Exclusive Partners Update
This information is confidential, thank you for your discretion.
1.2 Keeping an Eye on Your Money
September 8, 2021
As you know my belief is that an advisor should have skin in the game and that is best achieved is by showing you what is in my portfolio. I cannot promise the results, but I can guarantee that your financial fortunes will move in lockstep with mine. Moreover, when I do something dumb, I want you to derive some solace from the fact that my financial suffering is proportional to yours. I dedicate a considerable amount of time thinking about and trying to improve the portfolio. I ask that you not share this information with others because it would de-value my time and effort. For the past three months there were only two notable changes to the portfolio, the addition of BHR and an increase in VOO from 55% to 59%. I have not sold a share of the other holdings, I just incrementally added to VOO and its performance over the past three months was better than AMZN, BRK.B and LRCX increasing its proportion of the portfolio.
From 1871 to 1997 the return on the stock market after removing the effects of inflation was 6.7% per year. The corporate dividend yield and rate of earnings growth over that same period was also 6.7%, demonstrating overtime investment performance converges with business performance. Company performance varies from year to year and so do investor emotions and that is what drives the fluctuations in the market. This is core to my investment philosophy that a dollar is worth a dollar. If I purchase an investment other than a broad market index like the VOO, it is because I believe the earnings generated will outpace the market over a long period of time.
Most of the time, I have an agnostic view of the market. I think that many investors go astray by trying to have a system that will provide automatic good judgment on all investment decisions. To me this concept is too hard in practice and quite frankly ridiculous to always strive for perfect judgement. I am using a different approach, by looking for opportunities that offer a big statistical advantage. These opportunities need to show up in a place where I am smart enough to recognize them. Because of my cognitive limitations, I will likely only find one or two ideas per year. If we wait patiently for the big opportunity and grasp it firmly, that fortunately happens to be enough.
Performance of Wills Family Portfolio as of 8/20/21
*Total Return is an approximation - weights have varied slightly over the past year across several accounts
Braemar Hotels & Resorts (BHR)
"Choose a business any idiot can run, because sooner or later one will". Peter Lynch
Braemar Hotels & Resorts is the latest addition to the portfolio, and it is off to a terrible start. Sometimes we have disappointments, and I will try to be candid in informing you about them as I am in describing the happier outcomes. We purchased mid-summer when it looked as if the world was finally moving past the pandemic. And then the delta variant began spreading globally and has caused a sharp correction in travel related stocks and Braemar was not spared.
Why Own BHR?
Braemar owns 14 luxury hotels in prime locations throughout the United States. Included in these properties is the Ritz Carlton St. Thomas, Lake Tahoe, and Sarasota. It also has top tier properties in Colorado, Napa Valley, Washington DC, and San Francisco. Prior to the pandemic, BHR was generating approximately $40-$50 million of free cash flow for shareholders. On its current $300 million market cap, if operations return to 2019 levels, the cash flow yield would be ~15%. The company was paying $30 million per year in dividends would result in a 10% yield on our purchase price. What business travel looks like will be the key factor to monitor in recovering the 2019 performance. Because of the pandemic, the company was forced to stop paying its dividend. However, because the business is structured as a REIT, it will likely be required to start paying dividends again in 2022. The pandemic has hit its city-center properties hard, however its resorts have been generating record revenue. In fact, its latest update the company said several of its resort properties were generating revenue 30% above 2019 levels.
What is BHR Worth?
If we just took what the company paid to build its portfolio of hotels, it’s worth $10.50 a share. The hotel industry often discusses valuation in terms 'price per key' or price per room. At the current stock price, BHR's price per key is ~$300k. I have seen multiple sales of hotels in Chicago, Florida, and Napa Valley at prices of $475k, $750k, and $2 million. In my opinion, the properties sold where of a lesser quality, suggesting a price per key could be 2-3x higher for BHR putting valuation in the $10-$15 range.
