2018 Annual Letter

We had a good year in 2018. Most of you had returns of __%, which was ___ of the 4.5% loss for the stock market. As you are all aware, I judge performance by how our businesses perform over the long-term, and 2018 was, on aggregate, a very strong year in that regard. I believe those strong business results will fuel the strong long-term returns that we are all looking for.

We came into the year with a more than __% net cash position. Over 2018, thankfully, we were able to make many new investments and put a substantial amount of capital to work, and at this point many of you have cash balances in the ___% range.

In this report I will give an overview of our strategy, describe the transactions that we made over the past year, and discuss in detail the performance of this year’s portfolio companies within the context of the current state of the markets as well as of our broader investment strategy. Last, we will look ahead to the future and examine how our current portfolio might perform in a range of possible future market conditions.

Our Strategy, Generally Speaking

As I have maintained consistently, our strategy is to act like private market investors – find an excellent business run by able and honest management and wait to invest until we see the potential for at least a 4x return over 10 years.

These opportunities don’t come around all too often, which means that our activity usually occurs in spurts. We did relatively little in 2016 and 2017 as stocks posted strong returns. In 2018, in the face of a weaker market and with many individual stocks going down significantly, we had lots of activity and many new investments.

This highlights an important consequence of the strategy to act like private market investors - when stocks go up a lot we will do very little, and we will tend to be net sellers, but when stocks go down we will tend to be more active and be net buyers.

Some investors believe that it is prudent to sell some of their stocks when the market is having a bad stretch. The thinking goes that they are protecting themselves from further declines. We focus on long-term results and don’t care about the next six months. If prices for securities are lower, a rational investor with a long time horizon will want to own more equities, not less. We will operate by trying to be rational, selling some when prices are high and buying when prices are low.

Our Strategy, A Concrete Example

I want to give you an example of what happens when our strategy works. I often talk in generalities of “excellent businesses” and “the long-term,” so I wanted to give you a concrete example of the benefits of what happens when we execute this strategy well. Admittedly, this example is cherry-picked, but it’s also our largest position, so I believe that it has some broader relevance.

We first bought shares of Transdigm in ____ at an average price of $____. At that time, the company’s pre-tax earnings power was roughly $1.03 billion. Multiplying those earnings by a reasonable 15x multiple and subtracting out the debt of $5.2 billion from the first value, you would get an estimated value of the stock of ~$175 / share. I was happy to own the shares of this great business for a bit less than their worth, conservatively calculated.

Fast forward to today, five years later, and a lot has changed at Transdigm. The company grew organically at a decent clip in those five years, produced strong cash flow, and used this cash flow on a mix of dividends and acquisitions. The acquisitions have, on the whole, worked out spectacularly well and created enormous value for shareholders.

As a result of this growth, the company’s earnings power is currently about $1.96 billion, or almost double what it was five years ago. If you apply the same 15x multiple to the earnings and deduct out the current $10.8 billion in debt, you get a value for the stock of ~$335. In addition, the substantial dividends paid out by the company would have resulted in 56.6% more shares owned than in 2013 if all the dividends were reinvested.

If you add it all up, the rough value of the company increased 159% from December 2013 to today, good for an annual gain of 21%. Our initial investment has returned ___%, a bit ___ than the gain in intrinsic value.

This example shows the reason why I don’t worry so much about short-term stock movements. If we can discover an excellent business and buy it for less than it’s worth, we’ll make great returns over time. If the market crashed tomorrow and our return over the last five years simply matched the increase in its intrinsic value, I believe we would all be very happy with “only” a 159% return over the past 5 years.

Activity in 2018

Coming into 2018, we held large investments in energy pipelines, Transdigm, and Berkshire Hathaway; we owned small stakes in a few very well run companies; and we held __% of client assets in cash.

Over the course of 2018, we still own the large positions - Transdigm, pipelines, and Berkshire Hathaway - although in slightly different proportions and with a couple of substitutions in the pipeline space. The biggest change over the course of the year is that we have bought a few new stakes and added to some of our smaller positions. Last year many of you owned ~8 stocks, but now many of you own ~14-15. The new investments are in Brookfield Asset Management, Charter Communications, Post Holdings, Liberty Global, Tencent, and Facebook. Additionally, we roughly tripled the size of our position in Constellation Software.

The net result of this activity is that cash balances are down from prior year’s levels to ~__% of your portfolio. I would rather own shares in good companies than cash, so I am pleased that we have been able to find new opportunities to deploy capital this year.

Business Performance

In this section, we will examine how our investments have done this year:

Losers - Bank OZK, Liberty Lilak Group, and Liberty Global

I’m going to start off with these three because each stock has performed poorly in 2018 - the stocks are down __%, __%, and __%, respectively (either from the beginning of the year or when we initially bought them. These all started off as relatively small positions, at ~__% of client assets. I will discuss each in turn.

