Académique Documents
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Culture Documents
Markets are contemplating the potential for a tighter domestic monetary policy. As this would be the first
such shift experienced in a decade, the recent increase in volatility should not come as a surprise. The table
below illustrates each of the cyclical peaks and troughs in the Fed funds rate and the magnitude of changes
since 1919. As shown, the last time the Fed took rates to zero, they stayed there for over two decades. If
history were to repeat, investors might be nervously digesting a shift toward tightening for some time.
Low
3.96%
1.92%
Date
Oct-19
Jul-24
Change
1.92%
2.88%
Period
14
64
High
5.88%
4.80%
Date
Dec-20
Nov-29
0.00%
Sep-32
2.09%
251
2.10%
Aug-53
0.65%
0.88%
2.27%
3.33%
4.00%
4.75%
11.00%
8.00%
5.88%
3.00%
1.00%
Jun-54
Jun-58
Jul-61
Jun-67
Feb-72
Dec-76
Aug-80
Nov-82
Oct-86
Sep-92
Jun-03
2.94%
3.69%
3.32%
4.75%
7.00%
11.75%
8.00%
3.44%
3.87%
3.50%
4.25%
40
18
62
30
28
39
9
21
31
99
50
3.59%
4.57%
5.59%
8.08%
11.00%
16.50%
19.00%
11.44%
9.75%
6.50%
5.25%
Oct-57
Dec-59
Sep-66
Dec-69
Jun-74
Mar-80
May-81
Aug-84
May-89
Dec-00
Aug-07
0.00%
Current
Awilco (AWDR) was once again the largest detractor during the quarter. The only silver lining is that we
have resisted the urge to increase our position during the stocks decline and, as a result, the impact on the
portfolio has shrunk along with the companys market value. Awilco remains our only exposure to the
energy industry outside of a single investment in an oil refiner with little correlation to the price of crude.
Although a 50% success rate in the sector leaves much room for improvement, our investment in NTI has
returned more than 50% on our cost.
Other detractors Proctor & Gamble (PG), Arcos Dorados (ARCO) and Coca-Cola FEMSA (KOF) - had
one thing in common: significant operations outside of the United States. While a surging dollar has
convinced the consensus to limit investment in foreign operations, there is little empirical evidence that
extrapolating currency trends improves stock selection. Rather, exchange rates are just one small piece of
the much larger picture. Value is of far greater importance.
Conventional wisdom usually sounds right, but tactical calls of this nature often prove harmful to long-term
performance. Coca-Cola, which derives two-thirds of its sales from abroad, provides an interesting
anecdote. Cokes returns were positively correlated with the dollar rally in the 1980s but the opposite was
true during the dollars rally in the 1990s. The bottom line is that operating fundamentals and competitive
positioning are the primary drivers of performance, and the price you pay is the best predictor of returns.
New Investments
One of the most challenging aspects of investment is training the mind to tune out the noise as the
adrenaline rush that accompanies exciting new ideas can quickly lead you astray. There is no shortage of
ideas in this business; however, excellent ideas are few and far between. Consequently, one must be
meticulous in allocating our most precious resource - time.
We are often asked how we allocate our time and how an idea moves from being an idea to an investment.
There is no magic formula, but doing the work up front so that we are prepared when an opportunity
presents itself is a big part of turning research into profit. During the quarter, we reviewed dozens of ideas
brought to our attention from various sources. We spent considerable time on only a handful of these by
focusing our resources on the following opportunities:
Our Circle of Competence: We deepened our understanding of businesses within our circle of
competence and sharpened our work on a number of companies in the financial sector. While no
action was taken here, we are well prepared should Mr. Market offer us a better entry point. Since
quarter end, weve gotten a little closer.
Oil Related Weakness: After passing on many direct oil investments in the fourth quarter, we
moved on and began to examine ancillary businesses suffering from energy-related weakness. Price
declines in several high-quality industrial businesses piqued our interest but upon closer inspection
do not yet provide a wide enough margin of safety.
Special Situations: The combination of growing cash balances on corporate balance sheets and
activist war chests make for an eventful investment landscape. We ramped our efforts and refreshed
our work on several previous investments in the technology sector recently put back in play. This
may well be a source of opportunity during the year and one we continue to monitor closely.
Maintenance Research: The best opportunities often arise from continued work on existing
holdings. So far in 2015, this has been the case as our two new investments this year have been
sourced from existing ideas. We discuss the evolution of our research below.
During the quarter, we increased our investment in the industry with the purchase of Discovery
Communications (DISCK). Domestic advertising concerns and significant international exposure have
weighed on the stock in the short term, but are offset by the companys low-cost, fully owned content,
global distribution platform growing at double-digit rates, and abundant cash flow in the hands of astute
owner-operators buying back significant stock at a discount to fair value.
In January, GM assisted the companys diversification efforts by announcing its plans to use the new GM
Financial as its exclusive provider of the manufacturers leases. We believe the market overreacted to the
GM loss which provided an attractive entry point for our investment in Ally. We expect management to
execute on their multi-year plan to increase normalized earnings power through balance sheet optimization
given the easing of regulatory constraints after exiting TARP last year. Ally has already begun reducing its
high-cost funding which should allow for greater flexibility from its rapidly growing online bank. We expect
a continued reduction in funding costs this year.
