A Money Making Machine

The Value Fund was flat (0.10%) in the third quarter and is up 2.72% year to date.

Currency movements were immaterial during Q3.   The Canadian dollar has started weakening since September 11 and we are now recapturing some of the (6.5%) in performance that its previous rise has cost us this year (Canadian dollars are the Value Fund’s reporting currency).  We purposely accept this currency volatility in exchange for saving the hedging costs along the way.

 

Notes:  All returns and Value Fund details are as of September 30, 2017, based on Class A units and are net of all fees.  The Value Fund was launched on November 1, 2011. Prior to January 17, 2014 the Value Fund was managed by Lightwater Partners Ltd. while Mr. McCloskey was employed by that firm.

 

“The single greatest edge an investor can have is a long-term orientation.”

 

Seth Klarman

Baupost Group

 

Our best performers for Q3 by portfolio contribution were Berkshire Hathaway +8.2%, American Express +7.4% and Novo Nordisk +12.3%. Our biggest laggards were Allergan (15.7%), Coach (14.9%) and Nike (12.1%).

During Q3 we added CVS Health (NYSE:CVS) to the portfolio.  You are likely familiar with their retail pharmacies but may not know that CVS also owns a major pharmacy benefit manager (PBM) that competes with former Value Fund holding Express Scripts.  Many retail stocks are currently underperforming due to the threat posed by Amazon.  More specifically, there are reports that Amazon is contemplating a move into the online pharmacy space which is weighing on CVS’ stock – hence the opportunity.  We believe that pharmacy – a highly regulated business – is more difficult to tackle than selling general merchandise.  In addition, CVS’ PBM is an underappreciated jewel and it recently won a major PBM contract with health insurer Anthem (NYSE:ANTM).  We like CVS’ long-term prospects and the risk/reward at these prices.

In August we sold about half of our position in Corus Entertainment (TSX:CJR.B) due to price appreciation and our view of the stock’s intrinsic value.  Factoring in dividends, we were up about 49% in 18 months and decided to take some profits.  Subsequent to quarter end, we added a new European-based company to the portfolio.  As we may still accumulate additional shares, we will disclose this new holding in a future letter.

 

Visa, Inc. (NYSE:V) 

Value Fund holding Visa, Inc. is the world leader in retail electronic payments.  Visa, along with competitor MasterCard, form a global duopoly in the sector.  Visa is an incredible business.  The company grows steadily without much capital reinvestment required, adds value to both consumers and retailers and is very difficult to compete against.  Visa is truly a money-making machine.

A simplified overview of Visa’s business model is warranted as it is often misunderstood.  You have probably never given Visa’s business much thought despite having a Visa-branded card in your wallet.  While often thought of as a credit-card issuer, Visa is actually a technology company.  Visa owns and operates VisaNet – a highly secure and reliable global network that authorizes, clears and settles financial transactions.  Visa operates an open loop or four-party system consisting of (i) Issuers, (ii) Merchant Acquirers, (iii) Retailers and (iv) Consumers (cardholders).

The Four-Party System
(Open Loop)

In an open-loop system, credit and debit cards are actually issued by banks (e.g. RBC, Scotiabank) – known as Issuers.  Visa authorizes these banks to issue Visa-branded cards and the Issuers agree to follow Visa’s rules and pay Visa certain fees.

Retailers that wish to accept Visa as a payment method enter into an agreement with a Visa-authorized bank (called Merchant Acquirers) who agree to help the retailer process and settle transactions.  Merchant Acquirers ensure that Visa’s rules are followed and pay Visa certain fees.

When a card is presented by a consumer for purchase at a retailer, VisaNet routes the payment request for authorization to the Issuer bank.  VisaNet’s algorithms simultaneously analyze the transaction to detect and prevent fraud.  Within one or two seconds the transaction is approved (or not) and the settlement of funds takes place between the two banks and the retailer within a few days.

An often misunderstood point is that Visa does not take any credit risk – that risk sits with the Issuing Bank that grants you the card, sets your credit limit and sends you your monthly statement.  Visa simply sits in the middle – facilitating payment transactions and collecting a modest fee from Issuers and Merchant Acquirers that averages about $0.18 per transaction.  That may not sound very impressive until you realize that VisaNet processes over 116 billion transactions every year or more than 3,700 per second!