Bank OZK has historically been perhaps the most well run bank in America, although it has a rather peculiar lending book, with large exposures to construction and development real estate projects. I am drawn to this business because of its excellent past performance - profitability ratios by any measure in the top decile of peers, growth far outstripping “normal” banks, record profits during the great recession, and a stock that had made over 20% annually for 20 years. However, its aforementioned “peculiar” lending book means that the bank is perceived as risky and many investors believe that Bank OZK is destined to fail.

Earlier this year, Bank OZK announced two write-downs in its real estate loan book, the first since the financial crisis. These write-downs were unexpected and spooked the market, cratering OZK’s stock. A few years ago, Bank OZK’s stock traded at a level that assumed that it would continue its best in class performance indefinitely. 1-2 years ago, which is when we purchased our stake, the stock traded at a level consistent with it being a “normal” bank with decent profits and low growth. Today, after the stock fell 52% this year, the stock is priced for Bank OZK’s liquidation. I believe that the bank’s loans are sound, with money lent at low levels of the estimated value of the projects, and that the bank will get back on its feet.

Crucially, for us to do well in the investment from this lower level, Bank OZK just needs to keep making good loans. If it continues as a moderately profitable bank, which is much worse performance than it has had historically, we should make good returns from today’s price. If it gets back closer to previous performance levels, we should make our money back and earn a good return on top of that. The big risk continues to be that the bank has made numerous, unsound loans. I will be actively examining this situation.

Liberty Lilak and Liberty Global are two international cable businesses that we own. Lilak was purchased in 2017 while Global was purchased this year. Cable stocks can be very volatile, as this year’s results have shown that with stock price declines of __% and __%, respectively. Each company is in a period of overinvestment in their networks, which is currently depressing cash flows. On top of that, cable businesses are largely debt financed, which means that the price of the stock can vary widely. It’s similar to what happens if you put 20% down on a house - if the value goes up or down by 10%, you either make or lose 50% of your equity investment.

We bought these stocks to own over a period of years, not months, which is a time period that will smooth out our return towards that earned by the business. Over the next few years, if each company can start to generate meaningful cash flow and grow earnings by a few percent each year, these two stocks will likely go from being our worst performers to our best performers. I expect positive cash generation next year from each, and I’ll have my eye on each company’s growth prospects.

I believe that each of these companies - Bank OZK, Liberty Global, and Liberty Lilak - will continue to perform well over time. We bought each at relatively low valuations and with the stocks of each going down significantly since we bought them, the valuations are even less demanding. All we need to do well in any of these stocks is for the business to perform decently. If we get good performance, which is the kind of performance that I expect, we should ultimately make our money back and then some.

Brookfield Asset Management, Charter Communications, Nexstar, and Post

These are all small to medium size positions, each making up __ - __% of portfolios. Each of these companies has a similar path for value creation - steady, if unspectacular, growth in the base business, excellent cash generation, and management with deep expertise in capital allocation. Each company grew its earnings organically this year, which paired with the aforementioned smart capital allocation led to increases in intrinsic value per share well above 10% for the year.

Constellation Software

We have owned Constellation Software for about 1.5 years. We originally owned a small position as I liked the company a lot but the valuation wasn’t low enough for me to get really excited and make it a large holding. As I’ve gotten to know the company more since we’ve owned it I’ve started to like it more and more, and last week the valuation became compelling, so I tripled the size of our position. It now makes up ~__% of client portfolios.

Constellation is a vast holding company that owns dozens of separate mission-critical software businesses. These aren’t usually sexy, high-growth businesses; instead, they tend to be very profitable, have low growth trajectories, and are rather boring (think of the software that a golf course runs to let you book a tee-time online). Constellation’s businesses usually grow a little bit each year and churn out cash. The magic comes when they use this cash to buy more software businesses, a capital allocation decision

that has historically lead to incredibly high earnings growth (if you remember, I profiled Constellation in a newsletter this year and mentioned that its stock has outperformed Amazon over the last 15 years).

Constellation’s earnings were up more than 17% this last year, and if the company can execute on more acquisitions we should have similarly strong earnings gains in the years to come.

Berkshire Hathaway

Berkshire continues to perform well for us. It’s never going to be the investment that gains the most in intrinsic value in a year, but it steadily builds good value over time. The company had another good year and I expect further prudent management and capital allocation to result in further solid if unspectacular results.

Energy Pipelines - Kinder Morgan and Magellan Midstream

We made a couple of large changes to our energy pipeline holdings this year. We switched from holding stock in a couple of smaller companies into Kinder Morgan, one of the largest pipeline companies in the US. We now own Kinder Morgan and Magellan (which we owned last year), with Kinder Morgan generally making up about __% of the combined investment.

I’ll start by looking at Magellan’s results. In short, they were excellent. Run-rate earnings are up a little more than 10% this year, the debt balance is down, and we received distributions of $3.83, which is equal to 5.4% of the value at the start of the year. The gain in intrinsic value is roughly equal to the increase in earnings plus the distribution yield, so in excess of 15%.

