DirecTV: Stock Buyback Will Drive EPS Growth

DirecTV (DTV) should be considered for potential purchase based on its leading position in the U.S. and Latin American pay television markets, 30+% EPS growth in the next two years, aggressive stock buyback and strong free cash flow generation. DTV’s stock is currently trading at a discount to its fair value estimate based on discounted cash flow analysis and at a discount to its peers despite its better sales and EPS growth outlook. DTV’s discounted cash flow price target is $52, which equates to a 17x forward P/E multiple and a 7.5x forward EV/EBITDA multiple.

Investment Rationale

Growing U.S. Pay TV business

• DirecTV’s market share is around 16% of all U.S. households today
• Subscriber growth should be in the 1.5% to 2.5% range over the next several years, benefiting from its strong sports programming and its leadership in pay TV product innovation
• Average revenue per user (ARPU) growth should be in the 4% to 5% range over the next few years, benefiting from its larger selection of video on demand movies and package upgrades, including Whole Home DVR (which allows families to watch downloaded movies from anywhere in the house)

Differentiated U.S. sports programming

• DTV has established itself as the pay TV leader in sports programming
• It renewed its agreement with the NFL to offer NFL Sunday Ticket to its subscribers through 2014
• The Sunday Ticket package allows subscribers to watch all Sunday NFL games nationwide
• About 10% of its U.S. customers subscribe to this package
• DTV also offers extensive coverage of NCAA March Madness college basketball, European soccer, grand slam tennis and golf tournaments (including the U.S. Open and Masters)

Leader in U.S. pay TV product innovation

• DTV has lead the industry in offering new video services, including the broadest line-up of HD channels, 1080P quality (same as Blu-ray) pay per view movies and Whole Home DVR
• The company is also expected to lead the industry in offering 3D channels and services that allow its customers to watch recorded television on tablet computers and smartphones

Latin American growth opportunities

• DTV LA should continue to generate strong subscriber growth due to increasing penetration rates in the Latin American pay TV markets
• The penetration rate is now 16%, 34% and 67% in Brazil, Mexico and Argentina respectively
• DirecTV LA is also well positioned to gain share based on its cost advantages (lower set top box costs due to its purchasing power with DTV US), exclusive Spanish soccer programming and technology leadership (able to introduce advanced video services quicker than competitors due to its relationship with DTV US)
• DTV’s share in Brazil, Mexico and Argentina was 25% (#2), 29% (#1) and 6% (#3) respectively in 2009
• DTV LA is expected to generate 17% of the company’s EBITDA in 2010
• Management believes that the LA business will double its subscriber base and EBITDA over the next five years

Strong free cash flow generation

• DirecTV generated $2.4 billion in free cash flow in 2009
• Management plans to buy back shares over the next several years (as it levers up its balance sheet to 2.5x debt / EBITDA level), which will contribute to 30+% EPS growth in 2011 and 2012

Concerns and Risks

Intense competition

• DirecTV competes with cable service providers, satellite competitors and telecom companies for subscribers in the U.S.
• AT&T U-Verse and Verizon FiOS plan to expand their video presence in more geographic markets in the U.S., which will increase competition in the pay TV market
• Currently, only about 30% of U.S. homes are able to receive telecom fiber television service
• Industry experts estimate that telecom fiber television service will be available to 40% of U.S. homes by 2015

Higher U.S. programming costs

• DTV’s annual payment to the NFL will increase 43% from $700 million to $1 billion when its new NFL contract begins in 2011
• DirecTV’s programming agreements with CBS, Fox News and Discovery are also expected to reset higher at the end of 2011, 2012 and 2012 respectively
• Programming cost increases have exceeded the rate of video revenue growth for several years and might become harder to pass through to customers given more competition and more budget conscious consumers

Change in television viewing habits poses threat

• The biggest longer-term threat to satellite and cable providers is that consumers watch more television over the Internet through providers, such as Netflix and Hulu, and that subscribers drop their traditional cable or satellite television service
• High end customers are unlikely to give up the better viewing experience available on their large screen LCD and plasma televisions to save money, but lower end subscribers might drop cable and satellite subscriptions as television content on the Internet becomes more ubiquitous
• The fees television content creators receive from the current pay-television model provides a critical source of revenue and limits these firms’ eagerness to expand Internet distribution too rapidly

Comparable Valuation Analysis


• DirecTV is trading at a discount to its peers based on 2011 EV/EBITDA and P/E multiples, despite its stronger sales and EPS growth outlook

Source: Bloomberg 12/17/10



Discounted Cash Flow Analysis

Price Target

DTV’s stock price target is $52 based on discounted cash flow analysis. This price equates to a 17x forward P/E multiple and a 7.5x forward EV/EBITDA multiple.


