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Investor Letters - Q1 2019

Annual Luncheon


Our second annual luncheon will be held in August. We will be sending out further details once the date and other details are set. Hope to see you all there!


1Q19 Results


During the first quarter of 2019, the Saga Portfolio (“the Portfolio”) increased 33.3% net of fees. This compares to the overall increase, including dividends, for the Russell 2000 and S&P 500 Index of 14.6% and 13.6%, respectively. Since inception on January 1, 2017, the Saga Portfolio returned 55.4% net of fees, compared to the Russell 2000 Index and the S&P 500 of 16.9% and 32.4%, respectively.



Interpretation of results


When we wrote about Mr. Market’s bi-polar behavior in last year’s third quarter letter, little did we know at the time we were about to go through one of the worst quarters, then subsequently one of the best quarters since S&P 500 data became available. It’s very interesting how quickly the market can swing from “risk-off” to “risk-on” over a relatively short period when the fundamental business environment changes little.


We make no attempt to predict how the markets will behave. There is a lot of noise in everyday commentary. Our advice is to ignore it. We understand and recognize the innate desire in trying to know the future but forecasting short-term stock price movements is something we think neither we nor anyone else is able to do successfully.


Our strategy for an inevitable future economic downturn is not to predict and profit from it, but to buy companies that will survive and likely benefit, either from being relatively immune to it or gaining a further advantage at the expense of weaker competitors during hard times. Buying quality companies, when priced right and run by honest, intelligent management teams, offers the best defense against challenging macro conditions. Over time, we expect our companies to be worth considerably more money than what we originally paid for them despite where we think we may be in a business cycle.


We hesitate to even discuss quarterly results because short-term returns are more or less random. However, we can confidently say that a +33% quarter is an anomaly and partially a subsequent reaction to the steep sell off at the end of last year. Many investment managers of average ability have recorded outperformance as well as underperformance over short periods. Evaluating investment results is like judging a round of golf. While a birdie on one hole may be nice, it’s the entire 18-hole round that counts. It is more important to focus on the long-term compounding returns of the Portfolio over a period of multiple years. Striving for quarterly or yearly returns would hurt and most probably prevent any potential for outperformance.


We think at least a five-year period of performance compared to the general market is a reasonable time to begin to assess an investment strategy, preferably with tests of relative results in both strong and weak markets. Once we have about five holes on the scorecard, we should start to have a general idea for how we are playing as we tee up for the remaining thirteen. In the meantime we suggest investors evaluate the Portfolio based on its philosophy, decision making, and the consistency of decision making relative to the stated philosophy as we develop a long-term track record.


Philosophy and Process


Several new investors joined the Portfolio over the last few months and since we are saving our semiannual review of the Portfolio’s top positions for the second quarter letter, we thought this is a good opportunity to spend a little time discussing our investing philosophy in more detail.


Our goal is to outperform the market by finding a few exceptional companies to own for the long-term. We evaluate opportunities for the Portfolio by applying four basic filters:


1. Do we understand the company and will it be around/prospering in 10+ years?

2. Is the company growing a durable competitive advantage?

3. Is management high caliber and aligned with shareholders?

4. Does the current price provide an attractive return if the company is owned for 10+ years?


We can usually find a few companies that meet filters 1, 2, and 3, but usually 4 disqualifies the opportunity. Finding the rare combination of these four filters will likely lead to lower risk and market-beating returns without the use of leverage in the form of margin or options.


Our approach when buying a stock is that we will hold it forever. This does not mean we will necessarily own a company forever, just that at the time of purchase we would be willing to own it forever based on our long-term expected returns. There is no time or price in mind for sale.


We are willing to hold a stock indefinitely as long as we expect the business to increase in intrinsic value at a good rate. Catalysts are not something we look for or require. In other words, we have the mentality of buying businesses, not renting stocks. It’s a fool’s game trying to guess where other people will try and guess where a stock will trade. In the short run, prices are driven by an infinite number of random variables that should either be ignored or taken advantage of when they drive prices to their extremes.


