There has been an abundance of commentary on all things COVID so I will not cover ground that has already been addressed elsewhere. I will simply say – we are all looking forward to better days ahead.
I would much rather spend time discussing our investment activities for 2020.
The U.S. equity markets moved higher during the 4th quarter, with all major indexes moving to new highs as the year concluded. The abundance of government stimulus, the vaccine rollout, and expectation of additional stimulus, all drove strong investment returns.
In general, we are pleased with our investment performance for 2020. The actions we took in February and March during the COVID sell off have delivered sizable results thus far. We used the market decline as an opportunity to eliminate holdings that participate in slower growing industries (carpeting, automobiles, glass containers, automobile coatings, iron ore, and glasses) and replaced them with large high-quality companies participating in faster growing end markets – Zillow (digitizing all aspects of a real estate transaction), Spotify (transforming music and podcasts), and Google (search, autonomous driving). We also purchased companies that dominate their respective industry and occupy either the #1 or #2 position. In this category you will find Otis (elevator manufacturing and service), Elanco Animal Health (disease prevention/medical for pets) and Charles Schwab & Co (investment custody and brokerage). We continue to see global business shifting towards a “winner take most” environment where the largest players in an industry are seeing market share and profits accelerate despite their growing size. The disproportionate capturing of industry profits will most likely continue until a regulatory shift occurs or the company gets lazy and complacent.
I can hear the groaning now as I turn to the topic of fixed income. I have no doubt there is fatigue when it comes to our views on this topic, so let me be brief. Nothing has changed, and the fixed income environment is still challenging.
Our equity portfolios produced strong returns in 2020. While it was a rollercoaster ride, we finished the year on a strong note and are pleased with our overall performance. For 2020 on average our equity portfolios generated a +16.5% return.
The changes we made during the market decline in March contributed to our strong investment returns through the balance of the year. An increased technology weighting helped drive our strong results. In total for 2020 we sold 17 positions and added 20. It was a busy year.
During Q4 2020 we added Applied Materials (AMAT), Coupa Software (COUP), Capri Holdings (CPRI), Camping World (CWH), 1Life Healthcare (ONEM), and Charles Schwab (SCHW).
Applied Materials (AMAT) / Market Cap: $96 Billion
AMAT sells equipment and services used in the production of semiconductors and electronic displays. It is the largest of four major companies that account for 70% of industry sales. There are more than 350 steps to producing a semiconductor with diverse equipment needed to execute the production process. AMAT has a leading, and in some cases dominant, market share in many key steps along the manufacturing process.
With each generation of semiconductors there is a step forward in complexity which has resulted in enormous competitive barriers to potential new competition by way of patent protection and manufacturing/design know-how of the incumbents. Industry leaders such as AMAT realize high margins and have long-term demand visibility. Capital equipment generally experiences meaningful cyclicality over shorter periods, but services and consumable have grown as a percentage of revenues. This mix shift has resulted in shallower down cycles than in the past. Likewise, there are numerous, very large secular growth drivers for semiconductors and a constant race to produce faster chips that consume less power.
Coupa Software (COUP) / Market Cap: $24 Billion
Businesses are increasingly digitizing back-office operations to cut costs and improve operational controls. COUP provides a cloud-based software platform for corporate spending, procurement, and supply chain management. When deployed COUP’s software can automate manual processes and improve efficiencies, with benefits including stronger compliance, fraud prevention, supplier search, mitigating supplier risk, controlling inventory, and reducing costs through aggregated pricing. The company has demonstrated substantial cost-savings and a quick payback on investment for large global enterprises as well as mid-sized businesses.
COUP is regarded as a best-of-breed provider in a market that is very under-penetrated but increasingly targeted as a strategic priority for businesses. Its current revenue run rate is close to $500 million, less than 1% of an estimated future addressable market opportunity of $56 billion. It is an attractive business model with high margins, low capital intensity, recurring revenues, high customer retention and strong network effects.
Capri Holdings (CPRI) / Market Cap: $6.5 Billion
CPRI designs and sells Michael Kors brand clothing and accessories thru its own company stores, and other channels, in addition Capri owns two recently acquired luxury brands, Jimmy Choo and Versace.
Apparel & accessories sales came to a virtual halt during the early part of the COVID pandemic. With consumers not traveling or dining out, they also were not spending much on fashion. CPRI shares declined as sales slowed and the company was slow to recover as the market rebounded from the initial pandemic sell-off. Sales and earnings will benefit substantially from the upcoming cyclical rebound and the company’s longer-term expansion strategy. There’s ample room for higher valuation multiples as these factors come into view.
As the economy re-opens in 2021 there will be significant pent-up demand for spending on fashion, especially in the luxury-class categories on account of higher-income consumers experiencing less unemployment and income declines. Many of these consumers did, however, cut back on spending and thus have built cash reserves.
Pre-COVID, the company was just beginning to realize the benefits of strategic actions to improve Kors profitability. The company has initiated a distribution channel rationalization and is just now seeing synergies from of its acquired brands.
Camping World (CWH) / Market Cap: $3 Billion
CWH is the largest retailer of RVs and accessories in the US. The company owns and operates 165 retail stores that sell and service new and used RVs in addition to selling outdoor and camping related products. The company also operates the Good Sam Club, a low-cost subscription service for RV owners which offers information, discounts, and perks.
