Hazelton Capital Partners commentary for the first quarter ended April 30, 2020, discussing their current portfolio holdings Renewable Energy Group, Apple and Berkshire Hathaway.
Hazelton Capital Partners, LLC (the “Fund”) returned -23.8% from January 1, 2020 through March 31, 2020. By comparison, the S&P 500 returned -19.4% during the same quarter.
Before reviewing the 1st quarter of 2020 and Hazelton Capital Partners’ portfolio, my sincere hope is that everyone, their family, friends, and communities are healthy – that the societal sacrifices made to both shelter and social distance from one another will, in the long-run, bring us closer together as we work to recover and rebuild from the ravages of Covid-19.
The Quarter in Review
Hazelton Capital Partners ended the 1st quarter with a portfolio of 17 equity positions and a cash level equivalent to 12.5% of assets under management. The top five portfolio holdings, which are equal to roughly 50% of the Fund’s net assets, are: Micron Technology (MU), Renewable Energy Group (REGI), Apple Inc (AAPL), Mylan N.V. (MYL) and Berkshire Hathaway Inc. (BRK-B).
“Toto, I have a Feeling We’re Not in Kansas Anymore.”
It is incredibly difficult to encapsulate the disruption, destruction, and despair that Covid-19 created during the 1st quarter of 2020, but if I were to try and distill it down into one word it would be unprecedented. Unprecedented, the speed at which the Coronavirus spread throughout the world. Unprecedented, the number of people impacted. Unprecedented, the shutdown of the global economy. Unprecedented, the vast number of people immediately unemployed. Unprecedented, the speed of the market sell-off and the amount of money spent by the Federal Reserve and the US Government to prevent an economic depression. Because the global economy has been put into an economic coma with only segments recently restarting, the full impact of Covid-19’s aftermath has yet to be fully experienced. Shutting down the US economy is not like pausing a movie, you cannot just press the play button and pick up where you left off. It is estimated that it will take over 6 months for the global logistics and supply chains to return to their “new normal” operations. It is important to keep in mind that the “new normal” will mostly depend on future demand and that remains uncertain at best. With small businesses making up most of US businesses and over half the nation’s workforce, it is truly unknown how many small businesses will survive, be able to reopen and remain open over the next couple of weeks and months.
In the past, investors looked to the equity markets as a forward-looking, discount pricing machine – distilling future economic expectations into current prices. At present, there appears to be a meaningful disconnect between the growing number of unemployed Americans still waiting for the economy to reopen and the upswing in the stock market indices at the end of March. For many, the market reversal is a sanguine forecast of a quick recovery and return to corporate growth. Unfortunately, I do not share that narrative or optimism. The stock market reversal on March 23rd was not an anticipation of a swift economic recovery, but instead, a direct correlation to the announcement that the Federal Reserve would begin purchasing corporate bonds (newly issued and outstanding) and exchange-traded funds, in addition to the $4 trillion of liquidity already committed. By acting as the lender of last resort not only to the financial system but to corporate America as well, the fed has all but guaranteed a sizeable portion of the $10 trillion corporate bond market, at least in the short-run. This has allowed corporations like Boeing, the airlines, and the cruise ship operators to tap the debt market to raise capital. Before the Fed’s announcement, the market was fearful that the debt market would “freeze up,” and businesses would be unable to fund their day-to-day needs. For now, the Federal Reserve has backstopped the US corporate bond market, which, in turn, has provided an overflow of liquidity into the equity market. With companies pulling their earnings guidance for the remainder of 2020, the Federal Reserve’s liquidity is the only catalyst at work and can, in the short to immediate run, lift the stock market much faster and more significantly than the promise of improved corporate earnings.
Throughout the 1st quarter sell-off, Hazelton Capital Partners’ portfolio, on aggregate, performed better than the overall market. However, in late March, when the indices rebounded off their quarterly lows, the Fund’s portfolio failed to keep pace with the rapid upswing. The market began to coalesce around specific companies and investing themes that are expected to be less impacted by the economic shutdown in the short run. Most of these companies were deemed either essential businesses or benefitted from their digital footprint. The rest of the stocks were tossed to the side, some, like the airlines, rightfully so. For the patient, long-term investor in search of a business with a strong balance sheet, generating healthy cash flows, and a management team skilled at allocating that cash flow, then the recent turmoil has created a fertile hunting ground, and an opportunity for the partners of Hazelton Capital Partners to add to their capital accounts.