We believe our “edge and the biggest difference between Saga Partners and how most conventional fund managers think and behave is this forever approach. Though references to long-term investing is common throughout the industry, the rhetoric often deviates from actual behavior. Long-term means different things to different people. Much of the investment world only thinks out 1-2 years and then puts some multiple on earnings or cash flow proxy to determine a fair valuation. A smaller group claims to be long-term investors but then states an investment horizon of only three or four years.


In the life of a company three years is a blip on the radar. The value of a company comes from what it produces for owners over its life, often spanning multiple decades. This fundamental reality naturally leads to a farther outlook, forcing us to focus on factors related to business durability such as barriers to entry, obsolescence risk, and competitive dynamics. If you value a company using simple discounted cash flows, even a more mature, slower growth company will likely have over 80% of its discounted cash flow value come after three years.


Patient and Focused Investing


The enemy of investment success is activity. It’s normal to associate activity with progress and to feel the need to do something all the time. However, the actual important action happens below the surface of the Portfolio through constant reading, learning, thinking, analyzing, and preparing for the moment when a great opportunity comes up.


The major advantage one has investing in the stock market is the ability to patiently wait for the “fat pitch down the middle” opportunity. There is no requirement or reason to try anything overly difficult or reaching beyond one’s strike zone.


You can’t force something to be a good investment because you want it to be. The 10-year treasury will yield what it yields, and a stock will return what it returns. The work is in calculating a realistic expectation of what a company will earn, having conviction in those expectations, and then buying it at an attractive price relative to those expected earnings. If there isn’t a good pitch to swing at, we are ok just standing at the plate. We’ll stay busy waiting while we continuously explore the universe of companies in search for that right pitch.


Focusing on our few highest conviction ideas lying well within our circle of competence naturally leads to a more concentrated portfolio that tends to be more volatile than the indices, something Wall Street and most investors seldom have the stomach for.


Much of the financial services industry is based on the idea of controlling volatility at the expense of long-term returns. When we see people decades away from retirement with a decent allocation of their 401K or IRA in low yielding bonds, including those popular target date funds with higher fees, we have to bite our tongue before going off on a tangent about opportunity costs.


Just because you can’t see the unearned returns in your portfolio doesn’t mean you didn’t lose them. Opportunity costs are real. Loss aversion is a normal cognitive bias, with some studies suggesting losses being twice as powerful as gains. In other words, the average person with a $1,000 portfolio would rather earn a steady 5%, providing $1,050 at the end of the year, than a portfolio that rises 20% to $1,200 and subsequently falls to $1,100, for a 10% annual return. While the latter portfolio is the logically better option, leaving the investor with double the return and a fatter wallet, the pain of “losing” $100 leaves them emotionally disappointed.


Investors in the Saga Portfolio understand that volatility does not equal risk, short-term returns are largely random, and outperformance will likely come in lumps overtime. We disagree with conventional portfolio theory that recommends wide diversification into smaller position weightings and rapid turnover likely leading to more mistakes, frictional costs, and average results at best.


Over the past year we’ve been on calls and had several meetings with prospective investors into the Saga Portfolio. Many times these capital allocators initially express admiration for our general philosophy and results thus far, but in order for them to invest we would need to not only continue to find undervalued stocks but many more of them, as well as lower allocation to certain names, industries, or geographical regions, and then have monthly update calls to review short-term performance. We are flattered they believe we have the ability to outsmart more people, more often, and in more ways, but we are much more skeptical that we can successfully go into areas of the market that look fairly efficient from our viewpoint and we do not believe we have any significant edge.


One can’t be all things to all people. As we continue to develop our track record, explain our philosophy and how we manage the Portfolio, prospective investors are increasingly self-selecting into the Portfolio. More often, interested investors reach out to us after reading these letters and understand what we are trying to do and how we are doing it. Our preferred means of marketing and growing the Portfolio are through these letters and our research. When investors self-screen, it creates an aligned investor base which is also long-term oriented, letting us spend our time managing the Portfolio to the best of our abilities.


While investing is a continuous process of learning and improving, our philosophy and strategy are fixed. We have no interest in trading our philosophy for assets, even if it means it takes longer to grow. We are in this for the long haul and gain more satisfaction from producing strong results by sticking with what has worked for us thus far.


