Smart Money Masters — November 2017 Issue

Nicholas Vardy

Nicholas Vardy has a unique background that has proven his knack for making money in different markets around the world.

Follow in the Footsteps of Buffett’s Favorite Investor

Your Smart Money Masters portfolio had another strong month. Markets continued to look favorably on the big bets made by some of the world’s leading investors.

The standout performer of the month was Prem Watsa’s bet on BlackBerry Ltd. (BBRY). After better-than-expected financial results, the stock closed the month 21.66% higher.

Bill Ackman’s Restaurant Brands International (QSR) jumped 8.23%. Carl Icahn’s bet on PayPal Holdings Inc. (PYPL) gained 7.85%. Monish Pabrai’s well-timed bet on Fiat Chrysler Automobile N.V. (FCAU) soared 7.38%. Warren Buffett’s Berkshire Hathaway (BRK-B) jumped 6.02%.

That was its best performance in many months.

PayPal remains your Smart Money Masters portfolio’s top performer, up 61.86% since my initial recommendation. Fiat Chrysler’s gains have come even quicker, its 53.27% jump has come just since Aug. 11.

The big news this past month in your Smart Money Masters portfolio was BlackBerry’s remarkable 20%-plus gain. On Sept. 28, BlackBerry trounced analysts’ estimates, reporting an adjusted profit of $0.05 on total revenue of $249 million.

BlackBerry now has beaten analysts’ earnings per share (EPS) estimates for the last five consecutive quarters. Looking ahead, BlackBerry CEO John Chen believes the company is well positioned for further growth after it made “significant progress” on its transformation to a software company.

Starting on Oct. 16, BlackBerry Ltd. is delisting on the NASDAQ Global Select Market under the BBRY stock ticker. The stock will move to the New York Stock Exchange (NYSE) where it will trade under the stock ticker “BB.”

A Big New Bet on Energy

This month’s Smart Money Masters recommendation, Vistra Energy (VST), is a low-profile and contrarian bet on the U.S. energy sector. Vistra is also the largest position in investment leg-

end Howard Marks’ fund, Oaktree Capital LP. According to the fund’s most recent 13F filings with the Securities and Exchange Commission (SEC), Marks has invested more than 20% of his fund’s assets in this Texas-based company.

Given Marks’ bearish views on both the U.S. and global financial markets, investing in Vistra is a highly defensive bet.

Vistra has the kind of financial profile, high free cash flow and strong balance sheet that will allow the company to thrive, even in a broader market pullback. Vistra is also set to soar on

any price recovery in the energy sector. Finally, the company’s strong cash position also allows it to gobble up other distressed energy assets at fire-sale prices.

How Howard Marks Thinks About Investing

Like many of the other money masters, Howard Marks is a committed value investor and invests exclusively in out of favor stocks and sectors.

Howard Marks is also a prolific writer. Since 1990, Marks has shared his investment views with Oaktree’s clients through memos that have garnered

a devoted readership among some of the world’s leading value investors. As the website Business Insider has written: “the letters read like Michael Lewis ghostwriting for Warren Buffett: insightful, direct, homespun, expert and sharply pointed.”

It is little wonder that Warren Buffett is one of Howard Marks’ biggest followers. In fact, Buffett contacted Marks out of the blue in 2011. He told

Marks that if he writes a book, Buffett would be the first to endorse it. That’s how Mark’s 2011 book, ”The Most Important Thing: Uncommon Sense for the Thoughtful Investor,” was born.

I’ve compiled a bullet point summary of Howard Marks’ investment philosophy, as he sets it out in his writings:

  • Risk Control

Marks believes that “if we avoid the losers, the winners will take care of themselves.”

  • Consistency

Marks thinks that a superior record is best built on a high batting average rather than a mix of brilliant successes and dismal failures. His mantra? “Be a little bit better than average all of the time.”

  • Market Inefficiency

Marks invests in less efficient markets where skill and effort should pay off.

  • Specialization

Marks believes in practicing a single investment specialty — and doing it as well as you can.