Company Description

DirecTV is the largest satellite provider of multichannel video services in the U.S. with over 19 million customers. The company provided video service to markets covering about 95% of U.S. television households at the end of 2009. DTV US currently uses 11 satellites and has 1 under construction.

DTV is focused on delivering great customer service. DirecTV expanded its lead over Dish Network and cable providers in customer service in the most recent American Customer Satisfaction Index (ASCI) survey and has built up a lot of brand equity.

DirecTV has also focused on increasing the quality of its subscriber base in recent years. Customers with weak credit scores have to pay an upfront deposit of $200-$300 to sign up for DTV service, which discourages some from subscribing. This focus on high end customers allowed the company to be less impacted than the cable providers by the recession in 2008. DTV’s current churn rate is only 1.5% and its customers tend to be the biggest spenders on television services, as indicated by average monthly revenue per user (ARPU) approaching $90.

DTV wins new customers through direct sales (uses effective customer screening and target marketing campaigns), consumer electronic stores such as Best Buy, independent dealers and telecom partners. DTV has relationships with each of the three largest phone companies in the U.S. (AT&T, Verizon and Qwest).

DirecTV on Demand, its video on demand service, offered 6,000 movie titles at the end of 2009. DirecTV Cinema, one of its newest services, significantly increased the number of new release movies available for its customers to purchase.

Only about one million DirecTV customers in the U.S. have their set top boxes connected via broadband currently. DTV expects that 40% of its subscribers will be Internet-connected by the end of 2013. This will allow DTV to increase its revenue from pay per view movies as subscribers download video on demand movies to their digital video recorders.

DTV also owns satellite operations in Latin America: 93% of Sky Brazil (2.4 mil subs), 41% of Sky Mexico (3 mil subs) and 100% of PanAmericana (3.3 mil subs), which covers most of the remaining regions in LA. The company provides services in PanAmericana and Brazil from leased transponders on two satellites. Sky Mexico provides its services from leased transponders on a separate satellite.

DTV added three regional sports networks based in Seattle, Washington, Denver, Colorado and Pittsburgh, Pennsylvania, and a 65% stake in the Game Show Network under its agreement with Liberty Media in 2010.



2010 Estimated Geographic EBITDA Mix

Source: DTV December 2010 presentation


U.S. Competition

DTV’s largest U.S. competitors include Comcast (the largest pay TV distributor), Dish Network (other major satellite player), Time Warner Cable, Cablevision, AT&T and Verizon. Cable companies have aggressively promoted “triple play” bundle of cable television service, broadband Internet access and telephone service to attract and retain subscribers. Dish Network has been aggressive offering discounts in the past.

AT&T and Verizon have upgraded a significant portion of their infrastructure by replacing their older copper wire telephone lines with high-speed fiber optic lines. These fiber lines provide the telecom companies with much greater capacity allowing them to offer new and enhanced services, such as Internet access at much greater speeds and digital-quality video. Verizon FiOS has been a major challenger to DTV in the markets it serves since DTV’s customers tend to be attracted to the best video service. Its telecom competitors have become more rational on pricing since they launched their service several years ago and are more focused today on investment recovery.


2009 U.S. Pay TV Segment Market Share Mix

Source: JPM



Latin American Competition

Cable companies in Latin America typically offer analog services for lower monthly fees and with lower upfront installation and connection fees than DTV does. Furthermore, they are also upgrading their networks to provide broadband Internet and phone service and are rolling out “triple play” packages in select markets. DTV’s satellite competitors typically focus on offering lower-cost, limited services packages tied to their telephone and broadband offerings.

In Brazil, its major competitors are NET Servicos (49% share in 2009), Telefonica (offered satellite TV starting in 2006) and Embratel / Telmex (offered satellite TV starting in 2009). In Mexico, DTV’s major competitors include Televisa (20% share), Megacable (18% share) and Dish Mexico (satellite JV between Echostar and MVS). In Argentina, its major competitors are Cablevision (42% share), Super Canal (7% share) and Telecentro (4% share).


2009 LA Pay TV Market Share Mix

Sources: Citigroup, CIRA Analysis


DTV introduced new video services such as HD and DVR (digital video recorder) faster than competitors in Latin America. DTV launched HD in PanAmericana in late 2008, in Sky Brazil in first half of 2009 and in Sky Mexico in the first half of 2010. DTV LA has been expanding the deployment and marketing of pre-paid services to make the product affordable to more of the population. Management currently estimates that the payback period for pre-pay is only 9 months, as roughly 50% of the subscriber acquisition cost (SAC) is paid up-front by the customer.


Full Disclosure
Family accounts that I manage own DTV
I recommended DTV to Bolter and Company, a NY-based investment management firm, on December 21, 2010

Opportunity to Buy Exxon at Great Price and Collect 3% Dividend

Exxon Mobil (XOM) should be considered for potential purchase based on its globally-diversified reserve base, excellent management team focused on maximizing shareholder value, industry-leading returns on capital and strong free cash flow generation. Exxon’s stock is currently trading at an attractive valuation based on historical and NAV valuation analysis.