In all the years that Hazelton Capital Partners has operated, the Fund has never recommended or suggested to its partners to add more cash to their account. I want to be clear: I am not suggesting that the market has bottomed or that it will be smooth sailing from this point forward. Throughout April, the Fund has been increasing its cash position by scaling down some of its holdings. For those partners who have the cash to invest (not needed to meet yearly expenses) and a long-term investing horizon, then the current, ongoing market disruption provides a distinctive investing opportunity. You can be assured that Hazelton Capital Partners will not deploy any of its cash until a strong compelling investment presents itself. Covid-19 has laid ruin to the global economy, shutting down nearly 2/3rds of businesses worldwide. There will be numerous companies, ranging from small enterprises to large corporations, that will not survive and still others that will remain weak, unable to stand without government support.
Then there are those companies that will emerge from this tragedy in a much stronger condition: leaner, focused, and more profitable. They will have adapted to embrace the changes in their workplace, their supply chains, and the future needs of their customers and how they transact business. Covid-19 has forever changed the way businesses operate, but some of those changes will create opportunities.
Alaska Airlines (ALK) – Closed Position – 26.8% Loss
Hazelton Capital Partners exited its position in Alaska Airlines in late February and March of 2020. The Fund originally established its position in the summer and fall of 2018. At the time,
Alaska Airlines had completed its $4.0 billion merger with Virgin America, creating the 5th largest domestic airline with a 6% market share and room to grow. Even though on paper Alaska and Virgin were officially one airline as of January 2018, they continue to operate as two distinct entities. It takes over 18 months for an airline to fully integrate the front-end and back- end systems, retrain ground crew, flight staff, and pilots. All that work translates into upfront short-term costs and expenses. Over time, as Alaska Airlines migrated to a single reservations, maintenance, and scheduling system, not only would the airline be able to reduce the short-term expenses but save what was estimated to be around $300 million per year. Additionally, the company was expecting to be able to leverage Virgin America’s gates, routes, and customers to both expand their footprint and loyalty program.
When Hazelton Capital Partners last reviewed our Alaska Airlines investment in mid Q4 of 2019, the company and its management were executing in line with our expectations with a tailwind from a robust economy. By February, concerns over international flying started to weigh on the larger domestic carriers and by mid-March, with states shutting down to protect against Covid-19, the entire industry had been forever changed. Selling out of Alaska Airlines was not an exceedingly difficult or emotional decision to make. The Fund’s original investment thesis and vision of how the industry would operate in the future was no longer valid. Even today, it is not at all clear what air travel is going to look like when passengers begin to fly again. What is certain is that not only will it take years for the airline industry to recover and learn to be profitable, but the US Government just cut in front of the shareholders in the lunch line as they will need to be repaid before shareholders benefit from the company’s earnings. Where Hazelton Capital Partners made a mistake was not recognizing how quickly the airline industry and its stocks were deteriorating in relation to the rest of the market and not being aggressive enough to exit the position quickly instead of over a few days.
Renewable Energy Group (REGI) – Current Holding
Renewable Energy Group remains Hazelton Capital Partners 2nd largest holding. In late December 2019, the US Congress, after a 2-year delay, retroactively passed the BTC (Biodiesel Tax Credit) for 2018 and 2019. In addition, they extended the $1/gallon tax credit through 2022 removing the opaque operating environment that REGI, its feedstock providers, and biodiesel blenders had been operating in for the past two years. After the reinstatement of the BTC, Renewable Energy Group announced that it would be receiving approximately $500 million from the BTC for fiscal 2018 & 2019. At the time of the announcement, REGI’s market capitalization was $660 million with $170 million of net debt (the net of cash and total debt including capital leases). As of December 31, 2019, REGI’s market capitalization improved to $1.05 billion with $330 million of net cash on the balance sheet (adjusting for the $500 million cash infusion from the BTC). By late February, Renewable Energy Group was hitting all-time highs as the company’s robust balance sheet provided the financial stability to expand its renewable diesel operations at its Geismar refinery and explore future opportunities.
I have often referred to REGI as a soap opera stock, as the company always seems to be caught up in a melodramatic headwind hiding its true earnings power. Over the past couple of years, those dramas have stemmed from the lack of clarity surrounding the BTC, and whether the EPA would actively support its mandate to protect the environment instead of being influenced by big oil and its lobbyists. Just as both headwinds were subsiding, the Coronavirus hit, shutting down the global economy. At the same time this was happening, Russia decided to break ranks with OPEC, refusing to limit production, adding to an already oversupplied oil environment.