Key Risks:
- COVID continues to have a significant impact on travel. City center properties are no longer losing money are still far from pre-COVID levels of profitability. To fully recover, business and group travel needs to return. Many businesses were requiring their workers to return to the office after Labor Day, but with the rise in the Delta variant have pushed the return out a few months. The BHR CEO has told me group travel bookings for 2022 are currently running near 2019 levels, a sign that we are nearing a return to "normal."
- I am unhappy with the CEO/CFO. I have a professional relationship with the CEO, and I believe he has done an excellent job running his hotel portfolio in very challenging times. However, he has shown that he does not understand basic finance. It's not his fault after all, he is a former investment banker, and I don't think bankers understand finance. He agrees with me that the value of the hotel portfolio far exceeds the current stock price, but he has been selling stock around $6.00 a share to pay down debt. He essentially sold $1.00 for $0.50, this dilutes our ownership and is contrary to our best interest. I recently had a heated two-hour discussion over what is in the shareholders' best interest If I got through to him and he ceases to selling stock, we should do great on our investment.
Berkshire Hathaway (BRK.B)
Why Own Berkshire Hathaway
Berkshire Hathaway is the conglomerate run by Warren Buffet. I think of it as an index fund made up of businesses that are better than the S&P 500 on average. Until recently following a 40% increase in the stock price over the past 12 months, I thought the company was trading at a valuation well below my estimated fair value. There are a couple of structural advantages the business has built over the past 50 years that will be difficult, if not impossible to replicate. Within Berkshire's collection of companies, there are some that are thriving, some that are mediocre and some that are declining. Because they are all held under a single umbrella, Berkshire can take the cash from the average and underperforming businesses and invest in the growers without incurring taxes. For the rest of us who want to take the cash out of one busines and invest in another, we would incur capital gains or a dividend tax. This allows Mr. Buffett to earn a few extra points of return per annum and has helped him achieve the greatest investment track record in history.
The business is also operated very conservatively, typically holding more than $100 billion of cash. When the economy runs into trouble and large companies need money, Omaha and Washington DC are the only two places they can go, and DC typically won't listen until a call to Omaha has been made. Berkshire's cash reserves and sterling reputation allowed it to acquire Burlington Northern Santa Fe Railroad and issue tens of billions of dollars of loans to GE, Goldman Sachs, Bank or America, Harley Davidsons, and Mars Candy at loan shark rates. To me Berkshire Hathaway is the business equivalent of the hydra monster from Greek mythology. When Hercules cut the head of the hydra monster, two grew back in its place. When trouble emerges in the economy or the stock market, Berkshire emerges stronger.
Key Risks to Monitor
- At age 91, we must accept Mr. Buffett will not be running Berkshire Hathaway for much longer. Although, he jokes his successor has a Ouija board. I am sure the stock will drop upon his passing; however, I do not believe there presently any "Buffet Premium" in the share price. If the stock falls too far, you can count on the company using its war chest of cash to repurchase shares.
- Competition for investments - With the enormous monetary and fiscal stimulus, the market is awash with liquidity making it harder for Berkshire to invest its capital at attractive rates.
What is Berkshire Worth?
I wrote last quarter that I made Berkshire my largest single holding, I have not sold a share but Apple's surge in price along with a modest decline in BRK.B has put it into second place. I also questioned last quarter if Mr. Buffett would continue his aggressive pace of share repurchases with the stock above my intrinsic value estimate. He did not, he only bought $6 billion of stock after buying back nearly $9B over the past few quarters. My guess is he stopped buying shares at the start of the quarter and resumed mid-quarter when the stock returned to a price at or below my valuation estimate. This tells me my intrinsic valuation estimate is close to his.