Why we like compound growth companies


There are many ways to invest in “undervalued” opportunities. Despite all the different approaches to take advantage of the inefficient spots of the market, the intrinsic value equation has and always will be the same. Warren Buffett often quotes Aesop’s fable, “a bird in the hand is worth two in the bush,” and subsequently adds the two other important investing variables of when you get the birds in the bush and what interest rates are; note birds equal cash.


This goes back to the longstanding topic of growth vs. value investing. Much has already been written on the subject but it’s important for investors to know how we think. Many investors like to bucket certain strategies with growth and value typically being in two separate categories, although a blended version has been created called GARP investing, or growth at a reasonable price.


In our view, every investing decision is a value decision based on what we estimate an asset is intrinsically worth; i.e. how many birds are in the bush, when you will get them, and what interest rates are. Usually people associate growth with more birds in the bush, but one must approximate when you will actually get them. We are simply trying to do what makes the most sense whether it is characterized as growth or value investing. Style definitions are not important to successful stock picking. Success will be based on the accuracy of the analysis and then not overpaying for the business.


Past letters discussed why we invest in “high-quality” companies that have a durable competitive advantage, but why do we prefer companies with strong growth prospects? We have found some of the largest market mis-valuations in companies that can compound earning power far into the future by reinvesting cash flows in either organic or inorganic opportunities. Investors struggle with identifying a fair price for these types of companies because they underappreciate the power of true compounding and current multiples offer a poor proxy for valuation.


High organic compound growth companies typically have large untapped “blue ocean” market opportunities. If there is an attractive, uncontested market space, increased competition is to be expected. Businesses that are able to grow profitably over competition over a long period typically become stronger with size, often due to increasing economies of scale relative to competitors or a self-reinforcing flywheel such as a network effect.


Alternatively, companies can grow inorganically by acquiring other companies, often within the same or related industry. Management quality and capital allocation is extremely important. While we have invested in serial acquirers, we have found that talented managers in this field are a rare breed. Even those with a track record of success are just one major acquisition away from a difficult marriage.


Much has been written about how corporate acquisitions often fail to meet original expectations. A KPMG study of 700 corporate acquisitions found that over 80% produced no business benefit in regard to shareholder value. This is largely because projections were too optimistic, purchase prices too high, and buyers were typically at an information disadvantage relative to sellers. That said, there are the few talented managers who are gifted capital allocators and have an ability to repeatedly make successful acquisitions that grow shareholder value over time.


Despite our preference for strong compound growth potential whether organic, inorganic, or a combination of both, the fact of the matter is that it’s extremely rare for companies to be able to compound at high rates for long periods on a per share basis. If you look at the largest 1,000 publicly traded companies by revenue today, the list that had at least a 10% compounded annual growth rate (CAGR) over the last 10 years is not very extensive, let alone those that compounded at a 15% CAGR. If you are looking over a 20-30 year period, you quickly realize how rare the true compounders are.


It can be very dangerous to assume high growth rates into infinity. Numbers become big fast and trees do not grow to the sky. Despite their scarcity, we continue our never-ending search to find the token few that we understand. If we are able to find a small basket of these exceptional businesses and purchase them at reasonable prices, it will likely provide very attractive returns over the long term.


When we do find the rare, long-term compounder with strong prospects, it is typically best to simply hold on for the ride. Few sayings have misled investors more than, “nobody lost money taking a profit”.Selling great companies with large growth potential, even at seemingly rich valuations is usually a mistake. Phil Fisher may have said it best in his book, Common Stock and Uncommon Profits:


After a sharp advance, a stock nearly always looks too high to the financially untrained. Those who follow the practice of selling shares that still have unusual growth prospects simply because they have realized a good gain and the stock appears temporarily overpriced seldom buy back at higher prices when they are wrong and lose further gains of dramatic proportions.


Valuation – growth is a component of the equation and it takes more than a moat


Valuing high growth companies can be difficult since the expected birds in the bush are much farther away. Reinvesting cash flows today means shareholders must wait at least another year before getting any birds.