Exxon’s stock price target is $86 based on applying a 15x multiple to its 2010 estimated earnings. A 15x target multiple is appropriate based on its ability to deliver double-digit earnings growth over the next several years and is in-line with its historical average.

Investment Rationale

• Largest reserves of oil majors
• Exxon had proved crude oil and natural gas reserves of about 23 billion barrels of oil equivalent (boe) at the end of 2009, enough to last 15 years at current production levels
• The company also controls a 70% stake in Imperial Oil, one of Canada’s largest oil companies that holds 465,000 acres of tar sand leases in Alberta and has 2.4 billion barrels of proved reserves
• In addition, Exxon had a total resource base of 75 billion boe, which the company will develop opportunistically

• Production growth of 2%-3% annually until 2013
• During 2009, Exxon started up eight major projects, which are expected to add 400,000 net barrels per day (bpd) of production in 2010
• The company also plans to start production on 12 other major projects in Qatar, Nigeria and Canada between 2010 and 2012
• Qatar has rapidly emerged as the world’s largest producer of liquefied natural gas (LNG)
• Exxon is developing seven facilities, or “trains” in Qatar that will convert natural gas reserves into liquefied natural gas that can be shipped worldwide for the highest prices
• When all seven hit peak output, they will produce the equivalent of over one million barrels of crude per day of which Exxon’s share is approximately 40%
• Exxon expects its new projects to increase production by 1.5 million barrels of oil (boe) equivalent per day by 2015 
• Its new production growth is expected to exceed normal field declines over the next three years

• Beneficiary of higher oil prices 
• Over the next decade, oil prices should increase based on higher demand in emerging markets and a challenging supply environment in which it will be difficult to increase production meaningfully over 85 million bpd level according to industry experts

• Best return on equity ratio in industry
• Exxon’s return on equity is 21%, the highest of its energy peers 
• The company evaluates projects from around the world against each another and only those with the most attractive returns receive funding
• Historically, Exxon has excelled at adding low-cost reserves at opportune times
• Its purchase of XTO significantly increases its exposure to unconventional natural gas at a time when natural gas prices are very depressed, which exemplifies its long-term strategy

• Strong free cash flow generation
• From 2007 until 2009, Exxon generated average free cash flow of $27.7 billion
• The company plans to continue to use its free cash flow to pay for its share repurchase program of $3 billion per quarter and to fund its dividend
• Exxon reduced its shares outstanding by 26% from 2005 until 2009 and increased its dividend by 57% in the same time period

Concerns and Risks

• Risk of lower returns on new oil output
• New oil discoveries are getting tougher to find and are more expensive to develop 
• Many of the exciting new oil fields are controlled by state-owned companies that offer less profit to production partners 
• Some industry experts believe that Exxon’s return on capital will be lower than in the past as a result of these factors

• Refining industry overcapacity 
• Earnings in the refining segment peaked at $9.6 billion in 2007 and declined to $1.8 billion in 2009 due to lower refining margins caused by combination of weak demand for gasoline and heating oil, as well as excess global refining capacity
• The worldwide glut in refining capacity should continue to pressure Exxon’s refining margins over the next several years
• Unlike some of its peers, the company has no plans to sell any of its refineries

• Cyclical chemicals business 
• Earnings in the chemicals segment also declined from $4.6 billion in 2007 to $2.3 billion in 2009 due to lower sales volumes and margins caused by the global economic downturn
• In the next year, chemical earnings should rebound with stronger global economic growth

• Political risk
• Exxon operates in many high-risk countries, where its contracts are at risk of being altered whimsically by government officials

Valuation

Historical Forward P/E

• On a forward P/E basis, Exxon is trading at close to the trough of its historical trading range in the past decade

Source: Raymond James


Historical Dividend Yield

• Exxon’s dividend yield of 3% is the highest it has been since the stock market crash in 2002

Source: Bloomberg


NAV Analysis

• Some analysts believe that Net Asset Value (NAV) estimates better capture Exxon’s fair value since NAV estimates incorporate cash flows from future projects that are discounted to present value

• On an estimated NAV basis, Exxon is trading at a 33% discount to fair value

Comparable Valuation Analysis

• Exxon stock’s historical premium to its peers has diminished over the past decade, providing an opportunity to buy a best-in-class energy company at an attractive valuation

Source: Raymond James

• Exxon is currently trading at a 12% premium to its peers based on next year EV/EBITDA multiples and a 16% premium to its peers based on next year P/E multiples; in the past, Exxon’s stock has traded at larger premiums

Sources: Bloomberg (7/12/10), Thomson


Price Target

Exxon’s stock price target is $86 based on applying a 15x multiple to its 2010 estimated earnings. A 15x target multiple is appropriate based on its ability to deliver double-digit earnings growth over the next several years and is in-line with its historical average.


