2023-11-01 11:30:00 ET
Summary
- Silver Beech is a value-oriented, fundamentals-driven investment firm that targets high-quality but misunderstood North American businesses and special situations.
- Silver Beech Capital has outperformed the S&P 500 and Russell 2000 with a year-to-date return of 12.7%.
- The fund focuses on durable businesses with low multiples of normalized free cash flow and prioritizes its best ideas in the portfolio.
- The fund believes that U.S. equities markets are overvalued but sees its portfolio as undervalued, particularly in the case of Dentalcorp, Fidelity National Financial, and Citigroup.
Dear Fellow Investors and Friends,
The estimated year-to-date 2023 and historical net performance for Silver Beech Capital, LP (“the Fund” or “Silver Beech”) is presented below. Monthly and quarterly results can be found on page 9.
Performance Summary:
Silver Beech | S&P 500 ( SPY ) | Russell 2000 ( IWM ) | |
2021 | 32.6% | 28.7% | 14.8% |
2022 | 6.9% | (18.1%) | (20.4%) |
2023 YTD (9/30) | 12.7% | 10.7% | (0.9%) |
January 1, 2021 – September 30, 2023 | |||
Compound Annual Return | 18.8% | 5.8% | (3.6%) |
Value of $100 Invested | $160 | $117 | $91 |
Performance Comparison: Value of $100 Invested at Inception
Returns presented above for Silver Beech are net of 1% management fee and 20% incentive fee above a 6% hard hurdle as of September 30, 2023, and since inception (January 11, 2023). Actual performance will vary depending on the timing of contribution(s) and fees. Returns for the S&P 500 and Russell 2000 are total returns and include dividend reinvestment. YTD returns begin January 11 to match Silver Beech’s inception. Please see additional disclosure. |
Silver Beech returned 12.7% year-to-date net of fees, in comparison to the S&P 500’s year-to-date returns of 10.7%, and the Russell 2000’s year-to-date returns of -0.9%. We are pleased with this outperformance but remain laser-focused on delivering long-term outperformance by diligently executing on our investment process.
We search for durable businesses that trade at unusually low multiples of normalized free cash flow. When we do find them, we aim to act decisively and arrive at a dispassionate investment judgment.
Our best ideas have the largest concentration in the portfolio. While the portfolio has constraints that prevent excess exposure to any single sector and other correlated risks, we believe that excellent risk adjusted returns and outperformance requires prioritizing our best ideas. In addition, our investment approach is well-suited for uncertain times because we invest with a margin of safety. We would like to spend a minute addressing just how uncertain today’s environment is.
In the American economy, as of the writing of this letter, the U.S. 10 Year Treasury is at high levels not seen since 2007 and 2001. This has enormous relevance for asset pricing, and in our view, U.S. equities prices do not broadly reflect the impact of higher risk-free rates.
There has been tremendous equity valuation dispersion this year. Valuations of the Russell 2000’s smaller-capitalization companies have recently fared much worse than the S&P 500’s large capitalization companies. Since the end of the first quarter through today, the S&P 500 has risen +2% whereas the Russell 2000 has declined –6%, and 10-Year Treasury rates have increased ~140 basis points from 3.5% to 4.9%. This is not a commentary on what an appropriate equities valuation might be today: we just observe that the simplistic mathematical impact of higher interest rates on valuations would have predicted both large and small-cap valuations decline somewhat proportionally presuming minimal divergence in cross-capitalization fundamentals.
Higher risk-free rates have also informed our recent investment thesis that market participants are undervaluing “float”-oriented business models, where cash is received at the beginning of a transaction and distributed later. Automobile insurance is a common example of such a business model: premiums are collected upfront and paid in the form of claims later. Float has become significantly more valuable as risk-free rates have risen, so the prospects of companies with float-oriented business models have also improved.
Against this economic uncertainty and growing global instability, we believe our portfolio of durable businesses will execute at a high level. In addition, while we think U.S. equities markets are overvalued, we believe Silver Beech’s portfolio is undervalued. Below we share the portfolio’s high-level operating and valuation metrics compared to S&P 500 benchmarks.