With the Coronavirus shutting down 2/3 of the US economy, the long-haul segment of the trucking industry has been playing a pivotal role in getting critical goods & essentials, including food, consumer products, and medical supplies across the country and to their destinations.
The surge in long-haul freight demand is being driven by e-commerce, grocery stores, and retailers like Walmart, Target, Home Depot, and Costco, all trying to keep their shelves stocked. But this does not tell the entire story. Local trucking/distribution servicing businesses impacted by the stay-at-home restrictions have seen their business decline and, in some cases, come to a complete halt. Up until the beginning of April, diesel fuel had seen only a slight decline in demand on a year-over-year and month-to-month comparison. Gasoline, whose supply is 2.25x greater than diesel, has already felt the demand destruction as daily drivers sheltered in place, and limited automobile travel reduces demand by up to 50%. In the short run, global demand for oil is expected to decline by 30%.
Despite Renewable Energy Group never having seen this type of demand destruction for oil and diesel, they are in a strong position both operationally (experience with managing feedstocks and output during disruptive cycles) and financially (robust balance sheet with a net cash position) to weather the storm. Even though bio and renewable diesel sales are correlated to petroleum diesel sales, the slowing demand for diesel has not had a demonstrative impact on REGI’s sales. As the US economy reopens and begins to recover, expectations are that diesel demand will have a steady recovery. During the first quarter sell-off, Hazelton Capital Partners repurchased shares of REGI that were sold earlier in Q1 when the company was hitting new highs. The price of the repurchase shares reflected a company with nearly 45% of its market capitalization in cash.
Apple Inc. (AAPL) – Current Holding
Being a global tech company with a supply chain and manufacturing footprint in China and retail stores throughout the world, Apple was able to see firsthand not only the impact of the Coronavirus in China but how quickly it was spreading globally. On March 13th, Apple took decisive action and closed all its global retail stores that were still open, while continuing to sell its products online. Selling products via its website is nothing new for the iPhone maker as many customers are now accustomed to buying their Apple products online and either picking them up at the store or getting them delivered. What was a surprise was the number of products that Apple either refreshed, introduced, updated, or launched, over the past two months. Since March, Apple has refreshed its iPad Pro line with a new 11” and 12.9” tablet, introduced the “Magic Keyboard” for each tablet size, updated the MacBook Air and Mac Mini, and launched the new iPhone SE 2020. The only thing that was different from past launches was the theatrical pageantry of Tim Cook and his team presenting each new product to unabashed adulation from the Apple faithful.
Of the products that were released, the iPhone SE 2020 gained the most attention. With a starting price of $400, the SE was specifically designed to be a “budget” smartphone to compete with a similar sub $400 Android phones from Motorola, Nokia, Google, and Samsung. The new iPhone has many of the key components (latest iOS features, storage, memory, and processing power) of the iPhone 11 without its high-end upgrades. There is no night mode, no ultra-wide camera, and no face ID to unlock your phone or to use with password-protected apps. Since the SE is housed in an iPhone 8’s chassis, it has a smaller form factor, a smaller screen with margins, and has the “old-fashioned” home button with a fingerprint scanner for unlocking the phone and password verification. Even Apple, with its Nostradamus-like insight into the consumer market could not have foreseen the Covid-19 pandemic, but its release of the SE could hot have arrived at a better time given the recent state of the global economy.
Smartphone growth is slowing. A mixture of higher priced phones, less meaningful innovative change between models, and a movement toward phone financing in lieu of carrier contracts has led to a longer life cycle for smartphones. When combined with market saturation, Apples once powerful growth engine has matured and is slowing and giving way to its Services and Wearables segment. Over the past 5 years, the combination of Services and Wearables has grown over 30% annualized vs. iPhone’s 7% annualized growth. In addition to having significant annual growth, both the Services and Wearables possess very healthy margins which are recurring for the Services segment.
Apple’s goal in launching the $400 SE was to convert the value-conscious, non-iPhone user while encouraging its own user base, who are currently using legacy models, to upgrade and not abandon the Apple Family. It is estimated that over 30% of iPhone users still use an iPhone 8 or older. Even though these tech “laggards” are happy with their current phones, Apple knows that their phone’s battery is decaying, causing the phone to slow down, “freeze,” and not able to hold its charge for the entire day. Without the iPhone SE 2020 and its $400 price tag, there is a good chance that Apple would lose some of its users to a competing “budget” Android device. By luring new smartphone users to the iPhone platform and keeping the legacy users in the family gives Apple ample opportunity to continue to cross-sell its services, wearables, and even its computers and tablets.
