2012 Yearend Update!

The quarterly blog is a little bit later than usual as I am always willing to defer the writing of the quarterly blog in favor of spending the time required for an existing investment in the portfolio or for the analysis of a promising new investment. As a result, these blogs occasionally get delayed, particularly, as one might expect, in a year as interesting as 2012.

On a risk adjusted basis the portfolio outperformed the major market indexes for 2012, even more satisflying the portfolio has never experienced a down quarter since inception and has adequate hedging in place as uncertainty regarding the fiscal cliff, the Eurozone crisis and China’s growth potential move back into focus.

Portfolio Update

 

During the quarter, I established positions in McDonald’s Corporation and Caterpillar both at or near its 52 week low.

 McDonald’s Corporation

 

McDonald’s Corporation is now 1.83% of the overall portfolio. McDonald’s makes money in principally two ways: first, by collecting an approximate 14%+ share of its franchisees’ revenues for the use of McDonald’s brand, a business coined “Brand McDonald’s” and second, by generating operating profits from a portfolio of company-operated stores. 

McDonald’s brand royalty business is one of the greatest businesses in the world because it generates an annuity-like revenue stream which can grow without the requirement for meaningful investment of capital from the company. Because the company’s revenue share comes from more than 32,000 different stores spread around the globe, it is an inherently stable, currency-hedged, inflation-protected stream of cash flow.  

Another underlying strength is McDonald's cohesive franchisee and affiliate system, which collectively operates 80% of the chain. This structure provides the firm an annuity like stream of rent and royalties even during challenging economic times with minimal corresponding capital needs. As a result, McDonald's generates excellent free cash flow and returns on invested capital in the mid- to high teens. These results are even more impressive when considering that the firm owns 45% of the land for its restaurants (more than $5 billion in land assets), meaning that the returns are generated on a higher invested capital base than most franchised restaurant chains.

 Caterpillar Inc.

Caterpillar Inc. is now 1% of the overall portfolio and is the world's dominant maker of construction and mining equipment, as well as a leading producer of diesel and gas engines, industrial turbines (essentially jet engines that power equipment and generate electricity), and locomotives. No competitor can match the breadth of Caterpillar's product line. Cat’s goal is simple: Ensure that customers make more money using Cat equipment than using competitors' equipment. Though Cat equipment generally costs more than anyone else's, the model requires it to be the least expensive over its lifetime, factoring in purchase price, maintenance costs, operating costs, uptime, life expectancy, and resale value. Dealers are key to these economics. A machine that breaks down can halt an entire job, and getting back under way in two hours rather than 48 hours means big money. Large, successful dealers that carry lots of parts, maintain skilled technicians, and move fast are thus a major selling point, and Cat's dealer network is the undisputed best in the business. Big, strong dealers help Cat sell the most machines; all those machines in the field bring dealers lots of revenue from parts and service, so much that they can survive in years when they don't sell any new machines at all; and that financial stability enables dealers to grow bigger, attracting even more customers, and build a larger base of machines that need to be serviced.

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Equities, while volatile, have marched higher over the past three-year recovery. Bonds, on the other hand, are almost pricing in a recession with 10-year yields at 1.73% in the US and 1.80% in Canada. Fed buying, deleveraging and a lack of investor confidence continue to put downward pressure on yields. While this disconnect between equities and bonds can be resolved in either of two ways, we believe there is greater risk owning bonds at these yields. From an asset allocation perspective, I am maintaining a significant underweight in bonds.

 

I decided to reduce my Canadian equity exposure in 2012 to source the cash. The European recession, slowdown in China and softness in many other emerging markets does not stack up well for commodity-focused markets like ours. Easy monetary policy has kept commodity prices elevated, but this does not substitute for real end-demand growth.