We are pleased to report continued positive performance across our strategies during the first quarter of the year. Before we dive into the details, we thought it would be worthwhile to review the competitive advantages of our investment strategy. While we have addressed this topic in previous quarterly letters, it seems particularly timely in-light-of the growing trend towards passive index investing. Lost in the love affair with low-cost, diversified index strategies are the benefits of a more selective and nuanced investment approach. After eight years of a bull market and increasingly high valuations, these benefits are more important than ever.
Nothing is more essential to a successful investment process than creating a sustainable competitive advantage. We have summarized below the attributes that differentiate our strategy – not just from passive index investing but from most other investors as well. This applies not only to equities but also fixed income, real estate and private equity.
- Value Discipline: Our ability and willingness to maintain a value-oriented investment philosophy provides us with a margin-of-safety that lowers the overall risk of any one investment. Internally, we refer to this as “buying 50-cent dollars”. This is in stark contrast to passively investing in a large basket of securities that inherently include many overvalued investments. Selectively investing in undervalued securities creates a natural advantage that should produce superior results with lower risk.
- Size: By industry standards we are relatively small-in-size – and in this business, size matters! There is ample evidence that large amounts of capital act as an anchor to performance. Conversely, our smaller size allows us to invest in many situations where a larger asset base would preclude us from investing. Case in point, the average market capitalization of our existing portfolio is approximately $17 billion compared to $42 billion for the S&P 500. With a larger pond to fish in we can be highly selective in the investments we make – this is a big advantage that applies to both public and private investments (i.e. real estate and private equity).
- Investing in Your Best Ideas: By definition, passive index investing results in the ownership of a broad selection of investments which inherently include a sub-segment of lousy businesses and overvalued securities. This is not a strategy for intelligent investing. Instead, we take advantage of a well- researched, carefully selected portfolio of 20-25 investments where our capital is concentrated in our best ideas. Over the long-term this portfolio should produce better results with lower risk.
- Long-term Time Horizon: We are afforded a major advantage by utilizing a truly long-term time horizon. Most of our investments are made with at least a five-year time frame in mind and some of them have been held for greater than 10 years. This allows us to capitalize on short-term dislocations to purchase investments at very attractive valuations and sets us apart from most other investors.
- Patient Capital: None of the above would be possible without a capital base that is patient and long- term oriented. Most investors, even those that wish to invest with a long-term viewpoint, often times are forced to react to short-term noise. This is dictated by the wants and needs of their capital base. We are incredibly lucky to have a client base that consists mostly of long-term relationships with high- net-worth families and individuals (average tenure of 9.5 years). Whether you realize it or not, your confidence and long-term trust in us serves as an enormous competitive advantage.
Our equity portfolio returned 1.9% during the first quarter. Excluding cash, the performance of the underlying investments increased 3.3%. Gains were dispersed broadly throughout the portfolio with particularly strong results from our investments in Apollo Group (+28%) and Richemont (+20%). This was partially offset by weakness in our energy investments and Wesco Aircraft (-24%).
We sold our position in New Senior Investments Group (SNR) during the quarter as the stock reached our appraisal of fair value. This position was held for just over one year – an unusually short time frame for us – but the result were very favorable with a total return of 33%.
At the end of the quarter we added an investment in Seritage Growth Properties (SRG) to the portfolio. Seritage was spun out of Sears Holdings in July 2015 as a publicly traded REIT with ownership of 266 Sears properties. The company has a large opportunity to “unlock” value because its master lease with Sears allows it to recapture up to 50% of existing square footage for re-tenanting and redevelopment. Based on results to date, Seritage is able to achieve a 4-5x increase in annual rent for third party tenants compared to legacy Sears leases. Assuming this ratio holds, the company will be able to more than double Net Operating Income (NOI) over the next five years which will result in very attractive shareholder returns.
Fixed Income Update
Our taxable fixed income investments, which consists almost entirely of corporate bonds, returned 2.5% during the quarter. Declining interest rates certainly helped results but we also benefited from strong gains in positions like Calpine and Titan. We added two new bond positions in Hertz and Windstream, both of which yield more than 7% and mature in less than five years. At quarter end the current portfolio of 18 positions has an average Yield-to-Maturity (YTM) of 5.6% with an average duration of three years.
The returns for our tax-free municipal bond investments also performed well during the quarter with a gain of 1.1%. The current portfolio has an average yield (YTM) of 4.4% with an average duration of approximately eight years.
We continue to be mindful of a potentially rising rate environment and as a result average durations remain relatively short. As you can see by the yields mentioned above, this stance hasn’t necessarily prevented us from finding attractive fixed income investments. By utilizing some of the advantages mentioned earlier we are able to deploy capital in a nimble and opportunistic manner to uncover some of the few remaining bargains left in the fixed income universe.
Real Estate Update
We are pleased to report the closing of our first private real estate transaction which took place in January. In coordination with our partner, F&F Investments, we purchased a 15-unit apartment complex located in Rolando Village (near SDSU) for approximately $4 million. We believe the property is in a highly desirable location and was purchased at a discount to current market rates. The business plan calls for an additional $500,000 in capital improvements for both interior and exterior renovations. Once completed, rental rates should increase materially and we are modeling for a total net return to investors of approximately 12.5%.
We currently have additional transactions in the pipeline with other partners at various stages of due diligence. We are a hopeful that at least a couple of these will close by year-end.
Private Equity Update
We continue to actively pursue private equity transactions, although, admittedly the pace has been slower than we anticipated. This is partly due to the inherent sporadic nature of investing in small private companies, but it is also a function of current valuations. As we mentioned in prior quarterly letters, we have been outbid on several transactions even though we believed our offers were fairly priced. You can be confident that we will maintain the same rigor and valuation discipline in evaluating private equity transaction that we have historically utilized in our other strategies.
As always, we thank you for your continued support and trust and welcome any questions or comments.