SBNY - Akre Focus Fund First Quarter 2023 Commentary

2023-04-19 12:00:00 ET

Summary

• The Akre Focus Fund invests in a small number of what we believe to be extraordinary businesses that are run by talented and honest managers who wisely reinvest free cash flow.
• Aftershocks from the sudden collapse and seizure of the Silicon Valley Bank, Signature Bank and Credit Swiss may topple more banks.
• The recent bank crisis demonstrates the profound difference between underlying investment quality and duration-driven price reductions.

Summary

• Aftershocks from the sudden collapse and seizure of the Silicon Valley Bank, Signature Bank and Credit Swiss may topple more banks and the widespread deposit flight that ensued is apt to slow economic growth via reduced bank lending. This may help the Federal Reserve’s fight against inflation, but at the expense of heightened recession risk.

• Unlike 2008-2009 banking crisis fueled by dubious quality residential mortgage loans, in the recent bank crisis, the securities that prompted it were predominantly long-dated U.S. Treasury bonds of the highest credit quality. It was the long “duration” of those bonds—their far-distant maturities—that rendered these securities vulnerable to substantial losses as interest rates increased. It is “Banking 101” to avoid duration mismatches between assets and liabilities. In this context, four things that relate to the Akre Focus Fund are worth mentioning.

• First, the latest official sector allocation categorizes over 48% of the Fund’s investments as being in “Financial” businesses as of March 31, 2023, compared to just 23% at the end of 2022. This increased allocation to Financials in Q1 reflects changes in the Global Industry Classification Standard (GICS) in March. GICS changes reclassified Mastercard and Visa—two of our top holdings— from “Information Technology” to “Financials.”

• Second, the Fund’s exposure to what we consider true “Financials”—businesses primarily engaged in lending—is almost negligible. The Fund owns no banks, nor does it own heavily indebted businesses. The balance sheet strength of the Fund’s holdings is very high and their dependence on bank borrowing is commensurately low. In our view, the Fund’s “Financials” are fundamentally different and superior businesses relative to traditional, lending-oriented financials.

• Third, we have taken extra precautions with cash. Cash and equivalents stood at 5.3% of Fund assets as of March 31 and comprise mostly very short-term Treasury Bills not subject to potential commingling with bank deposits.

• Lastly, the recent bank crisis highlights important observations about quality, duration, and risk. While the bank crisis involved duration risk posed by long-term Treasury bonds, never forget that common stocks with no defined maturity date are the longest-duration securities of all. No matter how high the quality of an investment, duration alone can produce lower valuations and prices, and vice versa, over the nearer term. Quality, on the other hand, runs on a different track than duration—a marathon versus a sprint. Duration matters now. Quality takes time to matter.

• The recent bank crisis demonstrates the profound difference between underlying investment quality and duration-driven price reductions. It also highlights the importance of not allowing the immediate effects of duration to obviate the gradual benefits of quality. Quality rewards endurance. And quality—of business model, people, and reinvestment—is the ultimate focus of our investment process.

Akre Focus Fund Commentary - First Quarter 2023

Greetings from Middleburg, where Spring is in full bloom. We hope this quarter’s letter finds you well.

The Akre Focus Fund’s first quarter 2023 performance for the Institutional share class was 5.91% compared with S&P 500 ( SP500 ) Total Return at 7.50%. Performance for the trailing 12-month period ending March 31, 2023, for the Institutional share class was –7.86% compared with S&P 500 Total Return at -7.73%.

The signature events of the first quarter were the sudden collapse and seizure of Silicon Valley Bank, Signature Bank ( SBNY ), and Credit Suisse ( CS ). Aftershocks may topple more banks and, in any case, the widespread deposit flight that ensued is apt to slow economic growth via reduced bank lending. Ironically, this may help the Federal Reserve’s fight against inflation, but at the expense of heightened recession risk.