Portfolio Comparison | S&P 500 | ||
Silver Beech | Cap-Weighted Equal-Weighted | ||
Price-to-Book Ratio | 1.7x | 4.1x | 2.7x |
Price-to-Earnings Ratio (GAAP 2023E) | 10.6x | 19.9x | 16.3x |
GAAP EPS Growth CAGR (2023E-2025E) | 14.2% | 10.9% | 11.0% |
After-Tax Returns-on-Capital | ~13% | ~14% | ~12% |
# Holdings | 10 | 500 | 500 |
Portfolio Update
For this quarter, we have written about our investments in Dentalcorp, Fidelity National, and Citigroup.
Dentalcorp ( DNTCF , DNTL:CA )
Dentalcorp is a small-capitalization owner/operator of dental practices in Canada. The company is Canada’s largest dental practice consolidator. By partnering with Dentalcorp, dentists monetize the value they have created in their practice, plan for retirement, and let Dentalcorp manage complexities of ownership and patient care. Since its founding in 2011, Dentalcorp has grown to over 500 practices and refined its acquisitions and operations playbook.
Dentalcorp has a 690+ acquisition pipeline that meet strict criterion: (i) larger size practices with 2+ dentists and 2+ hygienists; (ii) $2M+ of revenue and ~$500K+ of EBITDA; (iii) young average age of employed staff to ensure undisrupted patient care and relationships; (iv) strong clinical reputations; and (v), attractive location (physical location, demographic trends, facility type). Dentalcorp’s targets aren’t “fixer-uppers.” They are high-quality, profitable practices focused on patient care.
After acquiring a practice, Dentalcorp executes on its robust operations playbook to drive performance. By expanding product offerings, rationalizing fees, improving the customer experience via technology, and leveraging the broader company’s scale for equipment and labor procurement, Dentalcorp typically improves practice-level EBITDA by 10-15% after one year of ownership. The company retains dentists with 5-to-7-year service agreements. Practice-level alignment is achieved through stock- and growthbased incentives. Historically, 95% of dentists continue in their clinical role after selling to Dentalcorp.
Over 75% of Canadians see a dentist every year and (as depicted in the graph below) dental expense per capita has grown at 1.7x Canadian inflation since 1975.
Source: Canadian Institute for Health Information; Bank of Canada
Unlike U.S. counterparts that are generally reimbursed by insurers after a claim has been made, Canadian dental practices have low working capital needs as they receive cash payment at service from the patient.
We believe Dentalcorp is an attractive investment because:
- Scaled consolidator in an attractive market: Dentalcorp is the largest dental services platform in Canada but represents just 3.6% of the market. Having fine-tuned its acquisition and operations playbook, the company has a long runway of profitable acquisition opportunities. The Canadian dental market is essential, recession- and inflation-resistant, and poised to further expand as the country’s middle class grows.
- Sustainable debt load: we think the market is concerned by Dentalcorp’s higher leverage levels (4.2x net debt to run-rate EBITDA). Dentalcorp does have high leverage compared to the average public company, but it is supported by the company’s resilient cash flows. Management is aware of the market’s concern and is committed to lowering leverage via cash flow growth and cheap cash or equity-financed add-on acquisitions. 74% of Dentalcorp’s debt is fixed rate due to interest rate swaps that expire in May 2026 (when Dentalcorp’s debt is due). Dentalcorp’s higher debt levels at fixed interest rates will lead to outsized levered cash flow growth as the company grows.
- Attractive valuation: Based on prices at the end of the third quarter, Dentalcorp trades at a TEV/EBITDA of 9.3x run-rate EBITDA and 8.1x 2024E EBITDA. We think it is sufficient to value the company using EBITDA because maintenance capital expense is low and significant goodwill amortization from acquisitions distorts cash earnings. Free cash flow is reinvested into attractive add-on acquisitions that add to platform scale and further de-leverage the company. Valuations of comparables (other attractive consolidators and less scaled Canadian competitors) are greater than 12x TEV/EBITDA, implying 50%+ upside to Dentalcorp’s stock price.