My current fair value estimate for Berkshire Hathaway is $290 per B share. For the past few years, I have been able periodically purchase Berkshire shares at a ~10% discount to my fair value estimate. The company is expected to make approximately $27.5 billion this year. My valuation factors a 7% hit to earnings in 2022 for the proposed Biden tax increase and growing a conservative 3% annually afterward. The company has a $300 billion stock portfolio which contains $135 billion of Apple stock, $42 billion of Bank of America, $24 billion of American Express and $23 billion of Coca Cola. Essentially each share of Berkshire contains 1/5th of a share of Apple and 1/20th of a share of Bank of America and so forth. Add in $165 billion of cash and subtract out its liabilities and I get an all-in valuation of $655 billion vs. the current $646 billion market cap. Because there are so many pieces to Berkshire, it is a difficult business to value. My valuation and purchases have been coincidentally aligned with Mr. Buffet's buying patterns.
How has it Performed?
Through August 20th, Berkshire is up 23.03% above the 19.3% return for the S&P 500 over the same time period. Mr. Buffet has purchased $30.5 billion of Berkshire stock over the past 12 months. While Berkshire was repurchasing its shares, the stock has risen 37.5%, again besting the 32.7% return for the market.
Lam Research Corporation (LRCX)
Why Own Lam Research?
Lam Research might be my favorite business for a very simple reason. When Apple announces a new phone, we can count on three things: the camera will be a little better, the processor will be a little faster and CEO Tim Cook will say, this is the best iPhone we have ever made, as if they were going to create a new phone worse than the last. But what you may not realize is those advancements require more data and more memory. Lam Research has a near monopoly on the machines that make memory chips. The company estimates it has >90% market share of all flash memory and greater than 50% of all DRAM memory. On top of that the company has been steadily taking market share with logic semiconductors. In short, you basically cannot make a semiconductor without Lam Research. Why is that? The degree of precision needed to make a semiconductor is almost unfathomable, today's leading chips can fit 6 million transistors in a space the size of the period at the end of this sentence. Once a piece of Lam's equipment is placed into service, it will never be replaced by another vendor locking in a lucrative parts and service business.
The shortage of semiconductors provides a very favorable backdrop for LRCX. For more than a decade companies kept minimal inventory of chips on hand and when the pandemic caused disruption to chip manufacturing, an acute shortage has resulted that has idled auto and electronics factories worldwide. Orders for Lam's equipment are at record levels and the growing nationalistic attitude in the US and Europe could bring strong demand for the next few years.
Key Risks
- Trade Dispute with China: China accounts for approximately 30% of sales and the US has prohibited sales of leading semiconductor technology to certain Chinese companies. The Trump administration took a hard stance, that has been mostly adopted by the Biden administration. To date the blacklist has not had a material impact, however if the dispute escalates, LRCX runs the risk of losing a major revenue source. While it would be disruptive, I am not overly concerned about a more restrictive ban. Demand for data, memory and semiconductors keeps marching higher and Lam's machines needed to fill that demand will be purchased by someone.
- Lam's customer base is highly concentrated, and the business is prone to boom-and-bust cycles. The stock can sell off sharply when demand ebbs. That will likely be a buying opportunity. I watched LRCX stock for years before making a purchase. Some of you do not own the stock, patience is required, we will buy when the time is right.
What is Lam Research Worth?
I think a fair value for LRCX is $575 and the stock is hovering around $600. If the stock pulls back, I will look to start building a 1-2% position to accounts where clients do not own LRCX. I think the present valuation is fair not cheap and if the stock continues to fall, I will add more. LRCX is a volatile stock and is prone to boom-and-bust performance and valuations. My $575 estimate assumes that LRCX will grow 5% per year on average over the next decade. I use 5% growth, because semiconductors have historically grown a couple percentage points above GDP.
How did it Perform?
LRCX stock is +20.7% through August 20th which has outperformed the +19.3% return for the S&P 500. Over the past 12 months Lam stock is +61.9% vs. a 32.7% return for the S&P 500.