If we buy a company valued at $1 billion and want a 10% return on our money, the company will have to pay out $100 million next year and into perpetuity. If the company retains its earnings, therefore paying nothing out next year, it would have to pay us $110 million the following year into perpetuity for us to get our expected return. Every year we must wait to take out any birds from the bush means we have to take out even more birds later in order to earn our expected return. If we require a 15% return over the long-term, the numbers become that much larger.


Obviously growth is never perfectly linear and we can never precisely predict the exact timing or amount of future cash flows in and out of a business. Therefore we try to keep estimates conservative and focus on high quality companies where business surprises tend to be positive rather than ones that cause pain to owners.


As discussed above, we prefer companies that can reinvest cash internally at high rates of return for a few reasons. Once a high-quality company can no longer reinvest incremental capital at attractive rates, management has more discretion with capital allocation. There is greater risk to potentially hurt shareholder value by pursuing expensive acquisitions with inherently less attractive economics, buying back stock at high prices, or simply holding excess cash on the balance sheet indefinitely. Additionally, when a high-quality business matures and growth slows, the market rarely values a business with predictable cash flows that would provide very attractive returns.


For example, Coca Cola has a wide moat with arguably one of the strongest brands in the world, distribution networks, and scale. It earns high returns on tangible invested capital and operates with little to no tangible equity. Despite having a strong durable moat, Coca Cola lacks attractive reinvestment opportunities.


Carbonated and flavored beverage markets are low growth and largely saturated. In recent years, Coca Cola’s unit volume and price/unit have both grown in the low single digits, providing low to mid-single digits organic sales growth. Gross sales have only grown at a 1% CAGR since 2007 (going back to 2007 to exclude 2008 recession year), share repurchases and margin expansion provided ~4% CAGR in earnings per share. After spending operating cash on capital expenditures, management has returned over 100% of free cash flow to shareholders since 2011 through dividends and share repurchases.


Coca Cola shares sold for a similar ~23x price-to-earnings (P/E) ratio at the end of 2007 and 2018. If you held stock from the end of 2007 through 2018, shares appreciated at a 4% CAGR, plus an average 2-3% dividend yield would have provided a total return of 6-7%. This compares to the S&P’s 7% CAGR including dividends over the same period.


Looking forward, we expect shares to return fairly similar returns. When buying shares, we imagine we are buying the entire company. Coca Cola is currently selling for $200 billion. It’s reasonable to expect long-term sales and earnings growth to be around global GDP growth of ~3% a year. In 2018 sales were $32 billion and earnings were $9 billion. If capital expenditures will roughly equal depreciation, earnings are a good proxy for free cash flow. Dividends will provide a 4-5% “coupon” that should grow ~3% a year. This will provide a longer-term return of 7-8% a year, on a $200 billion investment if all earnings are distributed out. These expected returns are satisfactory though far from inspiring when trying to beat the market.


We would be perfectly happy to invest in a high-quality, lower or no growth company like Coca Cola if the earnings can truly be returned to shareholders and we purchased the company at an attractive price relative to those expected no-growth earnings. Despite Coca Cola having a wide durable moat, expected future returns from today’s price do not look overly attractive if shares were held over the next 10+ year period.


Portfolio Update


We will provide a semiannual update of the Portfolio’s top positions in the second quarter letter. During the fourth quarter we started a position in Trupanion and added to it at the beginning of the year. You can view our research report outlining our investment thesis at this link, it was featured as a finalist in SumZero’s Top Stocks for 2019 contest in December. It is more extensive than our typical investment review, but we wanted to include it since Trupanion has since become our 6th largest position.


Conclusion


We are grateful for the opportunity to manage our investors’ hard-earned capital. The success of the Saga Portfolio requires investors that are stable, long-term, and realistic in their expectations. So far, we could not be happier in this regard. We would love to continue to grow with like-minded investors. If you know someone that may potentially be interested in an alternative investment strategy like the Saga Portfolio, feel free to forward on our information. As always, please reach out if you have any questions or comments, we are always happy to hear from you!


Sincerely,

Joe Frankenfield, CFA


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