed a phenomenal fourth quarter, soaring 47.1% net of fees compared to a gain of 18.3% for the S&P 500. FV finished the year with a gain of 29.8%, outpacing the S&P by 11.5%. Since inception, FV has returned 23.5% annualized vs 15.6% for the S&P 500.1
Part II: Anatomy of a Bubble
In the first half of the year, Fundamental Value struggled, giving up years worth of outperformance in two quarters. In the third quarter, FV outperformed slightly, but not nearly enough to claw back its losses. FV is down -11.8% net of fees in 2020, compared to a gain of 5.5% for the S&P 500. Since inception, FV has returned 12.3% annualized vs 13.5% for the S&P 500.1
Part I: Birth of a Bubble