Per Mark Twain, history does not repeat but does often rhyme. That may be especially true in financial markets. The recent banking crisis is not a repeat of the 2008-2009 banking crisis, which was fueled by residential mortgage loans of dubious credit quality. In contrast, the securities that prompted this recent bank crisis were predominantly long-dated U.S. Treasury bonds and so of the very highest credit quality. Rather than credit risk, it was the long “duration” of those bonds—their far-distant maturities—that rendered these securities vulnerable to substantial losses as interest rates increased. It is “Banking 101” to avoid duration mismatches between assets and liabilities. But that mismatch is precisely what too many banks (not just the aforementioned) have orchestrated for themselves, all under the “scrutiny” of dedicated regulatory agencies. For a bank to meet its demise in this way is both ignominious and inexcusable, the equivalent of drowning in a puddle.

What does this all mean, directly and indirectly, for our Fund? Four things we think are worth mentioning.

First, note that the latest official sector allocation categorizes over 48% of the Fund’s investments as being in “Financial” businesses as of March 31, 2023. This figure compares to just 23% in “Financials” at the end of 2022. The increased allocation to Financials in Q1 simply reflects changes in the Global Industry Classification Standard (GICS) under whose authority businesses are classified by sector (e.g., Consumer Discretionary, Industrials, Health Care, etc.). Changes to GICS that took effect in March reclassified Mastercard and Visa—two of our top five holdings— from “Information Technology” to “Financials.” Such changes occur regularly. Recall that American Tower was recently reclassified by GICS from “Financials” to “Real Estate.” What matters to us is the nature and quality of the underlying business; its GICS classification is of zero importance to us. Thus, we view the seeming step-up in the Fund’s exposure to “Financials” as a notable but insignificant change.

Second, the Fund’s exposure to what we consider true “Financials”—businesses primarily engaged in lending—is almost negligible. The Fund owns no banks. Indeed, the closest thing to a lending business owned in the Fund is CarMax (according to GICS, a “Consumer Discretionary”) which generates approximately half of its earnings from auto lending. Nor does the Fund own heavily indebted businesses. The weighted-average leverage (Gross Debt/Trailing 12-month EBITDA) across the Fund’s holdings as of March 31 was 2.0x and just 1.6x excluding American Tower. The balance sheet strength of the Fund’s holdings is very high and dependence on bank borrowing is commensurately low. The Fund’s “Financials” include names like Moody’s (which rates credit risk but does not take credit risk) and private-equity powerhouses KKR and Brookfield. These businesses are intertwined with the broader banking system and face risks and opportunities associated with rising interest rates and tighter lending. However, in our view, the Fund’s “Financials” are fundamentally different and superior businesses relative to traditional, lending-oriented financials.

Third, we have taken extra precautions with cash. Cash and equivalents stood at 5.3% of Fund assets as of March 31 and is comprised mostly of “equivalents” in the form of very short-term Treasury Bills not subject to potential commingling with bank deposits.

Lastly, the recent bank crisis highlights important observations about quality, duration, and risk. And while this recent bank crisis involved duration risk posed by long-term Treasury bonds, never forget that common stocks with no defined maturity date are the longest-duration securities of all. As so clearly demonstrated in this recent banking crisis, no matter how high the quality of an investment, duration alone can produce lower valuations and lower prices, and vice versa, over the nearer term. Quality, on the other hand, runs on a different track than duration—a marathon versus a sprint. Duration matters now. Quality takes time to matter. Silicon Valley Bank would have incurred zero losses on its long-dated Treasuries had they been held to maturity—i.e. if the bank had more time. The shorter duration of the bank’s liabilities assured it did not.

The recent bank crisis demonstrates the profound difference between underlying investment quality and duration-driven price reductions. It also highlights the importance of not allowing the immediate effects of duration to obviate the gradual benefits of quality. Quality rewards endurance. And quality—of business model, people, and reinvestment—is the ultimate focus of our investment process.

The top-five positive contributors to performance during the quarter were Constellation Software ( CNSWF ), Moody’s ( MCO ), Topicus.com ( TOITF ), Visa ( V ), and Mastercard ( MA ). Nothing noteworthy to call out.

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