Mutoro Group Partners, LP
“The problem is that we’re asking the wrong question. The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory. This may sound elementary, and many players may think they are following this principle, but few actually do. Under this mindset, everything but the odds fades from view. There is no such thing as ‘liking’ a horse to win a race, only an attractive discrepancy between his chances and his price.” – Steven Crist
Dear Partner,
The Fund was down 2.70 per cent for the first quarter of 2017. As I wrote in our first quarter letter last year, when we finished up 5.11 per cent, “I discourage us from being despondent when short-term results are not in our favor or too enthusiastic when they are.” I went on to say, “I manage our capital for the long-term, so I expect and recommend that partners in the Fund judge my performance over a period of five years or greater, not five months or less.” That is no less true today than it was then, and I do not unfortunately have much to add to that topic, other than to convey my appreciation to you. It is because of your patience that we do not have to worry about the quarterly, monthly, or even weekly performance derby many funds race. Thank you for allowing me to manage your capital and to take long-term and sometimes contrarian positions.
Given how transient and marginal I think our performance year to date has been, I think it would be productive for us to discuss the most notable changes in the portfolio over the last three months. We start, as we typically do, with our biggest position: cash. As the chart below indicates, our position there grew materially:
Portfolio Holdings
To be sure, our cash did not grow because of any thoughts I have about the general level of market prices. While I believe that a conservative portfolio stance is probably more advantageous today than it was five years ago (when a more aggressive stance was more likely to be profitable), I make no attempt to time or predict the near-term direction of the markets. Our cash grew for two reasons, both untied to general market conditions.
The first reason our cash grew is we added new limited partner capital. This is a positive if you read stories of funds experiencing the inverse. It is probably worth mentioning that I do not manage the portfolio with the assumption that we will continually have new limited partner capital arriving to put to work. If this were the case, we would probably be more aggressive with our cash. For example, imagine we were to fully own a diverse group of operating businesses supplying us with new capital to invest. We could truly weather market volatility on our own terms. Think Berkshire Hathaway. It has over $86 billion in cash on its balance sheet to invest and a constant stream of internally-generated cash from its collection of good businesses. Like Berkshire’s Chairman and CEO, Warren Buffett, we do not fear the always real possibility that our securities could on a given day close 20 per cent lower than the day before. For him, aside from temperamental advantages, this is largely because he has cash on hand and new capital coming in; whereas for us, it is mainly because we have cash on hand. We obviously are not set up like Berkshire and should not assume we will receive new cash. Hence, we manage what we do have such that we are prepared for surprises. That said, I think we should have more capital invested, ideally in companies with attractive economics and available at attractive prices. I am searching for those, while also reducing our exposure to those businesses we have which may no longer be worth owning for the long run. Which brings us to the second reason our cash grew.
We sold most of our holdings in the pseudonymously named Company A, reducing our position from almost 18 per cent of the portfolio to under 3 per cent. It was in total a lucrative investment for us. I first described Company A as an American media company with a highly profitable, monopoly-like position in the markets it serves. This was my not so subtle way of saying they owned newspapers. Company A initially interested me for the reason it probably disgusted most investors: Its substantial debt and declining top-line revenue, which had cratered its share price. However, when I began accumulating our position in early 2015 and into early 2016, publicly available information showed, despite its debt load and declining revenue, a business with surprisingly stable earning power over the previous six years. And the business was selling at 2x those earnings. Company A was smartly cutting costs and exclusively using its cash flow to service a debt burden that most recently stood at $600 million.
Though it may be surprising to hear this, Company A is fortunate to not own newspapers of international or national prominence. It instead has a collection of small-town and regional papers. Because of this, Company A does not face significant competition from other local daily papers in most of its markets and is the leading local digital news source. Unlike news outlets based in larger cities such as Washington D.C. or New York City that must choose local stories to publish that are relevant to millions of residents in vastly different neighborhoods, Company A’s papers have a much more central role in their communities. This allows it to bundle local news about sports, real estate, etc., and sell advertising space.
The Internet has eliminated the natural geographic reasons most newspapers could aggregate readers, and thus the ability of most newspapers to make money selling ads from bundling stories that interest those readers. Company A though seemed to be resisting the inevitable longer than others. Most of Company A’s revenue from selling advertising space is geared toward retailers, and this looked to be stabilizing, or at least moderating the rate at which it was declining. But something changed. Whether because of Amazon.com, e-commerce in general, or a change in how consumers prioritize their spending, retailers are struggling. And the retail advertising revenue for Company A appears to be deteriorating at a faster clip. It declined 11 per cent in the most recent quarter year-over-year, after falling 9 per cent between 2016/2015 and 4 per cent between both 2015/2014 and 2014/2013. And the first quarter of its fiscal year is usually its best, which suggests the rest of its year will also be lackluster and that management’s revenue initiatives over the past three years have found little traction. Many of those initiatives are in digital ad sales, which are not big enough yet nor growing fast enough to make up for the fall in retail ad sales. This relatively new area is only 25 per cent of ad sales and has grown at only 6 per cent year-over-year. Moreover, management’s cost-cutting initiatives, while impressive, will probably save only 6 per cent this year, which is also not enough to make up for the fall in retail ad sales.
This is not to say that Company A cannot meet its interest obligations or principal payments in the near term. Its $60 million in interest and $19 million in principal due this year is probably manageable. With an additional $7 million in capital expenditures, this is still true even if you take a conservative 25 per cent haircut to the bottom of my current estimated range for its 2017 unlevered cash flow of $125 million to $135 million. (Down from its 2012 to 2016 range of $148 million to $168 million.) Moreover, 86 per cent of Company A’s debt matures after 2022, and the company has $20 million in cash and another $33 million available under a credit facility. Hence, Company A’s balance sheet is not necessarily facing impending doom. This is also evident in the market quotations for its $83 million in publicly traded notes. At the time of my decision to sell, they exchanged hands at 106 cents on the dollar, showing little concern among its debt holders of a restructuring. But lack of concern is not the same as lack of reason for concern. Company A will probably have to slow down the rate at which it is paying off its debt. And in the event of a general recession, which would pressure advertising sales even more, Company A may again have to revisit its debt covenants and maturities. None of this is to say that the day of the newspaper is done. Far from it. Regional newspapers like those Company A owns play crucial roles in their communities culturally, socially, and politically. But this important role is one of many considerations worth weighing in an investment.
We first sold Company A stock in December 2016; a rise in the price of its shares grew our ownership to 33 per cent of our portfolio, which I deemed too much to hold given the risks inherent in the business’s outlook (versus its market price) and the odds of Company A reaching my estimate of its worth. We have retained (and may continue to hold) a small stake for the option value in the equity. But I doubt the expected value of our continued ownership warrants having more in the company.
Thank you again for your partnership. I remain grateful for your ongoing confidence, and I will continue to strive to deserve it. I am always available for any questions or comments you may have.
Sincerely,
Godfrey M. Bakuli
Managing Partner