FA Alpha Daily

This fund has all its eggs in one basket, and it seems to be working

When investing, we are often advised not to put all our eggs in one basket. Diversifying one’s investments reduces the risk exposure to any one particular asset. However, warranted by its market and industry expertise, Clifford Sosin’s CAS Investment Partners has more freedom in this regard, focusing only on select undervalued companies. In today’s FA Alpha Daily, we dive into Sosin’s investment strategy and see how CAS Investment Partners can sustain its recent outperformance.

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CAS Investment Partners has rallied heavily this year being up 88%, and this isn’t the first time the firm has seen these types of numbers. 

For context, the New York-based hedge fund was founded by Cliff Sosin who developed a unique investment philosophy during his time as the Director of UBS’s Fundamental Investment Group.

In its simplest form, Sosin found extreme value in identifying undervalued companies with solid underlying fundamentals, thereafter basing valuations on how and why the business could thrive. This type of investing disregards short-term projections and puts all of the emphasis on long-term compounding.

Sosin has exclaimed the importance of understanding all mechanisms of all investments, which is the driving force behind his preference for a concentrated portfolio. Quantity doesn’t appear to matter as Sosin understands the ins and outs of every holding.

Despite 2022, where the fund felt the impact of its 2nd largest holding tanking, CAS Investment Partners has delivered positive years since its inception in 2012. Compounded annually the fund returned 35%, with notable returns of 66% in 2013 and a record 97% in 2020.

The 2023 rebound can be attributed to Sosin’s focus on the consumer discretionary sector. The sector has climbed this year, doubling the S&P 500 with year-to-date returns of 24.51%.

Like Starboard Value, Sosin engages in activist campaigns and focuses on long-term valuation creation through restructuring and involvement in the business.

Notably, CAS Investment Partners’ largest holding is a 6.15% stake in Hilton Grand Vacations (HGV), and Carvana (CRVN) coming in at 2nd with a 6.41% stake.

CAS Investment Partners also intends to become more involved in Cardlytics (CDLX) as the fund announced a proxy battle earlier this year, in hopes of acquiring more representation in management and on the board. Cardlytics is down about 35% since Sosin’s first $34 million investment in the advertising company.

However, Cardlytics’ performance is a testament to Sosin’s philosophy of disregarding stock volatility in the short term. While performance may be concerning, Sosin appears to be more interested in evolving the company and cashing out in the future.

Today, we’ll take a look at CAS Investment Partners’ top holdings and determine if any of Sosin’s undervalued prospects present any opportunities in the years to come.

Economic productivity is massively misunderstood on Wall Street. This is reflected by the 130+ distortions in the Generally Accepted Accounting Principles (GAAP) that make as-reported results poor representations of real economic productivity.

These distortions include the poor capitalization of R&D, the use of goodwill and intangibles to inflate a company’s asset base, a poor understanding of one-off expense line items, as well as flawed acquisition accounting.

It’s no surprise that once many of these distortions are accounted for, it becomes apparent which companies are in real robust profitability and which may not be as strong of an investment.

See for yourself below.

Looking at as-reported accounting numbers, investors would see that CAS Investment Partners invests in extremely low-quality companies.

On an as-reported basis, many of the companies in the fund are notably below-average performers. The average as-reported ROA for the top holdings of the fund is -2%, which is significantly lower than the 12% U.S. corporate average.

However, once we make Uniform Accounting adjustments to accurately calculate the earning power, we can see that the average return of CAS Investment Partners’ top holdings is almost equally unprofitable as what as-reported metrics show, which is coming in at 0%.

As the distortions from as-reported accounting are removed, we can see that Hilton Grand Vacations Inc. (HGV) isn’t a 6% return business. Its Uniform ROA is 19%.

That being said, to find companies that can deliver alpha beyond the market, just finding companies where as-reported metrics misrepresent a company’s real profitability is insufficient.

To really generate alpha, any investor also needs to identify where the market is significantly undervaluing the company’s potential.

These dislocations demonstrate that most of these firms are in a different financial position than GAAP may make their books appear. But there is another crucial step in the search for alpha. Investors need to also find companies that are performing better than their valuations imply.

Valens has built a systematic process called Embedded Expectations Analysis to help investors get a sense of the future performance already baked into a company’s current stock price. Take a look

This chart shows four interesting data points:

  • The average Uniform ROA among CAS Investment Partners’ top holdings is actually 0%, which is way below the corporate average in the United States.
  • The analyst-expected Uniform ROA represents what ROA is forecasted to do over the next two years. To get the ROA value, we take consensus Wall Street estimates and convert them to the Uniform Accounting framework.
  • The market-implied Uniform ROA is what the market thinks Uniform ROA is going to be in the three years following the analyst expectations, which for most companies here are 2023, 2024, and 2025. Here, we show the sort of economic productivity a company needs to achieve to justify its current stock price.
  • The Uniform P/E is our measure of how expensive a company is relative to its Uniform earnings. For reference, the average Uniform P/E across the investing universe is roughly 20x.

