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Portfolio Activity Q3 2020 Thumbnail

Portfolio Activity Q3 2020

As the market quickly recovered from the lows reached on March 23, you’ve probably noticed a slowdown in activity in your portfolios.  When everything sells off, we see that as our opportunity to add holdings that don’t normally “get cheap.”  With that frenzy behind us, and stock prices less pessimistic, our search for values yields fewer opportunities, but we did find some last quarter.  This article highlights the prominent actions we’ve recently taken.


SOLD DISCOVERY COMMUNICATIONS to PURCHASE INTEL and TWITTER

We broadly sold Discovery Communications (DISCA) from portfolios during the third quarter to fund two new positions, Intel Corp (INTC) and Twitter (TWTR).  

Intel:  For Buttonwood’s Balanced and Diversified objectives, proceeds from sales of Discovery were generally invested into Intel (INTC), a leading provider of semiconductors, computer memory, and storage.  

A surge in demand for Intel’s products is expected to lead to a record year for revenues and profits in 2020, yet shares are deeply out of favor among investors because of the company’s difficulties ramping up its next-generation manufacturing process.  To stay competitive in the interim, Intel is enhancing its chips using existing manufacturing techniques.  Longer-term, the company is considering outsourcing at least some production, a strategy which has been very successful for competitors.    

As Intel works to regain its footing, we like the fact that the semiconductor industry is benefitting from a long tailwind of growth, stemming from the explosion in connected devices and software.  Meanwhile, high plant costs and technological barriers to chip design and production present sizable barriers for new competitors, helping incumbents maintain a tight balance between supply and demand.

At a time when technology stocks have been generally leading the market, Intel’s shares stand out as a potential bargain priced at just 10 times trailing earnings versus an average of 26 for the S&P 500 Technology sector.  

Twitter:  Whereas we see Intel as a more of a traditional value investment in that it is a low-priced, out-of-favor business with the ability to generate extra return if investors become less pessimistic about future prospects, by contrast, we view Twitter as a value in a different way: a unique company trading at a seemingly fair price, yet with an underappreciated opportunity to improve operating results.  We used proceeds from Discovery Communications to purchase Twitter for accounts in Buttonwood’s Moderate and Growth objectives.

Twitter is a growing social network with 186 million daily active users.  The platform serves as a critical venue whereby:

  •    News about current events is often first “broken”
  •    Brands and products are promoted
  •    Politicians, celebrities, entertainers, professional athletes, and thought leaders build followers 
  •    Research is conducted and distributed
  •    Like-minded communities interested in far-reaching topics engage in conversation and debate 

Twitter’s popularity has been increasing lately.  User growth jumped in 2020 to a mid-30s percentage rate, up from low single digit to mid-teens growth in recent years, spurred by increased online usage in the midst of COVID-related shelter-in-place requirements. With its critical mass of users, Twitter now enjoys a network effect of users and content providers that we believe would make it hard for a competitor to displace.  

Although Twitter has grown considerably since becoming a public company in 2013, many would say that it has underperformed its potential.  Twitter’s platform, for example, generates less than half the amount of revenue per user as rival Facebook, despite Twitter serving a demographic that is believed to be more affluent on average.  This is, in part, due to the company’s lackluster ad serving software that, by Twitter’s own admission, was sub-par, ad-hoc, and feature-limited.  Critics also point out that the company’s strategy and execution have been hampered by CEO Jack Dorsey’s decision to serve concurrently as the CEO of another public company, Square (in which he has a much larger ownership stake).  Today, Twitter’s share price remains barely above where it went public a full seven years ago.

In an effort to shake up company performance, two prominent, tech-focused activist investors acquired stakes in Twitter earlier this year, and both have gained representation on the company’s board of directors. Better execution on strategy and growth finally appear possible.  We point to two areas as early indicators of progress and potential.

First, the company instituted a complete overhaul of its ad server platform and is already delivering benefits.   

Second, the company announced that it is actively exploring new subscription-based products that are in addition to the company’s core advertising model.  Speculation is that subscription products could be geared towards Twitters’ power users, either adding desired features for a fee, or charging ongoing fees for those users with large audiences that generate enormous value from the platform, yet who pay nothing.  We believe that, even using modest assumptions for uptake and cost, the effect on the current cash flow could be material if the company can execute successfully.  At the time of our initial purchases, Twitter traded at roughly 25 times adjusted cash flow.  

BOUGHT ASPEN TECHNOLOGY

We added a new technology stock to portfolios in the quarter.  Aspen Technology (AZPN) provides automation software to manufacturing companies, mainly in industries including energy, refining, chemicals, engineering, and construction, and to a lesser extent pharmaceuticals, wood and pulp, and food.  Aspen’s software helps manufacturers design their facilities, optimize production, and limit expensive downtime by predicting points of failure before they occur.   

Aspen’s manufacturing customers tend to operate low-margin, high-volume facilities that run constantly.  Small increases in production usually flow directly to the bottom line, and help improve returns on costly capital investments.  Conversely, production breakdowns can be very costly.  

The risk of switching vendors, combined with benefits that often far exceed cost of Aspen’s services, has translated into very high levels of customer retention for Aspen.  Over time, the company has grown steadily and predictably from increases in overall economic activity, annual price adjustments to its services, and expansion into new industries. 

At our purchase price, Aspen traded at a mid-to high-20’s multiple to profits, a slight discount to the stock’s five-year average, and a level we view as largely reflective of the company’s strengths.  

While Aspen is the kind of company we hope to hold onto for a long time, as a mid-sized provider of industrial-focused software, we also see it as a potentially attractive acquisition candidate for a larger industrial business.  Industrial conglomerates have lately been expanding software offerings because they generally enjoy higher profit margins and far more stable revenues than the industrial sector overall.  The long-running trend towards industrial automation, Aspen’s bread-and-butter, further adds to the company’s appeal.

REDUCED APPLE

On July 30, Apple (AAPL) announced a 4-for-1 stock split.  Within a month, in the absence of essentially any other notable news, the stock rose an astounding 44% before giving back some of the gains.  

For context, Apple’s earnings-per-share have increased by a little more than 40% over the past three years while its stock has tripled.  In effect, investors have become disproportionately more enthusiastic about the company, driving the earnings-per-share multiple to over 30, a substantial premium to historical levels.  Much of the enthusiasm stems from Apple’s introduction of new 5G mobile phones, expectations for continued progress developing subscription-based revenue streams, as well as brimming investor recognition of the strength of Apple’s ecosystem.  

We agree that Apple is one of the world’s great companies, but view the recent, rapid price increase far in excess of any fundamental operating gains as warranting a reduction in your position sizes, so we trimmed the shares you own on what we see as heightened market enthusiasm.  

SOLD WABTEC

Wabtec (WAB) provides equipment and services for rail transport.  The position was not purchased directly for client accounts; rather, it was a spin-off of GE in early 2019 as part of a merger between the two companies.  

It is not uncommon for spin-offs to fall in price at the outset of trading as investors look to eliminate the newly received, and often undersized, positions, regardless of investment merit.  While we viewed Wabtec as a decent business with the potential to eventually report better operating results, we didn’t see it as an investment worth adding to.  After GE’s spinoff, we held onto positions, which were admittedly tiny, in hopes of enjoying a rebound after an anticipated period of non-economic selling pressure.  

A year and a half afterwards however, no rebound in operating results or share price materialized.  In the interest of consolidating the number of portfolio holdings, we exited shares of Wabtec in the third quarter. 

Thank you for trusting us to search for values.