Partners in WMK’s Strategic Opportunities equity strategy continue to own a small piece of several high-quality businesses. You can take comfort knowing that our businesses are led by individuals who are either founders or management teams that exhibit founder-like qualities of passion, obsession, and a long-term time horizon.
I am focused on delivering strong absolute returns. Our portfolio does not reflect any major benchmark, although we own several of the largest (and best) businesses in the world such as Amazon and Google. Since inception, we have enjoyed a healthy return. The period by which I can measure our outcomes is short and the market has performed at historically strong levels. Returns should be judged on a 3 to 5-year time horizon (at least!).
Year-to-date, the top contributor to performance has been Converge Technology Solutions (ticker: CTS.TO), which has delivered a strong return since our initial investment (and we have since added to the position). I discussed Converge in more detail in our Q1 portfolio update. The company continues to execute effectively and has recently outlined ambitious plans for significant growth in earnings over the coming years.
Another strong contributor to performance is The Charles Schwab Corporation (ticker: SCHW), which has increased significantly since our initial purchase. Charles Schwab is an exemplary operation that remains hyper focused on doing the right thing for their customers. I purchased the company when the market gave little credit for potential synergies with the acquired TD Ameritrade and seemed to price in zero interest rates forever. Charles Schwab has a banking arm, which allows them to earn interest income on cash balances. This interest rate exposure (known as “net interest margin”) will make Charles Schwab a large beneficiary if interest rates ever rise. I remain comfortable that Charles Schwab can perform well in many environments over the long-term.
We’ve had some detractors to performance as well. One example is Interactive Corporation (ticker: IAC), which we purchased when the market appeared to place little—if any—value on management’s ability to create shareholder value through thoughtful capital allocation. IAC is an investment platform with a long history of incubating early-stage internet businesses and growing them into substantial, standalone companies through a patient and disciplined approach. The leadership team, led by Joey Levin under the guidance of Barry Diller, has a strong track record of success. Their specialty lies in building two-sided marketplaces that bring together both supply and demand—an area where they’ve repeatedly demonstrated skill. A notable example of their past success includes a major online dating platform that became a highly valuable standalone business after being spun out. Over time, IAC and its spinoffs have significantly outperformed broader market indices.
I believe the market continues to undervalue Angi and does not provide credit for the billions of dollars that IAC can invest moving forward or the strong assets they still own internally like Care.com and a large stake in MGM. I remain positive on the long-term outlook, but thus far our portfolio has incurred a slight decline due to IAC.
Arch Capital Group
“Someone is sitting in the shade today because someone planted a tree a long time ago.”
– Warren Buffett
Given my persistent discussion of being long-term oriented, I thought it would be worthwhile to highlight the insurance industry as well as our second largest position, Arch Capital Group (ticker: ACGL). The insurance business can make money in a slow and reliable manner.
Insurance and reinsurance (often abbreviated as (re)insurance) collects premiums today in exchange for the liability of some event occurring in the future*. (Re)insurance businesses who price policies in excess of losses and expenses earn a profit.
The beauty of the insurance business – as Warren Buffett realized many years ago – is that you get cash today (known as “float”) and may never owe that money in the future. This enables (re)insurance companies to invest the float and earn a return while they wait for an event that requires payment. (Re)insurance businesses benefit from policies that are often several years old when they expire and earn a return in the interim.
Alas, the (re)insurance business model is not without major risk. Many large, global (re)insurance companies consistently destroy shareholder value. Why do some (re)insurance businesses impair value? They tend to share one common characteristic: A desire to be big rather than great. It is very easy to grow as a (re)insurance business by charging less than your competitors, but this is rarely a winning strategy.
Long-term success in the (re)insurance business requires strong “cycle management.” This means that a great management team is willing to shrink their business when competition is fierce so they can aggressively grow their business when competitors are suffering losses.
This leads to Arch, which is run by Marc Grandisson (CEO since 2018, but with Arch since 2001). Arch runs a diversified insurance operation with three distinct lines: Specialty Insurance, Reinsurance and Mortgage Insurance .
Arch has historically exhibited three key qualities that have generated tremendous shareholder value:
- They focus on specialty lines of business, which require more knowledge and expertise, therefore making Arch more valuable to the customer and deterring competition.
- They have three separate pillars to their business, so when pricing is weak in insurance they flex to grow in reinsurance and vice versa. They have rapidly grown their mortgage insurance business as well, which carries additional risk due to the housing market correlation.
- They are willing to shrink when opportunities to grow are weak.
The Arch formula is simple: use common sense and focus on areas where you can add value. But simple is not always easy and management is what keeps the discipline in place. The key risk I face when evaluating a (re)insurance business is that I truly do not know what insurance policies are being underwritten today at Arch and whether they are properly priced, I must trust that management will remain disciplined.
I purchased Arch in November 2020, when the company was trading near its equity book value. I believed the COVID-19 pandemic created a perfect storm for opportunistic (re)insurance businesses like Arch to grow. Arch management has since discussed mid-teens price increases over the last year, reflecting the struggles larger (re)insurance companies are facing due to losses faced during COVID-19 and extreme catastrophe events like hurricanes. Their mortgage insurance business has also benefited from the rapid appreciation in home prices. I expect that Arch’s recent business can generate returns on equity (before investment income!) in the low teens, which should drive mid-to-high teens growth in book value per share for the next 3-5 years.
Whether I’m ultimately right or wrong will depend on the continued discipline and execution of Marc Grandisson and his management team. That said, I take comfort in their strong track record. Arch has consistently demonstrated a thoughtful approach to underwriting and capital allocation, which has translated into meaningful long-term value creation for shareholders.
I am rooting for some big shady trees over the next few years due to the seeds that Arch has been planting over the past year…
*There are some unique lines of insurance that protect against prior events, such as our holding Fidelity National Financial, which is the largest title insurance company in the United States – a wonderful (and boring!) business for another day.
CFC Required Reserves
I have made several adjustments to the restrictive portfolio that several of my partners (and myself) are required to maintain.
I am concerned that fixed income largely represents “interest free risk,” due to very low interest rates.
To reduce our collective downside risk if interest rates rise—which typically causes bond prices to fall—I shifted a portion of the portfolio into an interest rate hedged ETF. This fund invests in long-term investment-grade corporate bonds but significantly lowers exposure to interest rate fluctuations. By doing this, I’m accepting more corporate credit risk on that portion of the portfolio. We continue to maintain a significant position in traditional investment-grade bonds.
I also replaced our preferred equity ETF with two individual preferred securities from Liberty Broadband and Qurate Retail. Fundamentally, I’m not a fan of preferred equities because they combine the downsides of both stocks and bonds: capped upside like bonds but downside risk like stocks. However, certain preferred securities offer a substantial yield premium compared to investment-grade fixed income.
Why choose Liberty Broadband and Qurate Retail preferred securities?
I’m confident in the cash-generating strength of both companies, which provides solid downside protection. Liberty Broadband, along with its underlying asset Charter Communications, is one of the largest holdings in our Strategic Opportunities Portfolio.
The preferred equity ETF has notable drawbacks, including a relatively high expense ratio. The individual securities I selected offer significantly higher yields and come without those fees.
Preferred equities make up only a small portion of the overall portfolio, in line with investment policy limits combined with our common stock holdings. Still, I aim to maximize every dollar, and this change is expected to improve the overall portfolio yield meaningfully compared to the ETF and investment-grade fixed income.
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.