Fidelity National Financial ( FNF )
Fidelity National Financial (“FNF”) is the largest title insurance agency in the United States and a leading provider of title-related real estate transaction services. FNF also owns 85% of F&G Annuities, a life insurance and annuity business.
Real estate transaction volume is tied to the interest rate cycle; therefore, title insurers are cyclical and often dismissed as bad businesses. FNF’s title profits will likely decline by over 50% in 2023, a cyclical trough, versus profits in 2021, a cyclical peak. Lumpiness in FNF’s title profits is to be expected, yet investors over-extrapolate FNF’s earnings power to the upside and downside. Since 2021, FNF’s stock peaked at ~$50 per share and troughed at ~$32 per share, a greater than 60% dispersion in equity valuation (including share repurchase accounting but excluding spin-offs).
Though volume is cyclical, real estate transactions are a constant feature of the American economy and FNF’s title profits will normalize. FNF earns the highest title margins in the industry and remained profitable this year despite the challenging operating environment. This is important because title fees are regulated at the state and local level, restricting excessive take rates, so effective expense management is essential. Fee regulation entrenches the title market’s status quo because returns on capital are good but not high enough to justify new competition. Regulators and customers are most comfortable with existing providers because they are compliant with the regulatory landscape, reliable, possess the most data, have the deepest customer relationships, and constitute a tiny fraction of spend in the value chain.
Even though FNF’s title business is a clear industry leader with the highest market share, highest margins, and highest returns, it trades for the lowest multiple among its peers. We would argue the entire title sector, not just FNF, is undervalued. Though title insurance is currently the primary driver of customers to FNF’s value-added real estate transaction services, we also think of FNF as a nascent data business that over time could monetize its data assets by becoming an independent provider of real estate transactions data.
We believe Fidelity National Financial is an attractive investment because:
- Customer value proposition & durable market structure: most real estate in the United States is debt financed and thus requires title insurance. Title insurance is a tiny fraction of the real estate transaction value chain. The title insurance sector is concentrated among three firms, resulting in disciplined expense management and rational competition. As a result, even in 2023’s cyclical trough, all three players expect profitability. FNF is the largest provider in a concentrated market, with the strongest margins and returns.
- FNF’s cash flows are less cyclical after 2020 acquisition of life insurer: cyclical weakness in FNF’s title insurance business from high interest rates are somewhat offset by cyclical strength in FNF’s 85% ownership of F&G Annuities (NYSE: “FG”), a life insurance and annuity business. FNF acquired F&G in 2020 and completed a public spin-off of a minority stake in November 2022. Though looking through F&G’s spin-off impact on FNF is not complex, we think the market is overlooking the fundamental strength and value of F&G today due to noisy financial statements. On a combined basis, FNF’s cash flow profile is significantly less cyclical than a pure play title insurer. Steadier cash flows will enable FNF’s management to allocate capital effectively between its complementary segments.
- Alignment & strong capital allocation track record: FNF’s management owns more than $450M of stock. The company is led by William Foley, a talented owner/operator who has led FNF since 1984. Foley is an excellent capital allocator: as an example, consider that Black Knight Financial (just acquired by Intercontinental Exchange) and Fidelity Information Serviecs (NYSE: “FIS”) were both spun out of FNF. Over the last 18 months, FNF also spun-out a minority stake in F&G, and opportunistically repurchased shares of stock, taking advantage of the market’s mispricing.
- Attractive valuation: assuming market value for F&G, which we believe is too low given a trading discount for a low-float minority stake, FNF’s title segment trades at an implied 14% normalized free cash flow yield. On a combined basis, FNF trades at a P/E of ~8x 2024E EPS. We think FNF’s intrinsic value is greater than 40% above the current stock price.
Citigroup ( C )
Citigroup (“Citi”) is a large-capitalization global diversified financial services holding company that primarily serves multinational institutional and high net worth consumer clients. Citi is one of three large American banks to be designated in “bucket 3 or 4” of the “global systemically important bank” (“G-SIB”) framework by The Basel Committee on Banking Supervision. The other banks in this group are J.P. Morgan and Bank of America.
