Partners in WMK’s Strategic Opportunities portfolio have experienced significant volatility along with the broader market. The market value of our business holdings declined, but performed better than the relevant benchmark in the quarter. Despite the relative outperformance, we remain focused on absolute value creation, which has been challenging.
More important than the volatility of market prices is the performance of our underlying business holdings. Regardless of the environment, the commitment is to own great businesses that are reasonably valued based on future expectations of free cash flow per share.
Returns should be judged through a cycle, with a minimum of a multi-year time horizon. A longer outlook is a much more reasonable measurement period for long-term investors.
Market Environment
The market’s volatile path is driven by factors discussed in prior notes, namely the persistence of high inflation and subsequent tightening by the Federal Reserve as well as central banks around the world. The Fed is tightening aggressively by increasing interest rates and reducing liquidity that had been fueled by their quantitative easing strategy.
The issues underlying the U.S. market are prevalent around the globe. Further stressors on international markets include the conflict between Russia and Ukraine, supply chain challenges, and the U.S. dollar reaching elevated levels relative to other currencies.
The net effect of these issues has been declines in global equity and fixed income markets. A sample of widely followed indices reflects broad-based negative performance.
Perhaps more distressing has been the impact on the average retail investor. According to data from JPMorgan Chase, the average personal portfolio in the U.S. has suffered a significant decline during the year. These are real financial impacts on individuals who have been heavily levered towards higher-growth businesses that dominate the news flow.
Portfolio Update
Managing a portfolio in turbulent times requires deep focus on ensuring our businesses are executing in a strong manner. This does not mean every business should be expected to grow every quarter. No business – public or private – will avoid difficult periods. Our portfolio provides interesting views into the often-diverging paths between the business and near-term stock price performance.
The largest detractor to the portfolio’s performance in the quarter was Charter Communications, which experienced a steep decline. This decline ranked Charter among the worst performers in the major equity index for the quarter and contributed negatively to our overall portfolio.
Charter is a well-run cable company. The broadband internet access that Charter delivers in a cost-effective and reliable manner is approaching the importance of a public utility. Charter also has a rapidly growing mobile phone offering that should create significant incremental earnings over time.
The market is concerned about two primary factors:
- Increasing competition: Companies like AT&T are pursuing aggressive fiber strategies, and fixed-wireless access from mobile companies like Verizon presents a competitive offering to Charter’s broadband.
- Leverage: Charter targets a leverage ratio that implies meaningful debt usage. The increase in interest rates implies a more expensive cost of debt for Charter moving forward.
First, we own Charter due to a belief that individuals will forgo almost anything before they give up internet access. Charter can deliver the most cost-effective and reliable internet to their markets, making the company a highly defensible business through the economic cycle. This business model is augmented by a best-in-class operational management team that has significantly reduced their share count over time.
While quarterly net customer additions are slowing, this is not the primary driver of value. The company has continued to grow earnings meaningfully. It is rare for a growing, stable business to suffer as significant a drawdown as Charter. Because of that, we must inspect whether the market’s concerns are likely to be true.
As it relates to competition, the economics of existing cable networks are significantly better than fiber competition. The cost to bring fiber to a home can vary widely depending on housing density, the existing network, and whether infrastructure is above or below ground. It is capital intensive to build a fiber network, with a wide range of estimated per-household costs in upfront capital expense for the operator. Currently, a minority portion of Charter’s network faces existing fiber competition.
Some customers will undoubtedly switch to fiber. However, we doubt that many shareholders of fiber buildouts will be satisfied with the return on capital it takes to create a fiber network and then price at sub-standard rates to try and gain market share. This is a poor strategy to generate high returns.
Some may recall that Alphabet had significant aspirations for their Google Fiber network. Ultimately, they curtailed these plans after a multi-year investment period. Alphabet does not have the same infrastructure of some competitors, but they have more capital and cash flow than almost anyone, which is a strong vote of confidence for the incumbent Charter network.
Further competition comes from wireless carriers pushing for fixed-wireless home internet. These carriers can provide strong mobile products; however, serving all internet needs is a different challenge. One should consider that the typical wireless customer uses a small amount of data per month, compared to broadband-only subscribers who use vastly more. For those who have experienced poor speeds on their cell phones from time to time, the increase in network intensity should create some concern about the efficacy of fixed-wireless home internet.
The other key consideration the market is concerned about is Charter’s balance sheet. Management aggressively utilizes leverage for capital investments and share buybacks.
Charter’s interest expense is moderate with long-dated maturities on both secured and unsecured debt. It is almost certain that incremental leverage will come at higher rates – this is a function of the market environment. However, the current debt strategy has been well executed by management.
As minority owners, we are trusting management to make intelligent capital allocation decisions moving forward. It could be that management seeks to maximize their secured debt positioning and reduces their unsecured debt offering. Management could also view their own stock as such a high returning asset that paying higher interest rates is a small price for enhanced long-term returns.
The leverage will be closely monitored, but the current capital structure is an asset in an environment where interest rates remain below inflation. We believe management will remain thoughtful allocators of capital.
Despite the challenges in the quarter, there were multiple strong contributors. South Korean e-commerce company Coupang drove a positive contribution to the portfolio. Convenience store operator Alimentation Couche-Tarde has also been a standout since its purchase. Couche-Tarde has benefited from increasing gasoline margins and is a high-quality operator that added further gains to the portfolio during the quarter.
CFC Required Reserves
Note: Feel free to ignore this section if you do not own a Controlled Foreign Corporation as many of my investors – and myself – do. These entities are captive reinsurance businesses for operating assets and are required to hold a very conservative portfolio of primarily investment grade fixed income with a limited exposure to U.S. common equities.
The persistence of inflation – and subsequent increases in interest rates – drove a further decline in the broad U.S. investment grade bond market. The continued decline in bond prices serves as an important reminder that even “safe” assets can show significant strain in periods of turmoil.
Given the constraints of the required reserves portfolio, the goal has been to minimize the exposure to rapidly increasing interest rates by keeping the duration (interest rate sensitivity) of the portfolio relatively short. This has been an effective strategy on a relative basis but has still resulted in losses on an absolute basis.
The only material change in the portfolio has been the addition of floating rate treasury bonds. These instruments have the security of being backed by the U.S. Government but also reset to higher (or lower) interest payments based on prevailing rates. These instruments further reduce the portfolio’s interest rate sensitivity.
The portfolio is conservatively positioned and has minimal risk of significant capital impairment if held for the long-term. Cash and short-term Treasuries now also offer a reasonable yield. This enhances our options to deploy capital in a safe, predictable manner.
Disclosures:
The views expressed above are those of WMK Investment Partners. These views are subject to change at any time based on market and other conditions, and WMK disclaims any responsibility to update such views.
Past performance is not indicative of future performance. Principal value and investment return will fluctuate. There are no implied guarantees or assurances that the target returns will be achieved, or objectives will be met. Future returns may differ significantly from past returns due to many different factors. Investments involve risk and the possibility of loss of principal. The values and performance numbers represented in this report do not reflect management fees.
WMK may discuss and display, charts, graphs, formulas which are not intended to be used by themselves to determine which securities to buy or sell, or when to buy or sell them. Such charts and graphs offer limited information and should not be used on their own to make investment decisions. To the extent that certain of the information contained herein has been obtained from third-party sources, such sources will be cited, and are believed to be reliable, but WMK has not independently verified the accuracy of such information.