| Arete Quarterly Q211 |
Welcome
Summer is a great time to get away and to explore new places. A remote trail with beautiful scenery, an underappreciated historic site, and a new restaurant with an interesting menu are but a few of the new experiences that can be sought.
While our process of uncovering new stock ideas extends throughout the year, the quest for unique, new ideas is very similar. In order to guide our way, we pay special attention to tidbits of information that suggest interesting and overlooked phenomena in the market.
One recent tidbit, in particular, is that there have been more corporate spin-offs than usual over the past several months. Helen Thomas also noticed this developlment in a recent article for the Financial Times. She reports, “Divestitures have risen to a record share of global mergers and acquisitions activity so far this year, according to Dealogic data. In the US, [spin-off] activity is up more than 40 per cent on the first half ot 2010.”
In identifying the rationale for this activity, Thomas quotes Mark McMaster, vice-chairman of US investment banking at Lazard. According to McMaster, “There is a trend right now in the public markets towards purity, focus and specialization.” He continues, “The impetus for separation is usually a meaningful and persistent undervaluation of a portfolio business.”
The notion that value can be created through spin-offs has been documented and is not new. In fact, we highlighted spin.offs as one of many factors that make the mid cap universe so robust and dynamic in our 2007 white paper, The Case for Mid Cap Stocks.
The increasing incidence of spin-offs, however, is interesting for a couple of reasons. One reason is that the recent trend to become smaller is occuring in direct contradiction to forces that naturally compel organizations to grow ever-larger, a phenomenon Warren Buffett has labelled the “institutional imperative.”
Buffett illustrates, “Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds . . . any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops.” It shouldn’t be surprising that executive compensation also tends to grow as companies swell with these projects and acquisitions.
Another reason why the increasing incidence of spin-offs is interesting is because the trend also runs counter to the advice of many financial advisers who are recommending large cap stocks. While the majority of large cap stocks do not spin-off business units, the trend does suggest a something of a disconnect between large cap advocates and the executives that prefer to subdivide their companies.
Consider what it means for a CEO of a large company to pursue a spin-off. First, he or she must engage in an active effort to effect a spin-off; it is far easier to do nothing and to remain large. Further, the CEO will likely relinquish a certain amount of power and compensation attendant with a larger organization. Also, by engaging in a spin-off, the CEO rejects a preference of many investors for size. Clearly, a CEO must require overwhelming evidence regarding the net benefits of a spin-off to overcome so many hurdles.
Spin-offs often happen because they allow for more efficient capital allocation by deliberately constraining company size. Indeed, the rationale of resolving “meaningful and persistent undervaluation” by pursuing “purity, focus, and specialization” through spin-offs sends a powerful signal: Many businesses can be much more effective as mid cap companies rather than as divisions of very large corporations.
Arete began its existence by focusing on mid cap stocks because we thought this was an extremely exciting area that lent itself to terrific opportunities for stock selection. Large companies often become too large to be efficient through the “institutional imperative.” When executives choose to get smaller through spin-offs, it often provides interesting new mid cap stocks for us to investigate. For us, new ideas are always in season!
Summer is a great time to get away and to explore new places. A remote trail with beautiful scenery, an underappreciated historic site, and a new restaurant with an interesting menu are but a few of the new experiences that can be sought.
While our process of uncovering new stock ideas extends throughout the year, the quest for unique, new ideas is very similar. In order to guide our way, we pay special attention to tidbits of information that suggest interesting and overlooked phenomena in the market.
One recent tidbit, in particular, is that there have been more corporate spin-offs than usual over the past several months. Helen Thomas also noticed this developlment in a recent article for the Financial Times. She reports, “Divestitures have risen to a record share of global mergers and acquisitions activity so far this year, according to Dealogic data. In the US, [spin-off] activity is up more than 40 per cent on the first half ot 2010.”
In identifying the rationale for this activity, Thomas quotes Mark McMaster, vice-chairman of US investment banking at Lazard. According to McMaster, “There is a trend right now in the public markets towards purity, focus and specialization.” He continues, “The impetus for separation is usually a meaningful and persistent undervaluation of a portfolio business.”
The notion that value can be created through spin-offs has been documented and is not new. In fact, we highlighted spin.offs as one of many factors that make the mid cap universe so robust and dynamic in our 2007 white paper, The Case for Mid Cap Stocks.
The increasing incidence of spin-offs, however, is interesting for a couple of reasons. One reason is that the recent trend to become smaller is occuring in direct contradiction to forces that naturally compel organizations to grow ever-larger, a phenomenon Warren Buffett has labelled the “institutional imperative.”
Buffett illustrates, “Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds . . . any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops.” It shouldn’t be surprising that executive compensation also tends to grow as companies swell with these projects and acquisitions.
Another reason why the increasing incidence of spin-offs is interesting is because the trend also runs counter to the advice of many financial advisers who are recommending large cap stocks. While the majority of large cap stocks do not spin-off business units, the trend does suggest a something of a disconnect between large cap advocates and the executives that prefer to subdivide their companies.