As a G-SIB, Citi is subjected to increased regulatory supervision by global bank regulators and central banks. Enhanced regulatory supervision was an important post-crisis reform to strengthen the global financial system by increasing bank capital ratios, transparency, and decreasing risk-taking. These reforms resulted in the largest G-SIBs moving away from risk-oriented banking activities such as advisory, high-yield lending, and trading, towards lower-risk activities. Indeed, Citi’s most valuable, high-growth segment, Treasury and Trade Solutions, is in lower-risk and entrenched activities such as liquidity and cash management, payments, trade solutions, and automated receivables processing. In our view, somewhat unintuitively, Citi’s increased regulatory supervision contributes to the company’s less risky banking business model, and thus its attractiveness as a downside-oriented investment opportunity.
Citi’s market perception suffers from the bank’s negative historical reputation. In 2008 during the Great Financial Crisis, Citi received the most TARP funding (the largest “bailout”) of the U.S. banks. TARP funding was provided by the U.S. government to forestall a liquidity problem that threatened to become a solvency problem. More recently, Citi mistakenly used its own capital to pay lenders when acting as Revlon’s loan agent, resulting in a $400M fine by the Federal Reserve and orders to resolve internal controls (which Citi fulfilled). Citi’s large global consumer bank was assembled by prior management in the early 2000s to attract and service high-end global consumers. Unfortunately, this pivot was costly and ill-timed in the context of increasingly complex multi-jurisdictional regulation to prevent money laundering and tax evasion. The global consumer bank has been a drag on Citi’s overall performance.
We believe the market dislikes Citi for these historical reasons and because Citi earns lower returns on equity (“ROE”) than its peers. In 2023, Citi has so far earned an ROE of ~7%, compared with peers that earn 10%+ ROEs. Recognizing that Citi is less valuable than its peers because it is a lower performance bank, we would argue that Citi’s valuation is still far too low. We believe the market is over-discounting Citi at its current valuation of ~0.48x tangible book value (“TBV”).
In our view, today Citi is:
- Less risky than it ever has been.
- Cheaper than it has ever been, even when we burden our estimate of intrinsic value to account for the bank’s lower returns on equity.
Citi’s CET1 ratio, a risk-sensitive measure of capital adequacy, increased from 10.6% to 13.5% over the past ten years. Citi’s increased capital adequacy underscores the regulatory transformation that has resulted in large G-SIB banks being less risky. While increased capital adequacy does burden a bank’s ROE, Citi is more resilient today than any other point in recent history. At the end of the third quarter, Citi’s balance sheet had $2.4T of assets, including $649B of loans (net of loss reserves), compared to $166B of tangible common equity (“TCE”).
In the following downside scenarios, Citi’s current market capitalization compares favorably to adjusted TCE. Also, this math does not include offsets for Citi’s earnings power over a prolonged period where losses would occur, nor the tax efficiency of those losses, making these comparisons even more conservative:
- If the Federal Reserve’s “severely adverse scenario” (the “Fed Stress Test”) materialized, Citi’s loans would see 5.9% loss rates, resulting in $39B of credit losses. Therefore, Citi’s TCE would shrink to $145B versus today’s $80B market cap, resulting in an adjusted ~0.56x TBV valuation.
- If we assume 2x the credit losses that Citi predicted during peak COVID fear, when the global economy stopped, locked down, and unemployment skyrocketed, Citi’s loan book would see 7.9% loss rates, resulting in $53B of credit losses. Therefore, Citi’s TCE would shrink to $131B versus today’s $80B market cap, resulting in an adjusted ~0.61x TBV valuation.
In the below table, we show that Citi’s G-SIB peers are valued at more than 2x Citi’s valuation though they do not feature operating performance commensurate with such a large dispersion.