Company Description

Exxon Mobil is the world's largest publicly traded integrated oil company with operations in over 200 countries. In 2009, 81% of the company’s operating earnings were generated from upstream exploration and production activities, 8% from downstream refining and marketing activities and 11% from chemicals.

In the upstream segment, Exxon had proved crude oil and natural gas reserves of about 23 billion barrels of oil equivalent (boe) at the end of 2009. The proved reserves are approximately divided evenly between crude oil and natural gas, and are geographically diversified with 38% located in Asia and the Middle East, 17% in the U.S., 14% in Europe and 14% in Canada and South America. The company also owns 70% of Imperial Oil, one of Canada’s largest oil companies that holds 465,000 acres of tar sand leases in Alberta and has 2.4 billion barrels of proved reserves.

Source: Exxon Mobil


In 2009, Exxon produced 3.9 million boe/day, with 62% derived from oil and 38% from natural gas. Overall production increased 1.6%, primarily due to new projects in Qatar, Africa and North America. Approximately 20% of Exxon's global oil output is tied to production sharing contracts (PSC), with much of the company's PSC oil being produced in Africa. According to management, Exxon has replaced more than 100% of its production in each of the past 16 years.


2009 Geographic Production Mix

Source: Exxon Mobil


Exxon increased its exploration acreage by over 40% since 2003, bringing its total acreage to 72 million acres. Key exploration areas include acreage in Canada’s Horn River Basin Devonian shale gas play, additional positions in the Marcellus shale gas play and licenses in Norway, Germany, Poland, Turkey, Vietnam and Indonesia.

In the downstream segment, Exxon is the largest refiner and marketer of petroleum products in the world with 6.3 billion barrels per day of refining capacity and 27,000 service stations. The company’s market share (measured by percentage of total capacity) was approximately 7% globally (#1) and 11% domestically (#3, slightly trailing Valero and Conoco Phillips). Exxon’s refining capacity is geographically diversified with 42% in the Americas, 31% in Europe, Africa and the Middle East, and 27% in Asia.

Exxon is the only major integrated oil company that has maintained a significant commitment to its chemicals business. In the commodity petrochemicals market, Exxon is #1 in paraxylene and #2 in olefins. In the specialty market, the company is #1 in butyl polymers, fluids, plasticizers, synthetics, oriented polypropylene films, and adhesive polymers, and #2 in specialty elastomers and petroleum additives. The commodity petrochemicals market is intensely cyclical, while the specialty market generates more stable profits. Its chemical business is 90% integrated with the rest of its business divisions, especially in refining where the two divisions share plants and the refineries supply feedstock to the chemical unit.

Exxon closed the acquisition of XTO Energy, the largest producer of U.S. natural gas, in June 2010. Following the acquisition, Exxon’s percentage of overall production coming from U.S. natural gas increased from 5% to 15%. Management believes that demand for natural gas will grow as U.S. carbon legislation encourages power producers to build gas rather than coal-fired plants. The company also expects natural gas demand to grow 1.8% per year through 2030, exceeding oil demand growth of 0.8% per year over the next twenty years.


Capital Spending by Segment

Source: Exxon Mobil


Exxon plans to spend between $25 billion to $30 billion per year on capital expenditures through 2014, with the majority focused on its upstream segment. Exxon’s management has a long-term capital spending strategy that is essentially fixed regardless of short-term commodity price volatility.


Global Oil Outlook

Global consumption of oil decreased since 2007 due to slower global economic growth and weaker manufacturing activity. Oil consumption declined the most in the U.S. and in Europe. Over the next decade, global demand for oil should grow, driven by incremental demand from emerging markets, especially China, India and Brazil. Following World War II, Japan’s per capita oil demand increased significantly driven by rapid urbanization and higher living standards. Oil demand should grow rapidly in emerging markets based on similar dynamics.

On the supply side, global oil production has decreased slightly since 2005. In 2009, OPEC production fell by 1.9 million barrels per day (bpd). Of the largest 21 oil fields in the world, at least 9 are in decline. According to some industry experts, one Middle Eastern country that might be able to increase production is Iraq if the country becomes more stable over time. Non-OPEC supply has not been growing rapidly and is often found in “harder-to-reach” areas that are costlier to develop. In 2009, non-OPEC production only grew 0.2 million bpd.

Sources: EIA, BP

Over the next decade, oil prices should increase based on higher demand in emerging markets and a challenging supply environment in which it will be difficult to increase production meaningfully according to industry experts. In the next year, oil prices should be supported by global economic growth exceeding 4% and a six month deepwater drilling moratorium in the Gulf of Mexico.