Visa’s Economic Moats

Visa is such a good business that you would think that others would try and replicate it.  Easier said than done.  Visa’s business is protected by multiple competitive advantages or moats.  The first is brand.  Trust is extremely important when it comes to payments.  Many years of usage by consumers and investment in security by the company gives all parties involved the confidence to use a Visa card.  Second, Visa benefits from a network effect.  Consumers want to use cards that are accepted by most merchants and merchants want to accept cards carried by most consumers.  This virtuous circle is very powerful and difficult to replicate.  To date, alternative payment providers, even those started by reputable and powerful companies (e.g. Apple Pay, PayPal) have generally partnered with Visa and MasterCard.  Replicating their global payment networks and technological prowess is not a small feat.

Visa also benefits from switching costs.  It is a major undertaking for an Issuing bank to switch all of its credit card customers to another branded card.  Finally, Visa benefits from scale.   Visa is largely a fixed-cost business.  The incremental cost of processing an additional transaction is close to zero.  Operating margins at Visa are currently 66% and rising!  As a result, the company sensibly focuses on driving cards in circulation, card usage and volume.

Business Tailwinds

Visa also benefits from a number of macro trends.  Cash usage continues to decline as consumers around the world are choosing to pay more often using plastic as incomes and standards of living rise.  The secular trend of online commerce also plays into Visa’s hands as online payments are all non-cash.  According to the Nilson Report, Visa currently represents about 54% of all global payment transactions and Mastercard another 26% (or 80% combined).  Given their dominance, both companies possess pricing power and regularly increase their prices.

Visa acquired Visa Europe for over $20 billion in mid-2016.  Visa Europe was previously owned by European financial institutions and operated as a not-for profit enterprise much like Visa was prior to its initial public offering (IPO) in 2008.  We expect that the integration of Visa Europe over the next few years will follow Visa’s historical path of expanding volumes and margins given Visa’s experience and global scale.

Valuation

As a result of all these factors, Visa has been able to consistently grow its revenues at double-digit rates and earnings even faster through operating leverage.  Over the past five years, Visa earned a cumulative $24.7 billion in earnings and paid out all of it to shareholders through a combination of rising dividends and share repurchases.

Without question, Visa is a remarkable business.  But even great businesses are not worth an infinite amount.  We believe that Visa will earn at least $4.00 over the coming year and should comfortably grow earnings per share at a double-digit pace for some time.  Combined with the quality of the business and its capital-light nature, we believe the stock is worth at least 25x earnings or about $105.   Many people think that value investing is all about low price-to-earnings (P/E) multiples.  It is not.  Value Investing is about buying something for less than its intrinsic value.  A fast growing and high quality company is worth a lot more than a slower growing and inferior business.  It is the comparison of price to intrinsic value that matters, not simply the relative P/E ratios.

We started buying Visa in late 2016 at a P/E in the low 20x range and our average cost is $79.38.   Visa is our fifth-largest position in the Value Fund but with the stock trading at close to $110, we believe it fully valued at present and do not plan to add to our holdings at these prices.   However, we are happy to allow our unrealized capital gain to compound at a reasonable rate unless and until a better opportunity presents itself.

Risks

There is risk in any investment and Visa is no exception.  Regulation is probably the biggest risk facing the company.   Visa’s dominance and market power make them an easy target for regulators who prefer to cap their prices and shape rules that Visa imposes on Issuers and merchants choosing to participate in the Visa ecosystem.  Class action lawsuits by consumers and merchants for monopolistic practices are another related risk.

Cybersecurity is another critical risk faced by the company.  A data hack similar to the one engulfing Equifax would be very damaging to Visa’s business.  Fortunately, the company knows this and spends a lot of time, effort and money on that front. Consumer spending is cyclical and while a recession wouldn’t expose Visa to credit risk, it would certainly slow payment volume growth.  Finally, a disruptive technology could come along and create added competition.  We believe that this is unlikely, but not impossible. We will continue to monitor these and other risks but remain long-term bullish on our investment in Visa.

“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

 

Paul Samuelson

late U.S. economist and Nobel Prize winner

Talk is Cheap

In a world of extremely low interest rates and an overvalued Canadian real estate market, we believe that equities remain an attractive asset class for Canadians.  However, market valuations remain elevated – which is why we don’t own the market.

Instead, we seek to invest in high-quality but undervalued companies with solid balance sheets.  In the present environment we are very focused on risk mitigation and capital preservation when selecting investments.

These are not merely empty statements.  We take the responsibility that comes with managing people’s money very seriously.  We are humbled by the trust that our clients place in us and work hard to ensure that that trust is continuously deserved.   You should also know that I have over 70% of my family’s net worth and 100% of our investible assets invested alongside the firm’s clients.   We walk our talk at GreensKeeper and believe in aligning interests.

In short, we are different.  If you are interested in learning more over coffee at our Oakville office or downtown Toronto, feel free to give me a call.

Michael McCloskey

President & Founder