Click here to read Andvari’s 2017q4 letter in pdf form. Otherwise, please read on…
Instead of beginning with a summary of investment performance, I begin with even more important news. As many of you know, my wife Leann has cystic fibrosis, a rare and life-threatening genetic disease that affects the lungs and digestive system. After being in the hospital six times in 2017, Leann and I traveled to Duke University so she could be evaluated for a double lung transplant. It was an exhausting five days of tests and meeting with everyone on Duke’s transplant team. Duke later told Leann she is a good candidate for their program and Leann decided to join.
Leann’s decision means she and I will be temporarily relocating to Durham at the end of January. Depending on how well Leann does, we could be in Durham for four months or up to a year. As the Chief Investment Officer and sole employee of Andvari Associates, it is important for all clients to know that in the coming months most of my time will be spent caring for Leann—not our investment portfolios.
With that said, I have reassured clients with the following points.
First, my investment strategy is to have a limited number of securities in portfolios—20 or less—and to have the top 5 make up a significant portion of each portfolio. This makes it easier and more efficient to keep up with what we own and to consider new opportunities.
Second, I prefer to invest in securities and companies that do not require daily attention. Good companies with good management teams have higher chances of earning strong returns over a long time despite any short-term difficulties that inevitably happen. However, I do and will still review everything we own, every day, and will be prepared to act as circumstances dictate.
Third, I am invested in nearly all the same securities in which clients are invested. This is a huge incentive for me to maximize gains and minimize losses. Balancing my time between caring for Leann post-transplant and caring for clients will be a challenge, but it is one I can handle.
Finally, I will not be alone in caring for Leann. When the time comes for transplant, Leann’s parents will be with us in Durham to help. Leann’s father is Executive Director of the Georgia Chapter of the Cystic Fibrosis Foundation and his employer expects him to be there.
Please keep us in your thoughts this year.
PERFORMANCE FOR 2017
For the full year of 2017, Andvari is up 18.9% net of fees versus 21.8% for the S&P 500. Focusing on the performance of just the taxable accounts Andvari manages that have a mandate for achieving maximum total returns over the long term, these accounts were up 25.0% net of fees. Below, the table shows Andvari’s composite performance figures against three benchmarks while the chart shows the cumulative gains of a hypothetical $100 investment.
DETRACTORS FROM PERFORMANCE
Although Andvari had a sizeable lead over the S&P 500 at the end of September, performance during the last quarter of the year lagged the market by roughly 8 percentage points and caused Andvari to underperform the market for the year. Large declines in our top positions—Mesa Labs (MLAB) and Liberty Broadband (LBRDA)—are the main culprits.
Mesa’s share price declined because recent results in two of their segments were surprisingly bad. First, in their Instruments segment, Mesa had discontinued an old product and rolled out a replacement, but adoption of the new product was slower than expected. Second, the company’s Cold Chain Packaging segment struggled from lower order rates and a delayed order from a very large customer. Mesa even stated in its regulatory filing that the company might take an impairment charge on this segment. Mesa’s share price fell from $158 per share to $125 over four days.
Despite Mesa’s poor results, I’m confident the company will fix the issues facing these two segments. My trip to Mesa’s shareholder meeting in early November is the reason for my confidence. All the employees I met were nice, happy, and enthusiastic about having Gary Owens on board as their new CEO. Also, everyone confirmed the company is embarking on the creation of a continuous improvement culture. This was music to my ears, given that Gary had spent 10 years of his career at Danaher, a company that has produced amazing shareholder returns with the help of its own continuous improvement system and culture. Although it could be a few years before shareholders see benefits from Gary’s efforts, I am excited about the opportunity to unlock Mesa’s full potential.
The other negative contributor to performance was the decline in Liberty Broadband’s price. This was likely because of Charter Communications (Liberty Broadband’s largest holding) losing video subscribers in the recent quarter and the decreased likelihood that Charter might be acquired in the short-term. The mitigating factor to these short-term concerns is that Charter still has much to do in terms of integrating its acquisition of Time Warner Cable and Brighthouse. One task is the harmonization and simplification of the various packages the entire company offers to customers. Some customers will inevitably leave during this process and some customers will continue to “cut the cord” and prefer an internet-only offering rather than an offering contains video. However, even if customers continue to cut the cord in favor of the internet, the margins on broadband are much greater than video. Charter will still be able to grow operating profits at a good clip even if revenue growth is less than what the market expected.