Source: Bloomberg


U.S. Natural Gas Outlook

U.S. consumption of natural gas has remained fairly steady over the last decade based partially on stronger than expected coal demand for electric generation and excessive volatility associated with natural gas prices that has discouraged some power producers from switching to natural gas. In 2009, consumption declined 1.8% due to weaker industrial demand for natural gas. Consumption should rebound with stronger economic growth this year.

On the supply side, natural gas withdrawals from wells increased 1.6% in 2009. Cash flow requirements and potential damage to wells forced producers to continue to withdraw gas from wells. Increased LNG imports and development of gas production from shale reservoirs are expected to add to future supply this year.

Source: EIA


U.S. natural gas prices should remain subdued in the next year due to the high number of working natural gas rigs, which rose 43% from last year, and high U.S. storage levels, which were 12% higher in July 2010 than their five year average. Some industry experts expect a more active hurricane season in 2010, which might disrupt production in the short term and drive natural gas prices higher. Longer-term, natural gas prices are poised to benefit from new climate regulations and its reputation as a source of clean energy. Historically, oil has traded at a ratio of 9:1 relative to natural gas. The current ratio of 17:1 suggests that more energy consumers will use natural gas in the future to lower their cost base, which should help drive natural gas prices higher.

Source: Bloomberg


Full Disclosure


Recommended to Bolter and Company, a NY-based investment management firm, on July 13, 2010

Family accounts that I manage currently own XOM stock

Highlights from Asset Allocation Summit

I attended the Asset Allocation Summit in New York on May 17th and May 18th 2010. The conference brought together investment officers of endowments, foundations and pension funds as well as leading portfolio managers. The following article discusses some of the topics and speakers that I found particularly interesting.

Tactical asset allocation gaining momentum

It was surprising to hear investment officers of endowments, foundations and pension funds stress the need for tactical asset allocation to take advantage of volatile markets. Endowments, foundations and pension funds have very long time horizons and in the past, took a longer-term approach to investing by not changing asset allocation frequently. Don Steinbrugge, Member of the City of Richmond Retirement Funds’ Investment Committee noted “institutional investors used to move glacially, but in the last two years, they have started moving more quickly to target inefficiencies in the markets”. He said that his investment committee used to make asset allocation changes over three to six month period and now make changes in one month. Several investment officers at the conference thought that it was important for investment committees to widen the asset bands that can be allocated to a particular asset class so that investment officers have more flexibility to act quickly to take advantage of daily opportunities.

The average holding period of stocks at mutual funds and hedge funds has declined in the past several decades due in large part to increased focus on outperforming benchmarks on a quarterly basis. If the majority of significant asset allocators, such as endowments and pension funds, adopt tactical asset allocation strategies, this will only add to more trading by direct investment funds and create more volatility in the markets.

Importance of liquidity for endowments

Yale University popularized the use of alternative assets in endowment portfolios to maximize long-term returns. Unfortunately, in 2008, this approach ended up hurting the returns of some leading endowment portfolios. The allocation to illiquid assets, such as private equity, was too high in some endowment portfolios according to many of the speakers, which forced investment officers to sell other liquid assets at inopportune times, exacerbating the decline in the public equity market. Michael Sullivan, Chief Investment Officer of the University of St. Thomas, noted that it was very important to communicate frequently with the treasury department of their school to ensure that the risk of the investment strategy was in synch with the liquidity and spending needs of the school.

Active vs. Passive discussion

Several foundation and pension officers mentioned that they had replaced their active large cap equity managers with index strategies because the active managers were not outperforming the index. However, these same managers noted that they still invest in a lot of active managers in small cap U.S., mid cap U.S. and international equity funds.

Importance of diversification for all investors

Peter Gunning, Global Chief Investment Officer of Russell Investments, said his firm was focused on finding the best global equity funds and adding alternative assets, such as commodities and infrastructure assets to benefit from low correlation with equities and income generation. Several panel participants emphasized that the major benefits of adding asset classes to a portfolio were higher portfolio returns and lower portfolio risk levels.

Louis Morrell’s thoughts and strategies

Louis Morrell is a Managing Director at the Wake Forest University Endowment where he is responsible for the management of approximately $300 million in multi-asset class investments following a dynamic tactical approach based on global economic factors. Mr. Morrell believes that “rocky periods lie ahead” and expects massive inflation in the future, but not in the short-term. He also stated that “central banks are not running the show, politicians are” and that political decisions will have unintended consequences. For example, Mr. Morrell is concerned that more bubbles will be created as a result of massive money printing. He also expects bubbles to occur more frequently than every 20 years like in the past.

