Phiwath Jittamas/iStock via Getty Images
|
Year |
MPE Capital |
S&P 500 TR |
|
2017* |
18.9% |
18.6% |
|
2018 |
-0.2% |
-4.4% |
|
2019 |
7.3% |
31.5% |
|
2020 |
25.1% |
18.4% |
|
2021 |
-24.8% |
28.7% |
|
2022 H1 |
-33.1% |
-20.0% |
|
*Inception January 25, 2017 Returns are shown net of a 1.5% management fee for a model account
|
Top 3 Portfolio Holdings (alphabetically)
Amazon (AMZN)
Squarespace (SQSP)
MPE Capital’s First-Half 2022 Letter
For the first half of 2022, MPE Capital declined 33.1% while the S&P 500 TR declined 20.0%.
The last twelve months have been a period of both tremendous pain and tremendous growth. When managing other people’s money, I feel a great deal of responsibly. And when the results are poor, I feel absolutely terrible. I can’t blame the overall market decline for our results. Had we just owned a few great businesses that temporarily declined in price, I would be completely okay with that. But that was not the case. I made two investments where I incorrectly appraised both business quality and intrinsic value. I take full responsibly for our poor results.
This period of poor performance has led to much time spent asking why. Why do I hold x belief and does it have fundamental basis? Going through this exercise led to great insights. Even simple things you believe to be absolutely true may actually be completely false. This exercise also led to a lot of simplification. Investing shouldn’t be too complex, especially since it’s not a hard science. There are a few basic axioms like a business is worth the present value of its future cash flows. Once you begin to deviate too much, things can get messy very quick, which can potentially lead to permanent capital loss.
MPE Capital will now be making a small pivot. As I stated in my previous letter, my core investment philosophy hasn’t really changed, but my thinking is now much clearer on the types of investments I will be making. I’ve also refined my research process.
Going forward, MPE Capital will own a handful of what I consider to be the best businesses that I can understand. By understand, I mean I can look forward five to ten years and forecast with a high degree of confidence what the company’s worse case economics will look like. I will look to purchase these investments at reasonable prices and hold them for many years. I will sell only if I’ve found a superior investment, if the business is no longer great, or I’ve made a mistake. This is essentially the same philosophy I’ve tried to pursue since inception, but I now have a far more rigid framework for evaluating companies and investment opportunities.
There is the common financial disclaimer: past performance is not indicative of future results. In the case of MPE Capital, that will be very true going forward. Using MPE Capital’s historical performance as a gauge of future results won’t be very useful. The MPE Capital of the last five years can in some respects be compared to Berkshire Hathaway, (BRK.A, BRK.B) the textile business. Once Buffett took control, the business completely changed.
MPE Capital will also be completely different going forward compared to the past. Even today, we still own some legacy positions that will over time be sold off and the capital reinvested into present day thinking MPE Capital. I would say as of the second quarter 2022, 55% or so of our portfolio is present day MPE Capital while the rest is still legacy MPE Capital.
Most of the investments I’ve made since inception, I will never make again. The last five years have been a period of great learning—with lots of trial and error. Looking back in hindsight, I was full of hubris in 2017. I thought to myself I will definitely beat the S&P 500. Now, five years later, the results are in, and the S&P 500 has kicked my butt.
However, I now feel I am well equipped to go to war with the S&P 500. I have spent over five years training, learning, and growing as an investor. My investment philosophy and research process are far more refined. I am very much looking forward to the next five years where we can then look back and see how we’ve fared versus the overall market.
Mistakes of Commission (ATUS and POSH)
Two ((very)) costly mistakes I’ve made over the last twelve months have been my investments in Altice USA (ATUS) and Poshmark (POSH). Both are down over 50% from my initial purchase price. I not only poorly appraised business quality, I also incorrectly appraised the intrinsic value of both of these companies. It should rarely end up the case that we pay over intrinsic value, at worst case we should never lose money on an investment.
I will dive into one of these mistakes below and maybe dive into the other in a future letter.
