By Nathan Bell

Choosing the right fund manager isn’t easy. While a long-term track record of outperformance helps narrow your choices, you need to understand a manager’s investment process to judge its likelihood of future success.

Questions to ask include: 

  • Is the process repeatable, or does it rely on a specific individual, or only work in certain circumstances that aren’t likely to persist?
  • Are the manager’s returns based on luck, or skill?
  • How aggressive is the manager?
  • Does the manager speculate using leverage, or has their process stood the test of time and likely to work in the future, given enough time?

The easiest way to illustrate how to answer these questions is with a case study. What follows is the sort of opportunity we look for to diversify a portfolio with world-class businesses that aren’t available on the ASX.

Liberty Broadband

Predicting changes in macroeconomic variables with any consistency is impossible (which is why there are no economists on the Forbes 400 list), so we prefer to bet on trends that will persist regardless of the macroeconomic environment.

Along with the rapid growth in mobile usage, internet usage for entertainment in the home is another trend that’s growing quickly. According to Cisco, mobile data usage is expected to increase nearly eightfold over the next five years, as we watch more entertainment services (such as Netflix) on our mobile phones (the majority of this mobile data will be off-loaded from cellular networks to less congested Wi-Fi networks).

You’re likely familiar with the ‘FANG’ stocks benefitting from similar trends. FANG stands for Facebook, Amazon, Netflix and Alphabet (formerly Google). They currently command lofty valuations as their business models are well known, and their size allows large fund managers to invest huge amounts of money in them. Furthermore, their continued growth is an easy sell to potential investors in a world of elusive growth.

But if you’re prepared to look where others aren’t, you can find similar attractive businesses without having to pay a hefty premium. One example is Liberty Broadband.

Liberty Broadband’s only major asset is a 20% stake in Charter Communications, which recently merged with Time Warner Cable to become the second largest cable company in the US.

The new Charter Communications will boast 17m video subscribers who pay, on average, US$80 per month (this is essentially the same as paying for Foxtel here in Australia), and 19m broadband internet subscribers who pay US$48 per month.

Cord cutting

You may have read that many cable customers are switching to less expensive online, or ‘over-the-top’ entertainment options, which begs the question: why would you want to own a cable business?

Well, first, we don’t need rapid growth in Charter’s video subscribers to do well. This issue is well known and has already been priced into cable company valuations. Second, we expect Charter’s video subscribers to decline slowly, despite the rapid falls experienced by some rivals.

Our contrarian view is based on two factors. First, the biggest falls have been suffered by satellite TV providers, which have inferior technology to Charter. Charter’s video subscriptions have actually increased recently, as they have been able to keep video prices low, while bundling in faster internet packages. Satellite services don’t offer high-speed broadband connections.

Bundles of profits

The second factor is that Charter offers bundles where you receive a discount if you combine more than one service e.g. telephone, video and broadband (the ‘triple play’). Charter also hopes to offer a ‘quad play’, with an added mobile phone service, but that may require regulatory approval to do a deal with one of the major mobile carriers.

 

The benefit of bundles is that they produce much stickier revenue (or less ‘churn’ to use industry jargon) than if a customer only buys a single service, which can be easily replaced by a rival.

Though we expect video subscribers to fall slowly over time, that doesn’t worry us too much. We have confidence in Tom Rutledge’s stewardship; Charter’s chief executive who is widely regarded as the best operator in the cable industry.

Now that Charter has merged with Time Warner Cable, we expect Rutledge to take a hatchet to costs and reduce the company’s high debt levels before buying back shares. The operational improvements under a combined Charter and Time Warner Cable outfit should more than offset any video subscription losses in the medium term.

This brings us to our final point as to why we’re not overly concerned by video subscriber losses; the growth in broadband subscriptions, and the average price per customer, should provide plenty of growth in Charter’s cash flows.

This is one of the most overlooked points with cable companies. Broadband internet has none of the associated costs that video programming does, so broadband margins are significantly higher than video margins.

Assuming monthly broadband bills advance from $48 to $60, broadband subscribers increase from 19.4m to 27.1m, and we apply a multiple of 11 to pre-tax free cash flow of US$11.2bn in 2019, we estimated our returns could reach 18% per year based on our initial purchases in February.

That provides a decent margin of safety if video subscriptions fall faster than we anticipate, but our ‘Get out of Jail Free Card’ is that broadband subscriptions should increase if more people switch to over-the-top entertainment options. A case of heads we win, tails, we shouldn’t lose much.

US broadband providers enjoy monopolistic positions, so broadband usage should surge over the next five to ten years as our favourite online entertainment services become just another regular monthly bill.

And keep in mind that the cost of adding an extra broadband subscriber is minimal, so small increases in revenue can have a large impact on the bottom line. The costly part is investing in the best technology and content.

Discount on a discount

We could’ve bought Charter and done very well, but there was another way to increase our returns without assuming more risk.

Instead of Charter, we bought Liberty Broadband. Remember, Liberty’s largest asset is its stake in Charter, as it was trading at a 12% discount to the value of its interest in Charter.

Better yet, we’re invested alongside John Malone, who has made billions investing in cable around the world. 

Let’s summarise the investment merits of Liberty Broadband and how it reflects our investment process.

Liberty Broadband is a perfect example of the type of monopolistic business — run by one of the world’s greatest managers with his own money on the line — that is simply unavailable on the Australian Stock Exchange.

As value investors, we need to go against the crowd when the facts contradict widely held views. In this case, the market was myopically focused on video subscriptions and cord cutting, instead of the operational improvements from a combined Charter and Time Warner Cable led by Tom Rutledge, and the increasing cash flows from the rapidly growing broadband business.

By looking in unusual places, we also found an opportunity to own Charter at a discount by purchasing Liberty Broadband instead.

As an investor, you need to have an edge, otherwise it’s impossible to consistently beat the index. Our edge in this case includes our long-term view (i.e. we’re looking out five years rather than focusing too much on the short term), our contrarian view on video subscribers, and a full appreciation for the economics of the broadband business.

To learn more, download this quick guide or contact us.

Disclaimer

This is a sponsored article by Peters MacGregor Capital Management.

Peters MacGregor Capital Management Limited holds a financial interest in Liberty Broadband through various mandates where it acts as investment manager.

Peters MacGregor Capital Management Limited do not take into account the investment objectives, financial situation and advisory needs of any particular person, nor does the information provided constitute investment advice. Any information, material or commentary by Peters MacGregor Capital Management Limited is intended to provide general information only. Please be aware investing involves the risk of capital loss. Before acting on any advice, any person using the advice should consider its appropriateness having regard to their own or their clients’ objectives, financial situation and needs. You should obtain a Product Disclosure Statement relating to the product and consider the statement before making any decision or recommendation about whether to acquire the product. Past performance is not a reliable indicator of future performance.