Amazon (AMZN)
Why Own Amazon
I live in a small town in the mountains that has a grocery store, a gas-station, a liquor store, and a casino (it is Nevada). If we need something that doesn't fit into those four categories, or we don't want to pay the mountain prices it means we need to gather the family and go-over the mountain to Reno, or we order from Amazon. I have noticed since the start of the pandemic firsthand at our post office the growth of Amazon. We are no longer allowed to enter the lobby of our post-office because it is filled with Amazon packages. The post-office has run out of storage space and the new protocol is to walk in the front door tell the clerk your PO box and they bring your packages outside.
The business model is to provide a vast selection of goods at cheap prices with fast convenient delivery. I doubt consumers will ever want the opposite. While Amazon is mostly known as a retailer, its computing service is even more valuable. Amazon Web Services (AWS) has similar economics to the retail business. A disproportionate share will be aggregated to the company with the most scale. After building out an enormous IT infrastructure to support Amazon.com it started offering companies access for a fee. The result was an entirely new industry that as changing the tech landscape. Any company now has access to world class IT systems via the internet for a fraction of the cost it would take to build the infrastructure themselves. As AWS has grown, the scale has resulted is a decline in the cost of operating the business. Amazon has in turn passed a portion of the scale benefits on to its customers through more than 50 price cuts over the past 15 years. Few businesses can compete with Amazon on cost and functionality, Microsoft, Google, and Ali Baba that is about it. Because Amazon started the industry, its lead is considerable over these firms.
Build scale, lower per unit costs, and pass a portion on to the customer. Amazon's extreme focus on delivering value to the customer is a very difficult model to beat.
Key Risks
- Like Apple, success brings jealousy and criticism. When a previously successful business finds itself hopelessly outflanked by Amazon, the last resort is to bribe - oops I mean donate to a politician. Amazon is presently facing a lawsuit over its policy requiring 3rd party sellers, utilizing its logistics service, to set prices on Amazon's site equal to or lower than other sites. Amazon's policy, using some backward logic, is considered detrimental to the consumer according to an attorney general in Washington DC.
- I'll repeat a section of Jeff Bezos' latest letter to shareholders about their anticompetitive behavior.
- "Customers complete 28% of purchases on Amazon in three minutes or less, and half of all purchases are finished in less than 15 minutes. Compare that to the typical shopping trip to a physical store - driving, parking, searching store aisles, waiting in the checkout line, finding your car, and driving home. Research suggests the typical physical store trip takes about an hour. If you assume that a typical Amazon purchase takes 15 minutes and that it saves you a couple of trips to the physical store a week, that's more than 75 hours a year saved. That's important. We're all busy in the early 21st century."
- "So that we can get a dollar figure, let's value the time savings at $10 per hour, which is conservative. Seventy-five hours multiplied by $10 per hour and subtracting the cost of Prime gives you value creation for each Prime member of about $630. We have 200 million Prime members, for a total in 2020 of $126 billion of value creation."
What is Amazon Worth?
The present valuation of Amazon implies the company will hit $1 trillion in sales in the next 10 years and generate more than $100 billion a year in cash. Amazon's growth over the past decade has been phenomenal and accelerated last year in the pandemic. Last quarter when I sent this letter out the implied valuation suggested Amazon would hit $1 trillion in sales within 6-7 years and with the underperformance of the stock it is now ~10 years which I view as more reasonable. I would consider adding to the position again around $3,000 per share which implies a reasonable 10% per year growth rate over the next decade.
How did it Perform?
Amazon stock is down 1.75% through August 20th which has underperformed the +19.3% return for the S&P 500. Over the past 12 months Amazon stock is -2.6% vs. a 32.7% return for the S&P 500. The performance of the stock has been disappointing. When Apple recently changed its privacy settings, making it difficult for Facebook and Google to track people's online activity, advertisers started turning to Amazon. This is a very profitable business that posted impressive growth during the quarter. I have a close eye on AMZN and am performing additional due diligence to increase my conviction level in my price target for purchase.
Apple (AAPL)
Why Own Apple?