Consider what it means for a CEO of a large company to pursue a spin-off. First, he or she must engage in an active effort to effect a spin-off; it is far easier to do nothing and to remain large. Further, the CEO will likely relinquish a certain amount of power and compensation attendant with a larger organization. Also, by engaging in a spin-off, the CEO rejects a preference of many investors for size. Clearly, a CEO must require overwhelming evidence regarding the net benefits of a spin-off to overcome so many hurdles.
Spin-offs often happen because they allow for more efficient capital allocation by deliberately constraining company size. Indeed, the rationale of resolving “meaningful and persistent undervaluation” by pursuing “purity, focus, and specialization” through spin-offs sends a powerful signal: Many businesses can be much more effective as mid cap companies rather than as divisions of very large corporations.
Arete began its existence by focusing on mid cap stocks because we thought this was an extremely exciting area that lent itself to terrific opportunities for stock selection. Large companies often become too large to be efficient through the “institutional imperative.” When executives choose to get smaller through spin-offs, it often provides interesting new mid cap stocks for us to investigate. For us, new ideas are always in season!
Business Update
The more I think about how Arete creates value, the more I see connections to my education at Grinnell College. This shouldn’t be too surprising since Grinnell had such a powerful influence on my thinking. Indeed, the name Arete comes from Greek philosophy which I first read in my studies there.
I can still remember vividly how excited I was to attend Grinnell. I was anxious to learn — about everything. While I enjoyed math, science, and economics, I also really enjoyed literature, history, and sociology. When I took my first philosophy class, I felt like my mind was stretched in all kinds of unfamiliar, but good ways. I was hooked.
I found my studies, as those in any good liberal arts program, to provide me with a rich source of ideas and metaphors from which to better understand the world. Because my studies were so diverse, I found it difficult to become overly dogmatic. Whenever I may have been tempted to relax intellectually, I was always exposed to a swarm of models and paradigms which begged for my consideration. By de-emphasizing structure, Grinnell’s culture really nurtured independent thinking. It was a wonderful learning experience and continues to influence my approach to learning today.
While this learning environment worked extremely well for a lot of students, there was a potential weakness. With few real constraints or objectives, it was not hard to get “lost in learning.” The experience could certainly become addictive and self-serving. As much as I enjoyed learning, I realized learning alone wasn’t enough for me. As I approached graduation, I had to find a way to put my learning and knowledge to good use.
With this context, I believe it is much easier to articulate what I have tried to do by founding Arete. The essence of Arete is a platform to leverage curiosity to learn, to develop unique insights and knowledge through independent thinking, and to apply that knowledge so as to increase well.being.
As much as I enjoy these activities intrinsically, I created Arete so they could also be delivered in the form of a valuable service. While Arete explicitly strives to increase well-being through long-term portfolio performance (and that has certainly been my personal experience), it is not all.
Because I spend so much time reading, researching, modeling, analyzing, meeting management teams, and assimilating information, I develop all sorts of knowledge that can be useful beyond portfolio performance. I share some of these insights through Arete’s newsletters. I also enjoy volunteering in my community. Importantly, however, I really enjoy sharing insights with clients so they can better understand market activity and risks — and enjoy the greater sense of empowerment that provides.
An interesting footnote to my college experience is that I never could have afforded Grinnell if it were not for the school’s need-blind admission policy. Although I worked several jobs there, received scholarships, and took on several loans, Grinnell still granted me a huge portion of the tuition.
Grinnell was able to make such a large and meaningful contribution due to the strength of its endowment — which is the second highest per student behind Harvard University. The endowment was managed extremely well for years under Joe Rosenfield, but also received valuable input from Warren Buffett, who has served on the Board of Trustees since 1968.
The learning experience at Grinnell — that made my life immeasurably better — serves as a powerful reminder to me of the good that great money management can produce.
Exceptional money management also serves as Arete’s mission. I created the organization in order to improve well.being, not least of which is through helping people’s money work harder for them. If you know of someone interested in talking to such a devoted manager, please let me know.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
The more I think about how Arete creates value, the more I see connections to my education at Grinnell College. This shouldn’t be too surprising since Grinnell had such a powerful influence on my thinking. Indeed, the name Arete comes from Greek philosophy which I first read in my studies there.
I can still remember vividly how excited I was to attend Grinnell. I was anxious to learn — about everything. While I enjoyed math, science, and economics, I also really enjoyed literature, history, and sociology. When I took my first philosophy class, I felt like my mind was stretched in all kinds of unfamiliar, but good ways. I was hooked.
I found my studies, as those in any good liberal arts program, to provide me with a rich source of ideas and metaphors from which to better understand the world. Because my studies were so diverse, I found it difficult to become overly dogmatic. Whenever I may have been tempted to relax intellectually, I was always exposed to a swarm of models and paradigms which begged for my consideration. By de-emphasizing structure, Grinnell’s culture really nurtured independent thinking. It was a wonderful learning experience and continues to influence my approach to learning today.