CONTRIBUTORS TO PERFORMANCE
Sientra was one of our best performers during the year—up 65%—for two reasons. First, it acquired Miramar, a company with a promising device that reduces underarm sweat and odor and permanently reduces hair. This acquisition was a signal to the market that Sientra is serious about becoming a more diversified medical aesthetics company.
Second, Sientra continued to execute on its business plan. The company sold its remaining inventory in a controlled fashion throughout the year. At the same time, Sientra diligently prepared for FDA inspection of the production facilities of its new manufacturer. Although the FDA completed its inspection later than Sientra had wanted, the company is extremely confident the FDA will grant pre-market approval for its newly manufactured breast implants in the first quarter of 2018. If Sientra is finally able to make and sell new implants, and with several new products in the arsenals of its sales reps, 2018 could be another banner year.
Micro Focus was also a solid contributor to 2017 performance with a gain of 21% (including dividends). The company has been extremely busy as it prepared for and completed the acquisition of HPE’s software business in September. Upon completion of that transaction, Micro Focus tripled in size and has an extraordinary opportunity to double the margins on HPE’s software business. Another important result of this transaction is that Micro Focus now has shares that trade in the U.S. as American Depository Receipts—Andvari was finally able to add Micro Focus to the retirement accounts we manage.
Shares remain undervalued as many investors are still unfamiliar with Micro Focus even though it’s now the 7th largest pure-play software company in the world. Many new and potential Micro Focus shareholders may also be turned off by the company’s operating model of operating as efficiently as possible a portfolio of low growth software assets. Over the long run, sales growth will be in the low single-digits, but there will occasionally be a year or two where sales growth will be negative: Micro Focus management expects sales growth for the upcoming year to be down 2%–4%.
When an analyst asked Micro Focus management what’s gone wrong with sales growth, Executive Chairman Kevin Loosemore responded:
“The [question of] ‘What’s going wrong?’ is based on an assumption that revenue growth is a good thing in a business. It is if that’s the right thing for the business. If it’s the wrong thing for the business, chasing revenue growth is actually damaging to shareholders.”
Micro Focus, unlike most other software companies, is extraordinarily focused on their internal operations and uses continuous improvement concepts to produce great value for their customers and great returns for their shareholders. This sometimes means their best opportunity is to reduce expenses rather than waste valuable resources trying to grow an asset that is incapable of high growth. In a world where growth is the goal and natural progression, many investors have a psychologically difficult time with companies that choose to voluntarily shrink their business. As such, they will sell their shares at the first sign of “poor” guidance or will not even consider becoming a Micro Focus shareholder in the first place. Andvari, on the other hand, accepts and endorses Micro Focus’ unique strategy and we are happy to endure a journey likely to be bumpy in exchange for robust shareholder results over the long-term.
Despite not owning any of the largest and best performing companies in the S&P 500 (like Google, Facebook, or Amazon) and despite having a meaningful allocation to fixed income assets because of the IRA accounts we manage, Andvari’s net performance for 2017 of 18.9% was quite good on a relative and absolute basis. With the U.S. economy chugging along and with increasing levels of optimism, it seems like 2018 might be another good year for investment performance. However, I continue to caution that investment returns over the next 5 years are unlikely to match what we have experienced in the prior 5 years.
I am extremely thankful for the trust, understanding, and encouragement I’ve received from all clients over the years and especially as we head into 2018. I wish everyone a happy and prosperous year.
Douglas E. Ott, II
¹ “Andvari Total” represents all of Douglas Ott’s investment accounts and all the discretionary accounts Andvari manages where it takes an active role in picking individual stocks and receives a fee. From 12/31/12 to 4/12/13 results included only Ott’s personal and retirement accounts—the first Andvari clients transferred their accounts on 4/12/13. Andvari believes including Ott’s performance figures for the first 4 months of 2013 is fair as he managed those assets similarly relative to later clients. Results are net of management fees (1% per annum), time-weighted, and includes all cash and other securities. The indexes and funds are listed as benchmarks and are total return figures and assumes dividends are reinvested and net of their respective underlying fees.