The iPhone has become an integral part of our daily lives and it keeps getting more and more engrained each year. With more than 1 billion iPhones in active use we can make reasonable assumptions about how often they will be replaced/upgraded and see that Apple has a steady stream of cash coming in for a very long time. Add in iPads, computers, watches, airpods and apps with its large network of users and it’s not a stretch to believe the captive users base that will generate more sales each year.
Key Risks to Monitor
- Antitrust: With great success comes jealousy and criticism. Apple is actively litigating a case to break up its App Store and is being investigated by the Department of Justice along with the other tech giants (Amazon, Google and Facebook). Antitrust regulations are in very early stages and often takes several years before a settlement is reached. It is far too early in the process to be able to accurately assess any potential impact.
- Taxes: The devil is in the details of the tax proposal from President Biden. While the headline has an increase to 28% from the current 21% is still well below the 35% prior to President Trump's tax cut. However, within the proposal is a doubling of taxes on international income which could result in a tax bill 4x greater than the amount Apple saved from the Trump tax cut. The US is the only country in the world that taxes international income, a doubling of the overseas tax rate is a big deal.
What is Apple Worth?
I think a fair valuation for Apple is $130 and that is factoring in a higher tax rate for both the Biden administration and globally. That assumes Apple continues to earn around $100 billion per year in the future. $100 billion dollars of annual profit seems like a ridiculous number that is hard to grasp, and it is. So, we need to break it down. Apple has >1 billion active users and 1.65 billion active devices. If we assume the average user upgrades their phone every five years that generates $175 of revenue per user per year which works out to 60% of Apple's device revenue. The 650 million installed base of computers, iPads and watches generates approximately $112 of revenue per user per year. Add in another $70 per user for software and services - think about the revenue generated from apps, cloud storage, Apple care and its subscription services. With Apple's 22% average profit margin over the past decade suddenly $100 billion seems very achievable and we are not factoring in any new products the company will inevitably become a must have for its user base. The biggest risk is an anti-trust breakup of Apple's app store. It is hard project what would happen but let's hypothetically assume they must cut their 30% take-rate of apps to 15%. With a very rough estimate because Apple does not disclose its revenue from 3rd party apps would result in a loss of $17 billion of revenue. This would drop Apple's valuation to $100.
How did it Perform?
Apple stock is +12.21% through August 20th which has underperformed the +19.3% return for the S&P 500. Over the past 12 months Apple stock is +20% vs. a 32.7% return for the S&P 500. Apple stock has rebounded nicely over the past three months and the most impressive accomplishment to me is the 3.5% increase in profit margins. For a company of Apple's size this translates to about $13 billion a year in extra income. I found it encouraging that CEO Tim Cook felt the improvement in profitability over the past year is permanent with room to continue growing.
Verizon (VZ)
Why Own Verizon?
Verizon is in the portfolio as a proxy for bonds. The Vanguard Aggregate Bond fund has an indicated yield of 1.89%. Bonds carry two risks: first, the loans are defaulted, and you do not get your money back. Second, and larger risk is rising interest rates. When rates go up the price of bonds goes down. Through the first quarter of the year the Vanguard bond fund dropped -9.56%. After the dramatic fall in the first quarter rates again fell and the fund is now down -0.77% for the year. We purchased Verizon because of its 4.5% dividend yield and stable free cash flow generation. I estimate Verizon can produce $4.65 a share in cash flow which works out to about 8.5% yield. So, we have a stable business with an estimated 8.5% cash flow yield with the potential to grow with the proliferation of 5G service vs. investment grade bonds with a 1.89% yield that will not go up unless rates go higher but that will bring more losses to the principle.
What Will Make Our Investment in Verizon Work?