Operating Performance (5-Year Average) | Citigroup (“C”)
| Bank of America ("BAC") | Delta (BAC minus C) |
Return on Equity | 9% | 10% | 1% |
Return on TCE | 11% | 14% | 4% |
Capital Adequacy | |||
Reported CET 1 (Q3 2023) | 13.5% | 11.9% | -1.6% |
CET 1 (2023 Fed Stress Test) [1] | 9.1% | 9.3% | 0.2% |
Valuation (9/30/2023) | |||
Stock Price / Common Equity | 0.42x | 0.87x | 2.1x |
Stock Price / TCE | 0.48x | 1.20x | 2.5x |
Citi is cheap on an absolute basis and compared to peers. Citi has large margin of safety and earnings power to absorb unforeseen loan losses (even if substantial). The bank is protected from typical bank risks such as bank runs given its G-SIB status and the structure of its deposits. At the end of the third quarter, Citi’s P/E was ~6.8x 2023E earnings. We believe Citi’s shares are significantly undervalued. In our base case underwriting, Citi’s shares are worth more than $68 (~0.8x tangible book value).
We also note that Citi is in the middle of a corporate transformation which could provide additional upside in excess of our base case underwriting assumption. Management’s promised transformation includes simplifying and shrinking the company, divesting the global consumer bank, and investing in higher growth business activities with premium ROEs. If the corporate transformation is achieved, Citi would deserve a higher valuation more in line with its peers. In an “upside case,” we estimate Citi is worth more than $85 per share, or double the company’s share price at the end of the third quarter. Management’s transformation would also free up substantial regulatory capital, enabling accelerated capital returns to shareholders through share repurchases at today’s accretive stock prices.
Conclusion
We welcome new Investors that have committed to joining the investment partnership and thank you for the trust that you have placed in us. We also greatly appreciate your referrals and capital introductions. We look forward to providing you with the next update in the fourth quarter of 2023, and please do not hesitate to contact us in the meantime.
Sincerely,
James Hollierk, Partner & Portfolio Manager | James Kovacs, Partner
Silver Beech Capital, LP
Footnotes
[1] Projected minimum CET 1 capital ratio under the Federal Reserve's severely adverse scenario.
Silver Beech Capital, LP – Fund Summary as of September 30 th , 2023
Important DisclosuresSilver Beech Capital Management, LLC (“Silver Beech”) is a New York limited liability company that serves as the investment manager to Silver Beech Capital, LP (the “Fund”), a Delaware limited partnership. The principals of Silver Beech are James Hollier, who serves as the portfolio manager and managing partner of the Fund, and James Kovacs, who serves as the managing partner of the Fund. All performance results presented herein refers to the performance of an unrestricted investor in the Fund since its inception. Net performance is presented net of the highest performance allocation in effect at the time (20%) above a 6% hurdle rate, the highest actual management fees (1.0%) charged at the time, and net of other expenses, and includes the reinvestment of all dividends, interest, and capital gains. Performance for investors who subscribed on different dates, or who pay different fees would necessarily be different from the performance presented herein. The rate of return is calculated on a “time weighted” rate of return basis, which minimizes the effect of cash flows on the investment performance of the Fund. All monthly performance data presented herein reflects unaudited data, unless otherwise specified, and as such its accuracy cannot be guaranteed. Past performance is not necessarily indicative of future results. All securities transactions involve substantial risk of loss. The material presented is compiled from sources thought to be reliable, including in certain instances, from outside sources, but accuracy and completeness cannot be guaranteed. Any opinions expressed herein reflect the judgment of Silver Beech and are subject to change. The information in this letter is for discussion purposes only. Nothing contained herein should be construed as an offer to sell, or a solicitation of an offer to buy or sell any security or investment strategy or a recommendation as to the advisability of investing in, purchasing or selling any security or investment strategy, which may only be made in the Fund’s confidential offering memorandum and operative documents (collectively, the “Offering Documents”). Before making an investment decision with respect to the Fund, prospective investors are advised to read the Offering Documents carefully, which contain important information, including a description of the Fund’s risks, investment program, fees, expenses, redemption and withdrawal limitations, standard of care and exculpation, etc. Prospective investors should also consult with their tax and financial advisors as well as legal counsel. The Offering Documents are the sole documents on which a potential investor is entitled to rely in evaluating an investment in the Fund. The information in this letter does not take into account the particular investment objectives, restrictions, or financial, legal or tax situation of any specific prospective investor, and an investment in the Fund may not be suitable for many prospective investors. This letter is not intended to be, nor should it be construed or used as, investment, tax or legal advice. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. |
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
For further details see:
Silver Beech Capital Q3 2023 Investor Letter