While this learning environment worked extremely well for a lot of students, there was a potential weakness. With few real constraints or objectives, it was not hard to get “lost in learning.” The experience could certainly become addictive and self-serving. As much as I enjoyed learning, I realized learning alone wasn’t enough for me. As I approached graduation, I had to find a way to put my learning and knowledge to good use.
With this context, I believe it is much easier to articulate what I have tried to do by founding Arete. The essence of Arete is a platform to leverage curiosity to learn, to develop unique insights and knowledge through independent thinking, and to apply that knowledge so as to increase well.being.
As much as I enjoy these activities intrinsically, I created Arete so they could also be delivered in the form of a valuable service. While Arete explicitly strives to increase well-being through long-term portfolio performance (and that has certainly been my personal experience), it is not all.
Because I spend so much time reading, researching, modeling, analyzing, meeting management teams, and assimilating information, I develop all sorts of knowledge that can be useful beyond portfolio performance. I share some of these insights through Arete’s newsletters. I also enjoy volunteering in my community. Importantly, however, I really enjoy sharing insights with clients so they can better understand market activity and risks — and enjoy the greater sense of empowerment that provides.
An interesting footnote to my college experience is that I never could have afforded Grinnell if it were not for the school’s need-blind admission policy. Although I worked several jobs there, received scholarships, and took on several loans, Grinnell still granted me a huge portion of the tuition.
Grinnell was able to make such a large and meaningful contribution due to the strength of its endowment — which is the second highest per student behind Harvard University. The endowment was managed extremely well for years under Joe Rosenfield, but also received valuable input from Warren Buffett, who has served on the Board of Trustees since 1968.
The learning experience at Grinnell — that made my life immeasurably better — serves as a powerful reminder to me of the good that great money management can produce.
Exceptional money management also serves as Arete’s mission. I created the organization in order to improve well.being, not least of which is through helping people’s money work harder for them. If you know of someone interested in talking to such a devoted manager, please let me know.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
Market Overview
The character of the market has remained much the same over the last several quarters. The strong cyclical recovery unleashed in March 2009 reversed quickly beginning in April 2010. Fears regarding European sovereign debt and slowing economic growth emerged simultaneously which pulled the market down, but had an especially harsh effect on more cyclical stocks.
Late last summer, the Fed outlined its plan for quantitative easing which helped the market significantly, but not uniformly. Cyclicals continued to lag while companies producing short-term earnings improvements experienced huge price appreciation. This environment tended to favor many technology and biotech companies.
The Russell style returns also bear this out in a more general way. Returns of the Russell Midcap Growth® Index, for example, outpaced those of the Russsell Midcap Value Index® by almost 800 basis points for the latest twelve months. The style effect was even greater for small cap stocks. In short, relative performance over the past year depended meaningfully on style.
During this period, however, we have also seen increasingly violent market reactions to individual company performance, which has often been exacerbated by low trading volumes. Many of the earnings shortfalls and subsequent price-bashing have occurred with manufacturing companies that have not been able to pass through pricing as fast as raw material costs have increased. For strong companies, this is normally just a timing issue and does not reflect a permanent condition.
The good news in this is that many of the stocks we like are very cheap. The bad news is that in this unforgiving environment for short-term earnings misses, the stocks can continue to get even cheaper. While we constantly evaluate opportunities, we are also extremely aware of how fragile the market environment is right now.
The character of the market has remained much the same over the last several quarters. The strong cyclical recovery unleashed in March 2009 reversed quickly beginning in April 2010. Fears regarding European sovereign debt and slowing economic growth emerged simultaneously which pulled the market down, but had an especially harsh effect on more cyclical stocks.
Late last summer, the Fed outlined its plan for quantitative easing which helped the market significantly, but not uniformly. Cyclicals continued to lag while companies producing short-term earnings improvements experienced huge price appreciation. This environment tended to favor many technology and biotech companies.
The Russell style returns also bear this out in a more general way. Returns of the Russell Midcap Growth® Index, for example, outpaced those of the Russsell Midcap Value Index® by almost 800 basis points for the latest twelve months. The style effect was even greater for small cap stocks. In short, relative performance over the past year depended meaningfully on style.
During this period, however, we have also seen increasingly violent market reactions to individual company performance, which has often been exacerbated by low trading volumes. Many of the earnings shortfalls and subsequent price-bashing have occurred with manufacturing companies that have not been able to pass through pricing as fast as raw material costs have increased. For strong companies, this is normally just a timing issue and does not reflect a permanent condition.
The good news in this is that many of the stocks we like are very cheap. The bad news is that in this unforgiving environment for short-term earnings misses, the stocks can continue to get even cheaper. While we constantly evaluate opportunities, we are also extremely aware of how fragile the market environment is right now.
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