My thinking when buying Altice USA was that they operate as a duopoly in their main footprint, the New York Tri-State area. They provide a needs-based service: internet, video, and voice services. I figured this is a very stable business with high barriers to entry. Management seemed competent as well based on historical capital allocation decisions. I didn’t fully appreciate at the time how poorly positioned they were relative to Verizon (VZ) Fios, as well as how fiercely competitive the business can get on promotions and customer acquisition.
Altice offers hybrid fiber coaxial (HFC) while Fios offers fiber-to-the-home (FTTH). FTTH is a far superior product, which has led to some share loss to Fios in the parts of their footprint that overlap. There have also been some subscriber losses in their other footprint due to new cable entrants and fixed wireless offerings.
My original thinking was that the video business will go to zero overtime due to continued pressure from services like Netflix (NFLX). In hindsight, I overstated their free cash flows excluding the video business due to difficulties disaggregating their business results. This FCF delta is a huge contributor to the difference between my current and original estimates of intrinsic value. Now, it’s possible that the video business doesn’t go to zero; however, I have a hard time envisioning that many households in ten years will still subscribe to linear television.
After losing some subscribers and facing some headwinds, they are now reinvesting many billions over the next few years in order to fiberize the majority of their footprint. I think this is a great plan and it will hopefully cement their position as a true duopoly in the New York TriState area. However, in their other major footprint, new fiber entrants are coming in and competition will only intensify. There are also some new entrants entering this space like Starlink satellite internet and fixed wireless internet from tier one mobile carriers. I think these will generally be more expensive and inferior to FTTH; however, they may end up putting some pricing pressure on Altice over time.
One serious risk is the huge amount of leverage and the possibility of prolonged inflation leading to higher rates. They don’t have any major debt maturities coming due for a few years, but it’s possible that rates are much higher then and they have issues refinancing at favorable terms or at all. I’ve always detested companies with too much leverage not sure why I didn’t consider this enough upon my initial analysis. I guess I figured it’s a stable business that can handle some leverage. However, a business with a lot of leverage will always be at the mercy of capital markets, a fact I can’t ever feel very comfortable with.
In summary, I overstated steady state free cash flows, poorly appraised their value proposition versus peers, didn’t consider new entrants and technologies thoroughly enough, and I didn’t consider the risk of rising inflation and rates. I think once they fiberize their footprint and if they can bring their leverage down, and it’s clear that new entrants aren’t having much effect on their business, Altice might only then be a decent investment candidate.
Don’t Lose Money
These two mistakes have only fortified how important it is to avoid mistakes in the investment business. There is a reason Buffett says Rule #1 is to avoid losing money, and Rule #2 is don’t forget rule number one. A 50% loss means you need to make 100% in order to return to even.
The bigger the loss, the larger the gains necessary in order to just get back to even. Just one or two mistakes can lead to years of underperformance because of how long it takes to recover.
|
Loss (%) |
Gain needed to return to even |
|
-10% |
11% |
|
-20% |
25% |
|
-30% |
43% |
|
-40% |
67% |
|
-50% |
100% |
|
-60% |
150% |
|
-70% |
233% |
|
-80% |
400% |
|
-90% |
900% |
|
-100% |
Game Over |
One huge advantage to the investment business is that there are no called strikes. No one is forcing me to make a new investment. I would make many mistakes if I was forced to make a new investment every month. But that’s not the case, I can sit for years and wait until a pitch that aligns with my investment philosophy arrives.
Making an investment in a business that I thoroughly understand and deem to be high quality, run by a competent and honest management team, purchased at a price at or below a worse case intrinsic value should rarely if ever result in permanent capital loss.
Concluding Thoughts
I appreciate all of your support in me and in MPE Capital. This has been a very tough period but luckily it has also led to tremendous growth. Due to the fact that feedback is not instant in the investment business, unlike riding a bike, it will take a few years for these lessons to show themselves in our investment results.
I am very much looking forward to our future results. Going forward we will seldom make a new investment, but we will make it in size once a wonderful opportunity presents itself.
As always, please feel free to reach out with any questions. I look forward to updating you on our results at the turn of the new year.
Sincerely,
Michael P. Ershaghi
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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