With the air and cruise industry severely impacted in the US, RVs became the vacation mode of choice for many consumers in 2020. Some models of motorhomes are sold out well into 2021 and it could take until 2022 for dealer inventories to get back to normal levels. Pandemic aside, other trends already underway were leading to industry growth, such as a preference for both outdoor and experiential spending, mobile technology that makes it easier to stay in touch and work remotely, and the relative price attractiveness of RVs compared to rising rents and home prices. These factors are broadening the appeal to younger consumers, creating a larger and longer-lived consumer base.
While there is short-term risk the industry could overshoot production and demand softens as air/cruise travel picks up, CWH has multiple levers for long-term growth. First, it is a consolidator, actively acquiring and building new retail locations in a highly fragmented industry with many single location or small multi-location operators. In addition to RV sales, CWH benefits from the growing population of RV’ers through its Good Sam Club operations, a high-margin, recurring revenue business, as well as follow-on camping-related sales. Strategies to further expand beyond RV sales include partnerships for RV sharing/rental, a national service platform rollout for RV repairs, and a partnership for distribution of electrical vehicles and follow-on plans to develop EV-platformed RVs.
1Life Healthcare (ONEM) / Market Cap: $7 Billion
One Medical offers primary-care physician services and coordination of broader healthcare services in a consumer-friendly and tech-enabled subscription service. The company charges consumers or corporate plan sponsors a modest annual fee in exchange for access to 24/7 virtual app-based consultation and fast access to in-person services at its medical offices. It has over 500,000 enrollees and 7,000 corporate sponsors with the opportunity for substantial geographic expansion and in-market penetration.
The company focuses on fixing commonly poor-performing aspects of the industry, such as multiple-week wait times to schedule appointments, limited hours of availability, excessive waiting room time for scheduled appointments, in-office patient paperwork and hurried consultation times with overbooked providers. It also uses proprietary AI-enabled platforms to improve administrative efficiency, allowing doctors and nurses to spend more time on patient care. Doctors are salaried and insured by ONEM, removing incentives to speed patients through the care process. The more attractive working environment enables them to recruit and retain high-quality physicians that prefer roles as caregivers rather than administrators.
With quicker and easier access to care, ONEM corporate customers have seen cost savings of as much as 45%. These benefits are being driven by reduced ER visits, more comprehensive personal interactions, improved follow-up, and better coordination of specialists. Telehealth visits allow for faster access to care and meaningfully reduced the cost of care. In its most mature market ONEM’s market share is below 5% and its share in currently served markets is just 1%. The industry for commercially insured primary care consumers is large, generating $160 billion in annual revenue, but highly fragmented presenting the opportunity for sustained long-term growth.
Charles Schwab & Company (SCHW) / Market Cap: $105 Billion
Charles Schwab is a dominant player in the brokerage and custodian business. The company delivers these services to individual investors and Registered Investment Advisors. Schwab provides a full suite of trading, banking, and investment products. Unlike its primary competitors (TD Ameritrade and Fidelity) Schwab is also a bank and provides traditional lending and checking account services.
In 2017 Schwab faced two material headwinds. One, in February of 2017 Schwab surprised the market by announcing it was moving trading commission to $0, and second, as interest rates decline its lending business became less profitable. Despite a growing customer base and growing asset base, its earnings did not grow due to these two headwinds.
The $0 commission announcement hurt Schwab but also hurt its next largest competitor, TD Ameritrade, even more. Sensing weakness Schwab announced it would acquire TD Ameritrade.
We believe the sizable cost savings opportunity from the TD Ameritrade acquisition, coupled with new revenue opportunities will once again drive earnings growth at Schwab.
We sold Cintas (CTAS), Home Depot Supply (HDS), Lumen Technologies (LUMN), Carrols (TAST), and Nova Gold (NG).
Fixed Income Update
Our fixed income portfolios finished 2020 unchanged. Our municipal bonds holdings delivered their predictable 3.5% return, but this offset by the -3.0% return for our corporate bond holdings. Our energy exposure hurt performance during Q1 2020, and we spent the balance of the year recovering from the impact. With the energy exposure now eliminated our fixed income portfolio is once again performing as expected, generating +12.3% returns for Q2 2020 through Q4 2020.
The fixed income environment remains challenging and with the Federal Reserve’s continued stance of low rates for the foreseeable future, we expect the low return environment to continue.
We completed one new real estate investment in Q4 2020.
Our real portfolio continues to deliver results consistent with our original underwriting expectations. To date we have seen no material COVID related impacts to performance.
After a quiet summer and fall we are now seeing our opportunity pipeline rebuild. Today we are evaluating three potential opportunities – a multi-family opportunity in Boise Idaho, the redevelopment of a grocery anchored center in California, and ground up development in the hotel sector. As these develop and we complete our underwriting we will share them with you.
A more detailed description and update can be found in the “Real Estate Update” included with this letter.
We did not make any new private equity investment in Q4 2020.
As the economy has slowly come back to life our private equity pipeline has refilled. We are currently evaluating three opportunities – two in the Quick Service Restaurant sector (one could possibly complement our Quantum Restaurant Holdings investment) and one in the grocery store sector. We are in various stages of diligence with each and should be in a position to share more later in Q1 2021.
A detailed update on our current holdings can be found in the “Private Equity Update” included with this letter.
The year 2020 will be remembered for a lot of firsts. Over time we will all have an opportunity to reflect on this period. As I look back on the year, I am proud of the Carmel Capital team. During some stressful and turbulent times, we not only delivered strong investment results, but also continued to engage with our clients and deliver high levels of service.
Like many others, we are happy to bid farewell to 2020 and welcome 2021 with the prospects of better times ahead. Our attention is on the road ahead and on the exciting opportunities we are working on.