Today, Ally is trading at 70% of tangible book value. Even assuming no asset growth over the next few
years and cumulative losses on par with the financial crisis, book value should remain well in excess of the
current price, providing ample downside protection. Given the higher quality of Allys current book, lowhanging fruit in the form of high-cost debt and rapid growth in non-GM originations, we view this scenario
as quite extreme. We believe Ally is poised to grow its capital base and the returns it earns on that capital,
and if successful, the stock should trade at book value or higher.
The upside case is quite clear and far more likely in our view. Assuming management is successful in its
plan, which we believe is very achievable, and the company continues to grow per share book value at the
current pace, Allys book value should approach $40 over the next few years. If the stock were to trade back
to book value, this would represent a 2x return on our investment.
If I had more time, I would have written a shorter letter. But since this one has already run longer than
intended, well save our discussion of subprime auto lending for the appendix, which can be read (or
discarded) on its own.
Sincerely,
J., & Corkery, M. (2014, July 19). In a Subprime Bubble for Used Cars. New York Times.
J., & Corkery, M. (2014, September 24). Miss a Payment? Good Luck Moving That Car. New York Times.
3Silver-Greenberg, J., & Corkery, M. (2014, October 1). Loan Fraud Inquiry Said to Focus on Used-Car Dealers. New York Times.
4Silver-Greenberg, J., & Corkery, M. (2014, December 25). Rise in Loans Linked to Cars is Hurting Poor. New York Times.
5Silver-Greenberg, J., & Corkery, M. (2014, December 2014). Rise in Loans Linked to Cars Is Hurting Poor. New York Times.
6Silver-Greenberg, J., & Corkery, M. (2015, January 26). Investment Riches Built on Subprime Auto Loans to Poor. New York Times.
2Silver-Greenberg,
All businesses have their share of bad actors. The auto market is not different in this regard, but it is
dangerous to derive broad conclusions from isolated examples. A more rational approach would be to
examine the empirical data rather than relying on heart-warming anecdotes. A closer look at the loans being
extended shows that more credit is available to all consumers today, not just those with low credit ratings.
Auto Balances ($Billions)
While day traders and condo speculators each had their time in the spotlight, we have not seen any evidence
of record profits from flipping Honda Accords. Extremes in particular segments of the luxury market aside7,
depreciating, mass-produced assets are simply not obvious candidates for speculative bubbles.
Since the term "bubble" is often associated with loose lending, it may be instructive to compare the precrisis growth in home lending to the more recent growth in auto lending. Home lending grew 66% from
2002 through 2005. While auto loans have increased in recent years, growth of 31% since 2011 has been less
than half that pace coming off a much lower base. In comparison, C&I loans have grown 40%, multifamily
loans have grown 42%, and U.S. Treasuries have grown 49% over the same period. In other words, growth
in auto loans appears to be consistent with the overall growth in credit more broadly.
US Banks: Auto & US Family Cumulative Growth (%)
1963 Ferrari 250 GTO became the worlds most expensive car, selling for $52 million in October 2013.
Many pundits cite increasing subprime lending as a leading indicator of a bubble in auto credit. However,
while subprime auto loans have grown, they are growing at a slower rate than the overall auto loan market.
As a result, the share of subprime auto loans is declining and currently sits at 15-year lows. In contrast, the
share of subprime mortgages increased considerably from 2006 to 2010 as subprime mortgages grew 104%
relative to overall mortgage growth of 22% over the same period. The charts below, from the Federal
Reserve Bank of Atlanta, compare the percentage of subprime auto loans with the percentage homes loans
that are considered subprime.
Subprime Share of Loan Balances
Auto lending is closely correlated with other consumer loans that tend to have high levels of subprime
borrowers. The fact that one in four auto loans is subprime might raise red flags, but it becomes less of a
concern when you consider that more than one in two households in the U.S. is rated subprime today. The
quality of these loans is a much more important indicator than the overall quantity of lending in the
marketplace, and as such, we are monitoring loan terms closely. Historically, auto loans have median loss
rates that exceed mortgages; however, auto performed significantly better than mortgages during the crisis.
As they say, you can sleep in your car, but you cant drive your house to work.
Consumer Credit Default Indices
Source: Bloomberg
Headlines have highlighted increased delinquencies in individual markets as a sign of problems, but to date,
delinquency trends for auto are generally flat. The slight increase in recent write-offs is anticipated in light of
increased volume as lending standards are no longer as restrictive as they were during the crisis. The chart
below displays cumulative write-offs for subprime borrowers across vintages with the solid lines at the top
and bottom representing the maximum and minimum loss rates for 2006-2013 vintages. Note that the red
line which represents the average of the first six vintages from 2014 falls squarely in the middle of this range.
Finally, there are vast differences in the quality of loans being originated in this highly fragmented market.
A bottom-up analysis of vintage originations by issuer demonstrates the higher quality of loans made by Ally
over time and relative to peers. As should be expected, credit standards have loosened since the financial
crisis, but we see no evidence that loan terms have deteriorated substantially, outside of more aggressive
peers lending to deep subprime borrowers at 15% - 20% annually (chart below). More importantly, we see
no cause for concern at Ally, particularly at the current price, which already discounts a worst case scenario
in our opinion. Any positive surprises relative to depressed expectations should result in healthy gains for
investors today.
Average FICO Scores
Average APR
800
25%
750
20%
700
15%
650
10%
600
5%
550
500
Sep-08
Jan-10
Jun-11
Oct-12
Mar-14
Jul-15
Sep-08
Jan-10
Jun-11
Oct-12
Mar-14
0%
Jul-15