Kinder Morgan had a similarly excellent year. The company increased its run-rate earnings by ~$300 million, sold a troubled expansion project in Canada for a good gain, paid down ~$2 billion of debt, and invested significant sums into growth projects. Similar to Magellan, my estimate of the gain of intrinsic value in the equity is above 15%.

If you’ve been following the price of the stocks and didn’t know much about the progress of the business itself (likely many of you!) you might think that Kinder Morgan and Magellan had poor years as the stocks were down __% and __%, respectively. As the preceding paragraphs suggest, however, the results of the businesses have been strong while the growth of the stock price has been very poor. This divergence between the growth of the intrinsic value of a business and its stock price can happen in investing from time to time. As a long-term investor, there is no reason to worry. In fact, as long-term investors, we actually prefer lower stock prices as long as the intrinsic value continues to grow, since the low prices mean that we can reinvest the substantial dividends that we receive into even more shares. That reinvestment at low prices will enhance our long-term returns that we receive from owning the shares by perhaps 1-2% per year. While that doesn’t sound substantial, a 14% return instead of a 12% return over 10 years would mean an extra $0.70 in value for every initial $1 invested. Clearly, as long as the businesses keep performing, we prefer lower prices.

Transdigm

Transdigm has been our best, most important performer in 2018. It came into the year as our largest individual position and it has returned __% this year, significantly contributing to the strong annual results of our whole portfolios.

As I hinted at earlier in this letter, Transdigm had an excellent year in 2018. Management executed their playbook of strong organic growth and free cash flow generation, which would have led to roughly 15% earnings growth with no acquisition activity. Lucky for us, Transdigm also continued its tradition of closing a few accretive acquisitions which further increased its earnings power. My estimate of the company’s intrinsic value per share is 24% above my estimate at this time last year.

The biggest news is that Transdigm has agreed to acquire Esterline, an aerospace company with a lot of potentially good product lines but that has not been managed well. This is a much bigger acquisition than normal, with a purchase price of $4 billion, whereas a normal acquisition would be for $100 - 500 million. The acquisition should close by next summer, and once Transdigm gets its managers into important positions, I believe that Transdigm will turn around the operations and create immense value. My base case assumption is that the deal should add ~$70-100 / share of value to Transdigm shareholders, which is a large number compared to its current stock price of $340.

Future Outlook

Earlier this year I had spoken with many of you and mentioned that we will most likely have more volatility going forward than we had over the last few years. This wasn’t a bold prediction, mostly because volatility over the last few years has been almost non-existent.

I want to repeat that prediction in this letter, not because it will necessarily change how I invest your money, but so that you can expect a bumpier ride than we’ve had and not panic once we hit it. As an owner of stocks, you should be prepared to see large fluctuations in the value of your holdings from time to time. That’s completely normal and should be expected.

My future outlook is that we’ll see some volatility but that over time we’ll make a return that is similar to the gain in intrinsic value of our portfolio companies. As you can see from the previous section, the gains in intrinsic value have been quite strong this year for our portfolio companies, and you can expect to see those gains in value fully reflected over time.

Over the next year, I continue to assume, as I have over the past few years, that we will underperform a strong market but outperform a weak one. Our performance this year has born that out, as our best performance relative to the stock market was at the bottom of the market a couple of weeks ago and our worst relative performance was towards the top of the markets earlier in the year.

Conclusion

2018 was a good year. We ________ the market by ___%, but more importantly our businesses had excellent years, on aggregate. We did have a few losers, but those investments were generally smaller, so they didn’t hurt performance too badly. We also made a handful of new investments into companies that I believe should perform extremely well over time.

Even with all of that activity, we still own healthy cash balances and are positioned so that we can take advantage of any further weaknesses in the markets. You should continue to expect relatively better results if the markets falter and relatively weaker results in stronger markets. No matter what the market does next year, I believe we’re well positioned to make strong returns over the long-term.

Disclosure: Pursuant to the provisions of Rule 206(4)-1 of the Investment Advisors Act of 1940, we advise all readers to recognize that they should not assume that recommendations made in the future will be profitable or will equal the performance of past recommendations. This publication is not a solicitation to buy or offer to sell any of the securities listed or reviewed herein. This contents of this publication are not recommendations to buy or sell any of the securities listed or reviewed herein. Investing involves risk, including risk of loss. The contents of this publication have been compiled from original and published sources believed to be reliable, but are not guaranteed as to accuracy or completeness. Kyler Hasson is an investment advisor and portfolio manager at Delta Investment Management, a registered investment advisor. The views expressed in this publication are those of Kyler Hasson and not of Delta Investment Management. Kyler Hasson and/or clients of Delta Investment Management and individuals associated with Delta Investment Management may have positions in and may from time to time make purchases or sales of securities mentioned herein.

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