Platform Companies and the Capital Intensity Cycle

“Never regret thy fall, O Icarus of the fearless flight, For the greatest tragedy of them all, Is never to feel the burning light.” – Oscar Wilde

Platforms. Roll-ups. Capital Allocators in Chief. Leading into the second half of 2015, platform companies were the darlings of Wall Street. Not only did their acquisitions fill the coffers of investment banks, their equities were saturated by hedge fund investors. Their CEOs were also heralded as a new generation of model executives. The star power of this phenomenon came to shine at the 2014 Ira Sohn conference, when a brazen hedge fund manager in the throes of a banner year presented a defining thesis on Platform Value:

“Businesses managed by superior operators that execute value-enhancing acquisitions and shareholder-focused capital allocation”

The fund of course was Pershing Square, and Bill Ackman was fresh off the heels of multi-billion dollar gains on two of those very companies: Platform Specialty Products (NYSE:PAH), and Restaurant Brands (NYSE:QSR). Little did we know he was building an extremely aggressive stake to up the ante on platform acquisitions: a joint play on Actavis, with the now infamous Valeant Pharmaceuticals (NYSE:VRX).

Taken at face-value, the prescriptive is classic Buffett. Business operators that can compound growth and return on equity through strategic acquisition and focused capital allocation. With all of the focus in recent years on buybacks and record corporate profits, this seemed like the exact toolkit for a brave new market cycle. Disciples of Buffett, Steinberg, and Son were salivating at a new era of investment opportunities in these companies.

Contrarians who witnessed astounding compound returns up to this point were not particularly convinced. Over the next twelve months, fabled investor Charlie Munger (a legend who we at Novus admire) drew parallels to a similar boom phase in conglomerates: the 1960s. He spoke about the market’s neglect of accounting irregularities in conglomerate structures that render acquisitions opaque with regard to their true accretion; a classic treadmill omen. He cited a forgotten example of this in ITT Corp., a poster-boy for this phenomenon in the 1960s.

James Litinisky, the principal of JHL Capital (a fund we at Novus admire) apparently had similar thoughts to Munger. In a presentation made at Grant’s Interest Rate Observer Conference in October 2015, he laid out a presentation detailing the same parallels that Munger made about the stark parallel between Platform Companies and their predecessors, the conglomerates of the 1960s. Those companies had tremendous compounded growth until their precipitous fall in the late 1960s. Within the abbreviated presentation shown at the link above, JHL lists a subset of 24 companies which we loaded into our Alpha Platform to analyze their various traits. The companies are as follows:

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We created a synthetic equal-weighted portfolio of these holdings (one variant which rebalances quarterly, another which rebalances annually, both of which are veritably identical) in order to help unpack this phenomenon from a fundamental, industry crowding, and return on investment perspective. All return values are derived through simulation from 2010 through January 2016.

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Performance

Unsurprisingly, the performance of a portfolio invested in these companies has been amazing for the last 6 years. Leading up through July 2015, the portfolios annualized at a staggering 41.75% and 42.87%, respectively, against the 14.41% of the S&P 500. However, since then, the portfolios are down nearly a quarter compared to the SPYs which are down less than 700bps. Nevertheless, their cumulative gains still far outpace the broader market. Believers in true mean reversion may fear a continued slide for this composite:

Platform Companies with quarterly rebalance compared to annual rebalance & the S&P 500 TR USD.

Crowding & Company Fundamentals

As we alluded to earlier, hedge funds have been consistent owners of these securities, buying significant percentages of shares outstanding of the underlying companies. We capture this phenomenon with our proprietary crowding score. The snazzy gif below shows a time series shift of our crowding score for the names in the portfolio over 6 years. The last quarter (which we freeze for two seconds) shows the clustering of ownership at our most crowded quartile (bottom right) which is also correlated with negative performance:

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What is interesting is how consistent hedge fund participation has been from a concentration level: back in 2010, hedge funds represented on average 17% ownership of shares outstanding of these companies, and nearly 54,000% average ADV. Fast forward to the end of 2015, and average ownership of shares has ticked up to 18% and ADV has decreased to only 19,000%. Note, this decrease is probably a function of increased exposure to higher market capitalization names like InBev, Allergan, and Kraft. Just to give a sense, the average market capitalization of these names grew from ~$12bn in 2010 to nearly $40bn at their peak in late 2015. Perhaps more worryingly, the number of hedge fund ownership has changed from an average of 43 hedge funds participating in each of these names in 2010, to 66 in 2015 (a 50% increase).

Beyond the broader participation on these names by hedge funds, the more troubling factor may be the risk inherent in their fundamentals, which we can begin to unpack by analyzing the EV/EBITDA and Look-through leverage values across each company. Note the strong run-up into 2014 for EV/EBITDA (which was summarily cut down in October with Valeant’s most turbulent volatility).

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But the look-through leverage has been on the rise, reflecting the persistent balance sheet leverage of the companies.

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The rampup in balance sheet debt may be perilous in a less friendly high yield environment.

The market has not been kind to these types of companies in 2016.

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Top Performers / Mean Reversion

As we highlighted at the onset, this composite of names has compounded at an astounding rate, but has also begun to crack at an accelerated pace. Up to the composite’s high water mark on 07/17/2015, these are the names that had the highest return on average capital (quarterly rebalance of capital):

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After 07/17/2015, these are the names that have performed the worst:

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Note how three of those securities would have erased their entire principal deployed (>-100% ROAC) over less than 6 months had one rebalanced quarterly into these holdings!

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Capital Intensity Cycle (Conclusion)

Platform companies have witnessed astounding growth over the last several years. The influx of capital into these operators brings me to an investment principle articulated by Edward Chancellor, describing Marathon Asset Management’s investment philosophy:

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Marathon’s philosophy is probably more attributable to a business sector (e.g., North American E&P currently), but the idea is much the same.

Platform Companies may still be a viable business structure/philosophy and a continued driver of outperformance should this market cycle continue to award pro-growth appetite over fundamental fear. However, if this is indeed a replay of the 1960s and the phenomenon afflicting conglomerates, the recent declines of many of these companies may have even further to go should they mean-revert to broader market indices. We at Novus actively monitor crowding and contagion effects of various sub-sleeves of the markets for our clients, helping them understand concentration risks in their portfolios.