Mr. Morrell does not try to time the market and remains fully invested in different asset classes, but his allocation to asset classes changes depending on where he sees opportunities. As a result of the tremendous volatility in recent years, his endowment has given him more latitude to tactically move within asset classes, by widening the asset bands that are acceptable. Mr. Morrell believes that it is dangerous to be too risk averse and that he needs to take risk in order to achieve 8% long-term returns for the endowment.

Mr. Morrell has about 28% of his portfolio invested in alternative investments, including 14% in commodities and gold, 8% in real estate and 6% in currency. He does not believe that gold is in a bubble and instead views gold as a currency hedge. Mr. Morrell noted that the number of U.S. dollars and Euros in circulation is growing much more rapidly than gold production. His current target price on gold is $1,400 / ounce. When the price of gold is appreciating, he prefers to buy gold miners and when the price of gold is going down, he prefers to purchase bullion.

Mr. Morrell views commodities as inflation hedges and plans to increase his exposure in the future when he sees inflation increasing. He targets commodities that will benefit the most from increased Chinese and Indian demand and sometimes obtains specific regional commodity exposure through equities. For example, Mr. Morrell mentioned that he was playing Ivanhoe Mines because he thought the company would successfully mine for gold in Mongolia.

Emerging Markets: Cautious in short-term, positive long-term

Peter Gunning stated that his company was slightly underweight emerging market equities in the short-term due to concerns about inflation rising and central bank tightening. Xiao Song, Emerging Markets Portfolio Manager of Contrarian Emerging Markets, echoed that emerging market equities were a little overheated. He said he was concerned with the rise of inflation in China to around 3% and about the bubble in the Chinese real estate market, emphasizing that real estate prices had already appreciated 30% in the first four months of 2010. Mr. Song expected non-performing loan ratios of Chinese banks to increase as the real estate market deflates. Furthermore, he stated that when one stock market in Asia goes down, the tendency is for every other stock market in the region to go down due to the exit of “hot money”. Both managers were confident in the long-term outlook for emerging market equities based on their abundance of natural resources, high level of infrastructure spending, favorable demographics, growing middle class and low sovereign and personal debt levels.

Commodity Investments: Should benefit from eventual rise in inflation

Andrew Karsh, Co-Lead Portfolio Manager for the Credit Suisse Total Commodity Return Strategy, summarized the benefits of adding commodity exposure to a portfolio, including protection against inflation and non-correlated returns with equities. He pointed out that although commodities and equities both declined in 2008, that was the first year since 1970 when both commodities and equities fell in the same year. Christopher Burton, who manages the fund with Mr. Karsh and who did not speak at the conference, was quoted in a news article on May 10th saying “Because commodities are inherently a driver of inflation, and are therefore positively correlated to unexpected changes in inflation, we've seen a growing number of investors increasing their exposure to the asset class over the past few months."

Adam De Chiara, Co-President of Jefferies Asset Management and Jefferies Financial Products, pointed out that although spot prices of major commodities have risen 10% to 15% on an annualized basis over the last five years, major commodity indices have generated flattish or even negative returns in the same time period. He explained that this was due to major indices’ use of futures contracts and explained that index returns were often hurt by “negative roll”. Every month, futures contracts expire and in order to replace the exposure, new futures contracts need to be purchased. Negative roll occurs when the price of the futures contract is higher than the spot price, so index managers have to pay more to regain exposure, which decreases index returns. It was interesting to see in Mr. De Chiara’s bio that he was involved with designing the Dow Jones AIG Commodity Index at his prior firm.

Mr. De Chiara recommended investing in CRBQ, an ETF that contains commodity-linked equities to gain exposure to commodity spot price appreciation. Although this ETF has a low correlation with commodity spot prices on a day to day basis, over longer periods of time the correlation is higher. He also recommended investing in talented active managers of commodities futures, who could add 5% to 15% of outperformance annually relative to passive futures strategies.

Hedge Funds: Positive attributes should result in greater inflows

The panel participants highlighted the advantages that long/short equity hedge fund managers have over long-only managers including the ability to short stocks, use leverage, trade more actively and not be tied to an index. Bruce Ruehl, Principal of Advisory Services Americas, said that the top tier of hedge fund managers add value and he is very positive on the long/short equity space right now.

It was interesting to hear several speakers mention that long/short equity hedge funds were no longer placed in a separate alternative investments “bucket” within institutional portfolios, but were instead placed in the equity allocation. This suggests that institutional investors will allocate more dollars to hedge funds going forward since the equity “bucket” in most institutional portfolios is significantly larger than the alternative investments allocation.

Several speakers also pointed out the positive impact hedge funds had in a portfolio based on their ability to decline less in bear markets and therefore dig out of a smaller hole to recoup losses. Stephen Rich, Executive Vice President of Mutual of America Capital Management, said that if a fund was down 20% in a given year, the fund would need to generate 25% return to get back to breakeven point. However, if a fund lost 50%, the fund would need to generate 100% return to break even. Therefore, if a hedge fund manager can fall less in a down market, it will be easier for that manager to recoup losses. This point was confirmed by another speaker who stated that 65% to 75% of hedge funds are now back above their highwater mark.