The next big anticipated launch from Apple is expected to be the iPhone 12 which will be released in different sizes and price points, some of which will likely support the budding 5G network. Historically, Apple unveils its new iPhone models in mid-September with sales starting by the end of September/early October in order to gain momentum heading into the holiday season. Apple has already announced that it is delaying the launch of its new iPhone by at least one month. In the past, the market was extremely focused on iPhone sales because that accounted for a disproportionate percentage of the revenue, profits, and long-term growth of the company. As discussed above, with the saturation of smartphone sales, the services and wearables segments are beginning to close the gap, becoming the company’s future lifeblood.
Apple’s sell-off in Q1 provided an opportunity for Hazelton Capital Partners to repurchase some of the share that were sold in Q4-’19 and Q1-’20. The Fund’s strategy has never been to focus on short-term trading, but rather to take advantage of long-term investing opportunities.
Berkshire Hathaway (BRK.A) – Current Holding
Berkshire Hathaway was added to the portfolio and our top five holdings in Q1 of 2020. Market disruption and uncertainty creates an opportunity for companies and investors that have insight, patience, and cash. Berkshire Hathaway is one of those companies and Warren Buffett is one of those investors. Unlike the 2008/2009 financial crisis, Berkshire Hathaway is not actively deploying its $125 billion cash reserve. In the past, Warren Buffett has provided both guidance and has led by example when he put Berkshire Hathaway’s money to work during market disruptions. This time appears different. Over the past two months, the company and its CEO has been uncharacteristically quiet during the recent turmoil. Which begs the question: Why?
Berkshire Hathaway is a $500 billion holding company whose subsidiaries operate in a wide range of industries including: Insurance, Utilities, Energy, Manufacturing, Transportation, Real Estate, Retail, and Finance, giving Buffett a front-row seat to the impact the Coronavirus and the subsequent economic shut-down is having on the US economy. Warren Buffett’s lack of investments, even with the impressive sell-off over the past two months, is a clear indication to many that the “Oracle of Omaha” still believes there is more pain to be felt in the near term. At the very least, given the amount of insight that Buffett has from his operating subsidiaries, he is unwilling to speculate as to when the US economy will recover.
A key difference between the 2008/2009 financial crisis and today’s Covid-19 pandemic is the Federal Reserve unprecedented actions to keep the debt markets liquid and open for business. On March 23, the Federal Reserve announced it would be using its balance sheet to broaden its bond purchases to include investment grade corporate bonds (BBB rating or better). By April 9th, the Fed went all-in on its “whatever-it-takes” commitment by expanding its corporate purchases to include “Junk” bonds – those bonds rated below BBB (Caveat: The Fed is only buying “Junk” bonds that were rated BBB or better as of March 22 and has received a downgrade since that time). The goal of the Federal Reserve it to keep the US from falling into another Great Depression by keeping its financial markets functioning as the nation waits for the “all clear” sign to return to work. The Federal Reserve’s actions have removed the need for companies to come to Berkshire Hathaway with their hat in hand and the reason why Charlie Munger, Vice-Chairman of Berkshire Hathaway reportedly said in mid-April, “The phone is not ringing off the hook” in contrast to how busy Buffett was during the previous financial crisis.
With its strong balance sheet, large cash position, and Buffett’s ability to quickly deploy capital when a favorable deal presents itself, Berkshire Hathaway represents both a conservative holding during the ongoing economic turmoil, as well as an investment in the eventual US economic recovery. With $125 billion of cash on hand, Buffett could easily spend $50-$60 billion on a single deal. In addition, Berkshire’s subsidiaries will also be looking for long-term opportunistic acquisitions to expand their foothold in their respective industries. These purchases will be much smaller in scope but will help to reinforce Berkshire Hathaway’s long- term competitive edge. Of course, at the moment, it is about being patient and waiting for the opportunities to present themselves.
Investing in Hazelton Capital Partners
Hazelton Capital Partners was created as an investment vehicle, allowing those interested in long-term exposure to the equity market to invest along-side me. With a substantial portion of my own capital in the fund, I manage Hazelton Capital Partners assets in the same manner in which I manage my own capital. The best source of introduction to potential investors has come from those that have invested or followed Hazelton Capital Partners progress over the years. Introductions are both welcome and appreciated.
If you are interested in making or increasing your contribution to Hazelton Capital Partners or just learning more about The Fund, please feel free to contact me at (312) 970-9202 or email me email@example.com. Questions, comments and concerns are always welcome.
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