Verizon needs to keep growing its earnings a few percent per year and our investment will do just fine. This can be achieved by growing subscribers, increasing price, and adding new services. AT&T, T-Mobile and Verizon have all made the decision to make 5G service only available on their highest tier plans. Currently 35% of users are not on an unlimited data plan and only 25% are on the premium unlimited plan. When consumers upgrade or choose a new service the majority have chosen the top-tier plans driving a 1-2% lift in revenue per year. Growing subscribers is more challenged with cellular service reaching saturation. The pandemic has brought a shift to a mobile workforce which in turn may drive more corporate subscriptions and mobile hotspots. 5G service will bring numerous new use cases such as 5G in-home wireless broadband.
How did Verizon the business do this quarter?
Verizon bounced back nicely in the second quarter after a disappointing first quarter release. They added 197,000 new subscribers and posted a very low churn rate of 0.65%. Management also expressed optimism that they will continue to net add new subscribers for the rest of the year. I was disappointed last quarter when management chose to offer aggressive phone subsidies to new and existing subscribers. The offer was short lived and my concerns of a fierce price war among T-Mobile, AT&T and Verizon does not appear to be taking place. Cutting prices to attract customers in a low growth oligopoly industry structure can have destructive consequences for all parties and requires careful attention. In business, you are only as smart as your dumbest competitors and for years I have regarded AT&T as having the dumbest management team in the world. Just look at their disastrous acquisitions of DirecTV and Time Warner as proof. Verizon is still in the process of getting its 5G network up and running and lags T-Mobile but should catch up and likely surpass them in the next 12-18 months. I found it encouraging that all three carriers reported minimal churn in their customer base. Historically, customers have elevated levels of carrier changes during generation updates. Free financing on phones and their payment plans have done a great job keeping customers from changing their wireless provider.
Key Risks to Monitor
- Loss of subscribers to AT&T and T-Mobile: Verizon has a reputation of having the strongest nationwide network thanks to its aggressive 4G LTE investments over the past decade. With 5G, it is currently in 3rd place with T-Mobile in the lead and AT&T rated second. Verizon is working to bridge the gap and recently purchased half of the 5G spectrum the US Government made available for $45 billion.
- Dish Network: Dish network has been acquiring spectrum over the past few years and claims it can create a 5G nationwide network for a fraction of the cost of what Verizon, T-Mobile and AT&T have spent. Dish Network is still in the assembly phase and is targeting a launch in 2023. It remains to be seen if Dish will be successful and if they are we will likely exit our position. However, the threat is not immediate, customers are slow to change carriers and an unknown network/brand will take time before materially impacting the three main carriers.
- Inflation: My outlook for earnings growth is in line with the Federal Reserve’s inflation forecast. A large portion of Verizon's cost structure for its network is in long-term contracts with fixed price escalators of only a couple percent. The risk is competition within the industry prevents Verizon from being able to pass any inflationary pressures it faces.
What is Verizon Worth?
I estimate Verizon is worth $60 a share which is based on my outlook that cash flow generated by the business will grow 2-3% per year. If 5G service is successful in creating new revenue streams and cash flow grows 5% per year, I estimate the value of the business could go as high as $70 per share. Conversely if competition with Dish Network and the other carriers increases and earnings do not grow the stock could fall to $35 per share. These valuation scenarios take into consideration the proposed tax increase by President Biden.
How did it perform?
Since the purchase in the first quarter Verizon stock is +0.54% through August 20th. The return is inclusive of a $1.26 per share in dividends. This compares favorably to the -0.77% return of the Vanguard Aggregate Bond Fund. This investment has performed in line with expectations thus far.
Vanguard S&P 500 (VOO)
The S&P 500 is the centerpiece of our portfolio. It is comprised of the 500 largest companies in the US, essentially a bet on the US economy, and is viewed as the proxy for the overall stock market. Every month after I pay my bills, I make an investment with my excess savings. My default purchase is the VOO, unless I have an outstanding business selling at a fair price. My incremental savings for the past three months went into the VOO, which along with the strong performance pushed the percentage of the portfolio from 55%to 59%.