David Bailin’s Views on Hedge Funds

David Bailin is Managing Director and Global Head of Managed Investments at Citi Private Bank responsible globally for alternative and traditional investments. Mr. Bailin said that the average hedge fund was down 18% in 2008 in a very challenging environment in which liquid public equities were sold indiscriminately to raise cash and the rules for shorting financial stocks were changed overnight.

Mr. Bailin noted that it was easier to conduct due diligence on hedge funds following the crisis because hedge funds are now more willing to provide information more frequently and have their results tracked via external services. He said that institutional investors from emerging markets, including sovereign wealth funds, were increasing their exposure to hedge funds, while ultra high net worth investors were slightly reducing their exposure. However, he expects more ultra high net worth investors to invest in hedge funds over the next five years.

Mr. Bailin estimates that hedge fund assets will double to $3.2 trillion in 2015 from $1.6 trillion currently. He believes that large institutional hedge funds with great risk management will gain assets and that new hedge funds will form locally in select emerging markets, including India and China. Mr. Bailin also mentioned the potential for hedge fund managers in developed markets to relocate to emerging markets, if regulation intensified in developed markets.

Real Estate: Watching and waiting for opportunities

Several panel participants said that they are watching the real estate market and waiting for opportunities. Mr. Morrell stated that the U.S. real estate market remains a disaster and that nothing has changed at Fannie Mae or Freddie Mac. Michael Dean, Senior Associate of Meketa Investment Group, noted that the U.S. represents 35% of global property stock currently. He expects the international proportion of global property stock to increase as a percentage of total over the next decade, providing exciting investment opportunities.

Private Equity: Timing and manager selection critical

Anjum Hussain, Director of Risk Management at Case Western University, said that the time to invest in private equity was after markets have blown up, not when markets are at their peak levels, like in 2006 and 2007. Several panel participants noted that one of the dangers of investing in private equity was the additional layer of capital that was required of institutional investors during times of crisis, such as in 2008 and 2009, to maintain their equity stake. Mike Hennessy, Managing Director of Morgan Creek Capital Management, stressed how important it was to find skilled private equity managers. He believes that a private equity manager with no skill will only generate similar return to the public equity market, while a skilled manager will deliver 500 basis points of outperformance relative to the public equity market.

Highlights from Columbia Investment Management Conference

I attended the 13th Annual Columbia Investment Management Conference on Friday, February 26th, and had the opportunity to hear current views and insights from several esteemed value investors.

Martin Whitman, Founder and Portfolio Manager of Third Avenue Management, opened the conference by discussing his current portfolio, his largest holding and sharing interesting insights. Mr. Whitman’s current portfolio is 80% comprised of “Graham and Dodd Net Nets”, including Toyota Industries Corp., Brookfield Asset Management, Capital Southwest Corp., Investor AB, Henderson Land Development and Hang Lung Group. Third Avenue searches for companies with “super strong” financial positions that have excellent prospects of growing net asset value over the next five to seven years and that are trading at large discounts from readily attainable net asset value. Henderson Land is Third Avenue Value Fund’s largest holding and is well positioned according to Mr. Whitman based on its massive land holdings in Hong Kong and China, its 30+% stakes in Hong Kong and China Gas Company and Miramar Hotel, and strong management team led by Dr. Lee. Mr. Whitman also mentioned that his firm has found the most value opportunities in East Asia in recent years and that he does not worry about currency for foreign holdings, but that his portfolio will benefit when the Chinese Yuan appreciates over the next several years.

The first panel discussion focused on lessons learned from the financial crisis and the panelists included Wendy Trevisani (Co-Portfolio Manager of Thornburg International Value Fund), Matthew McLennan (Portfolio Manager of First Eagle Global Fund) and Thomas Russo (Partner of Gardner Russo & Gardner). Ms. Trevisani’s three major lessons from the crisis were the importance of remaining humble as an investor, of staying disciplined by holding on to great companies that you have done homework on during periods of crisis and of exercising risk control through purchase of diversified portfolio of assets when those assets are selling at discounts to fair value. Mr. McLennan said the main lesson that was reinforced was that human technology has advanced more than human emotions. He echoed that having humility and recognizing that the future is uncertain is very important to successful investing. Mr. Russo stated that the greatest lesson he took away from the crisis was not to sell a great company he was holding that was showing a loss only to replace it with a lesser company.