Embedded Expectations Analysis of CAS Investment Partners paints a clear picture. Over the next few years, Wall Street analysts expect the companies in the fund to remain at the same levels of profitability. However, the market has expectations for these companies to exceed current valuations.

Analysts forecast the portfolio holdings on average to see Uniform ROA stay at 0% over the next two years. At current valuations, the market has higher expectations than analysts and it expects a 6% Uniform ROA for the companies in the portfolio.

For instance, Carvana Co. (CVNA) returned -21% this year. Analysts anticipate its returns to remain around the same levels of -18%. The market seems to think optimistically about the company’s future and its pricing in an increase in profitability to reach a Uniform ROA of 3%.

Despite Hilton Grand Vacations (HGV), CAS Investment Partners doesn’t appear to be investing in highly profitable companies. At first glance this could be a concerning backdrop, however, the outlook is in line with Sosin’s investment strategy.

Sosin has repeatedly discussed his desire to invest in undervalued companies, typically these will be underperformers, as evidenced in the portfolio. Furthermore, market expectations corroborate this story.

The market is pricing these companies to actually become profitable within the next five years, which is where Sosin generates returns. CAS Investments Partners have bought into these underperformers as they believe that structurally they are sound but need a little “boost” to get to positive levels. This is exactly what Sosin, and other large shareholders, are trying to achieve and the market is obviously taking this into consideration.

Hilton Grand Vacations benefited largely from the consumer discretionary boost the economy recently experienced. However, the company may face macroeconomic headwinds in the future if recessionary signals continue. An initial 6 million share acquisition in 2021 has positioned the timeshare company to be CAS Investment Partners’ largest holding to date. It’s not clear what Sosin plans for the company. The recent Diamond acquisition and the support of Hilton’s members may allow the company to remain resilient in the future. Investors may want to keep a close eye on the outcome of this situation.

Secondly, Carvana (CVNA) is another company to dive into to completely understand the drivers of Sosin’s portfolio. This used car retailer is expected to see positive ROA inflections moving forward, even in an environment where consumers may begin to cut spending on luxurious goods. Sosin has been public about the potential of Carvana, detailing the cost and inventory advantages the company has over its competitors. Being CAS Investment Partners’ second biggest holding, the fund could see profits in the future as it continues to track the company’s transformation.

It’s too soon to make an exact judgment on the position of this portfolio in the future, but it’s evident that the fund’s performance will be heavily tied to changes made in Hilton Grand Vacations and Carvana.

With concentrated portfolios, especially activist hedge funds, it is necessary to look beyond the financial statements and stock prices. Sosin, and investors alike, go beyond short-term considerations and value the business on what it could be.

This type of mindset could create opportunities unseen by the market, try it out and it could transform your portfolio.

This just goes to show the importance of valuation in the investing process. Finding a company with strong profitability and growth is only half of the process. The other, just as important part, is attaching reasonable valuations to the companies and understanding which have upside which has not been fully priced into their current prices.

To see a list of companies that have great performance and stability at attractive valuations, the Valens Conviction Long Idea List is the place to look. The conviction list is powered by the Valens database, which offers access to full Uniform Accounting metrics for thousands of companies.

Click here to get access.

Read on to see a detailed tearsheet of one of CAS Investment Partners’ largest holdings.

SUMMARY and Hilton Grand Vacations Inc. Tearsheet

As one of CAS Investment Partners’ largest individual stock holdings, we’re highlighting the Hilton Grand Vacations Inc. (HGV:USA) tearsheet today.

As the Uniform Accounting tearsheet for Hilton Grand Vacations Inc. highlights, its Uniform P/E trades at 13.4x, which is below the global corporate average of 18.4x, but around its historical average of 12.7x.

Low P/Es require low EPS growth to sustain them. In the case of Hilton Grand Vacations Inc., the company has recently shown 96% Uniform EPS growth.

Wall Street analysts provide stock and valuation recommendations that, in general, provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Hilton Grand Vacations Inc.’s Wall Street analyst-driven forecast is for EPS to shrink by 14% in 2023 and to grow by 4% in 2024.

Furthermore, the company’s return on assets was 19% in 2022, which is 3x the long-run corporate averages. Also, cash flows and cash on hand exceed its total obligations—including debt maturities and CAPEX maintenance. These signal moderate operating risk and moderate credit risk.

Lastly, Hilton Grand Vacations Inc.’s Uniform earnings growth is in line with peer averages, and below peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

This portfolio analysis highlights the same insights we share with our FA Alpha Members. To find out more, visit our website.

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