The Rational Cloning: Weekly Ideas #10
Qualivian on Watsco, Rowan Street on China, Conor Maguire on Willis Towers Watson, Bill Miller on How to Pitch a Stock, and More
Welcome to the 10th edition of the Rational Cloning Newsletter (Weekly Ideas Series).
Helping you discover the best ideas of others.
Happy cloning.
Weekly Investment Ideas
(1) Qualivian Investment Partners Q3 2021 Investment Letter: Watsco (WSO) (LINK)
Superior Business:
• It is the #1 HVAC distributor with 15% market share. It is two and a half times larger than the next largest player.
• It has high returns on invested capital and is relatively asset light.
• Is extending and widening its already formidable competitive advantage due to a) its scale and b) its investments in its technology infrastructure. This leads to our differentiated view that Watsco will have higher EPS growth than consensus due to higher revenue growth and better operating margins.
Superior Reinvestment Opportunities:
• It benefits from a long growth runway arising from its predictable end market demand as well as its consolidator role in the HVAC market:
− The US has ~115 million installed A/Cs and furnaces, 92 million of which are over 10 years old. Systems last 10-20 years suggesting a solid replacement runway.
− The installed base of HVAC units has grown at a 3.6% CAGR since 1980.
Superior Management / Capital Allocation:
• Founder-led management team with focus firmly planted on long-term value creation:
− Founder/CEO, Al Nahmad, and the President, his son AJ (in charge of the technology investments), own 12% of the company, however, they control 54% of the voting shares.
− Focused on generating long-term value creation by growing market share organically and consolidating the industry. They are not managing short-term earnings results. “We care about the next quarter century not the next quarter.”
(2) Rowan Street Q3 2021 Letter: Ideas on Selling China (LINK)
Exit From Our Chinese Positions
As you know, we have owned stock in Alibaba and Tencent since 2018. We know both companies very well and have spent countless hours studying their operations over the past 3 years. We have published our detailed write-up on Alibaba in our Q3 letter last year. At one point, in the first half of 2020, we were sitting on substantial gains in both positions (2x on Tencent), and our China exposure had grown to around 25% at the time. We started actively trimming these in Q1 and completely exited both positions in Q2 (please see our rationale below). All-in-all, we ended up netting a small gain in dollar terms. However, both Alibaba and Tencent detracted ~5% from our performance in 2021.
We believe the number one mistake that we as investors can make is to be unwilling to admit that we are wrong. Sometimes being willing to change our mind in the face of new evidence, selling when necessary, is one of the most important skills that we as investors can have.
So what new evidence changed our mind?
As you know, capital allocation and reinvestment of capital is one of the most important foundational pillars that we spend a lot of time on and watch very closely. Recent Chinese government crackdown and CCP’s ”common prosperity“ policies, which you are all well aware of as they have been widely covered this year, have a direct impact on the future capital allocation policies of both Alibaba and Tencent.
When management of the companies that we are owners of do NOT have full control of the capital allocation, that goes against all our foundational principles as investors and stewards of your capital. At that point, we place a lot less importance on the size of revenues and cash flows that the company generates and how attractive their valuations may be (it’s very apparent to just about everyone how statistically cheap the stock of Alibaba and Tencent currently are). The only logical decision here, once one of our foundational principles is violated, is to sell and to reinvest the proceeds into our high conviction ideas that fit our investment criteria and that have a high probability of compounding our fund’s capital at double-digits (p.a.) in the next 5-10 years, which is exactly what we have done over the past several months.
(3) Conor Maguire: Willis Towers Watson PLC: From Busted Merger Arb Play to Value Situation (LINK)
Having examined the broken AON-Willis deal in further detail, I believe Willis Towers Watson (WLTW) is ironically the most interesting opportunity to come out of the current merger arb arena. Following my analysis of recent events, WLTW is my latest high conviction value situation, as I outline in this week’s memo edition of the newsletter.
I estimate WLTW to be worth $403/share [currently $248.15/share] upon delivery of management’s growth and capital return plan by FY24, based on FY24 EBITDA of ~$3.2bn at a 14x multiple, and capital returns via share buybacks and dividends.
(4) Wedgewood Partners Third Quarter 2021 Client Letter (LINK)
During the quarter we trimmed Alphabet, Keysight Technologies, and Starbucks. We increased our position in Taiwan Semiconductor Manufacturing and purchased UnitedHealth.
Taiwan Semiconductor Manufacturing detracted from performance as the market attempted to price in a downturn in the semiconductor cycle. Although there are some signs that memory markets might be somewhat oversupplied, we have yet to see any tangible signs that logic semiconductors – particularly at the leading-nodes where the Company dominates – are in anything but short supply. In addition, and as a result of this strong demand, the Company should be able to pass through price increases to help fund very attractive returns on the rare leading-edge capacity that serves this demand
UnitedHealth Group detracted from performance due to investor concerns about Medicare premiums as well as post-COVID medical cost trends. Medicare enrollment should continue to grow at double-digits at UnitedHealthcare. Meanwhile the Company’s Optum segment should be able to help bend the cost curve if indeed post-COVID volumes pick up to above pre-COVID levels. In any case, we do not think the long-term normalized trend of medical care in the U.S. has changed substantially and would look to add to our new position on any continuing short-term concerns.
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