Bruce Greenwald, the moderator of the first panel, questioned the panel speakers about which parts of the world presented the most opportunity at the present time. Ms. Trevisani said she was finding value opportunities in Western European companies that have exposure to growth in emerging markets, but are more attractively valued than emerging market listed companies. Mr. McLennan expressed that he was finding little opportunity in China and was concerned with balance sheet growth and complacency about long-term growth prospects in China. He made a fascinating comparison that investors’ current love affair with emerging market stocks over developed market stocks reminded him of investors’ passion for “new economy” technology stocks over “old economy” stocks in the late 1990s and he said he is finding more value in developed markets, such as Japan, right now. Mr. McLennan also highlighted the attractiveness of a position in gold as a “scarce store of value for mankind.” He mentioned that annual gold production only equaled about 1.5% of total gold in existence so it was possible to determine the amount of gold that will exist in a few years. Many paper currencies are being printed at much faster rates in developed markets right now so it makes sense that gold would appreciate relative to those currencies. Mr. McLennan said that he looks at total value of gold compared to global income per capita to get a feel for whether gold is undervalued or overvalued and feels that gold is “slightly expensive” right now. Mr. Russo stated that he was spending less time on U.S. companies and that he was concerned by record deficits and dependence on foreign countries to roll over U.S. debt. He did not recommend a favorite region in the world to invest right now, but mentioned that he favors those companies that can deploy capital flexibly around the world, such as Richemont.

David Dreman, Founder and Chief Investment Officer of Dreman Value Management, presented an interesting overview of the political and financial landscape prior to 2008 that contributed to the financial crisis and then shared his current views. Mr. Dreman expects the U.S. to inflate its way out of debt just like it has in the past. He anticipates double digit inflation in the U.S. once unemployment falls to 6%, which he felt could take a while. In the inflationary environment he foresees, Mr. Dreman thinks that stocks will be one of best inflation hedges and perform well over time.

The next panel discussion centered on distressed investing and the panelists included Jeffrey Altman (Founder and Portfolio Manager of Owl Creek Asset Management), Daniel Arbess (Portfolio Manager of PWP Xerion Funds) and Jamie Zimmerman (Managing Partner of Litespeed Management). Mr. Altman is seeing pockets of opportunities right now at lower levels of capital structure, including some equities. His favorite investments are HMO equities, including Cigna and Wellpoint and he also mentioned that the risk reward looked favorable for Fannie Mae and Freddie Mac preferred stocks. Mr. Arbess felt that there was currently a lull in the distressed credit cycle and that ultimate restructuring of corporate balance sheets would occur over the next several years as debt comes due, which should provide more opportunities. His favorite idea right now is Ivanhoe Mines, which has strong gold, copper and coal assets. Ms. Zimmerman is finding one-off opportunities in which companies are repairing their balance sheets and mentioned the challenge in determining the right EBITDA estimates to use given the volatility in profitability in the last several years. Her favorite ideas are Smurfit Stone Container unsecured bonds and Lyondell bonds.

The final panel discussion focused on mental models in investing and the panelists included David Abrams (Managing Member of Abrams Capital), William Browne (Managing Director of Tweedy, Browne Company) and David Greenspan (Managing Director of Blue Ridge Capital). Mr. Browne stressed the importance of having a value framework to invest successfully and that investing is an exercise in probabilities in which he tries to get as many factors working in his favor as possible. Mr. Abrams mentioned the importance of “getting out of the noise”, referring to information overload, and he said that there was less noise in Boston, where he currently works, than in New York, which has helped him to become a better investor. It is interesting that Warren Buffet has echoed similar sentiment in the past about the advantages of working in Omaha, including not being overloaded with noise and just independently figuring out stock. Mr. Greenspan expressed that extending his time frame and looking out at potential profitability over the next few years has helped him to invest successfully. He said that sometimes stocks look expensive on near term earnings, but have strong return on capital and look inexpensive on earnings a few years out, providing investment opportunities.

Michael Mauboussin, the moderator of the final panel, questioned the panel speakers about position sizing and evaluating management. Mr. Browne said that his firm’s maximum position size for a new position was 4% and that if a stock appreciates to 6% or 7% of the portfolio, his firm cuts back the position. Mr. Abrams stated that his firm usually holds about twenty positions with an average size around 5% or 6% and that he uses concentration to make sure his ideas are really good. At the same time, he likes to diversify so that if any one stock loses 20% or 30%, the overall portfolio would only be down 1% or 1.5%. Mr. Browne felt that the best indicator of management was to look at what management has done in the past and he was skeptical about the usefulness of management meetings. Mr. Abrams reiterated the importance of looking at management’s track record, including prior uses of capital. He also mentioned that he likes to look at employee turnover and compensation levels of senior management.

Overall, the conference was very well organized and offered the audience the opportunity to listen to current views of leading value investors. I found the discussion regarding portfolio management in the midst of the financial crisis to be very insightful. In addition, Mr. McLennan’s bullish argument for gold over the next several years was also very convincing.