  • Bottom Up Investing, Not Macro Forecasting

Marks follows an investment process that is entirely bottom-up and based upon proprietary, company-specific research. As he has written, “You don’t make money by buying good stocks. You make money by buying assets for less than they are worth.”

  • Disavowal of Market Timing
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Marks keeps his portfolios fully invested at all times. He buys attractively priced assets whenever they present themselves.

Marks Stands out as Oaktree’s Memorable Memo Man

Born in 1946, Howard Marks grew up in Queens, New York. Although he is  ethnically Jewish, his parents raised him as a Christian Scientist.

While an undergraduate at the Wharton School at the University of Pennsylvania, Marks came upon one of the guiding principles of his life in a Japanese studies course — the Buddhist concept of mujo, defined as “the turning of the wheel of the law.”

Mujo has had a profound impact on Marks’ investment philosophy. As Marks puts it: “Change is inevitable. The only constant is impermanence…. We have to accommodate to the fact that the wheel turns and the environment changes… It’s very helpful to view the world as behaving cyclically and oscillating rather than going in a straight line. Everything is cyclical.”

After Wharton, Marks earned an MBA at the University of Chicago at the ripe old age of 23.

Marks started his career as an equity research analyst for Citicorp in 1969. He eventually rose to serve as vice president and senior portfolio manager at Citicorp Investment. In 1985, he joined TCW Group in California and started one of the first distressed debt funds.


Howard Marks’ Most Famous Memo

Marks warned about the coming financial meltdown in a memo back in 2007 called “There They Go Again.”

Last July, Marks published a follow up a decade later titled “There They Go Again… Again.”

In 1995, Marks co-founded Oaktree Capital Management. The firm today manages $100 billion, including 100 of the 300 largest global pension plans, and 75 of the 100 largest U.S. pension plans.

Marks is best known for his “Oaktree memos” in which he details his investment strategies and insight into economics. Warren Buffett has remarked, “When I see memos from Howard Marks in my mail, they’re the first thing I open and read.”

Along with Buffett, a whole slew of other Smart Money Masters follow Marks’ memos. Fans of Mark’s work include Seth Klarman (Baupost Group), Joel Greenblatt (Gotham Capital), John Bogle (Vanguard) and Jeremy Grantham (Grantham Mayo).

In 2011, Marks published “The Most Important Thing: Uncommon Sense for the Thoughtful Investor.” Warren Buffett called it: “that rarity: a useful book.”

Marks is married and is a proud father. His son Andrew also works as a hedge fund manager. Marks splits his time between New York and London. 

The memo caused a firestorm in the financial press. Marks said he received more attention from that single memo than he had from any other piece he had written in 28 years.

In this latest memo, Marks recalled an iconic pre-crisis quote from then-Citigroup CEO Chuck Prince: “When the music stops, in terms of liquidity, things will be complicated. But as long as the there is a risk, but until then they have no choice but to keep investing.

“Today, I think most investors know the good times will end someday, as Prince did,” writes Marks. “But for now, they feel they, too, have no choice but to dance… in other words, there’ll be a time for caution, just not today.”

Marks emphasizes he doesn’t know precisely when a correction will happen. As he puts it: “My observations are always indicative, not predictive… an eventual increase in risk aversion — should happen, but they don’t have to happen.

And they certainly don’t have to happen soon.”

Marks continued, “It feels like we’re in the eighth inning, but I have no idea how long the game will go on.”

Oaktree’s Big Bet on Vistra Energy

Given Marks’ negative view of global financial markets, any substantial investment must have a particularly compelling story. And that story is Texas-based Vistra Energy (VST).

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According to 13F filing data, Marks acquired 1 million shares of Vistra at an average price of $16.80 per share between April and June of this year. That made Vistra the largest holding in Oaktree Capital Management LP. Today, the position accounts for 21.84% of the $3.869 billion equity portfolio.

Marks’ ownership of more than 50 million shares of Vistra — which amounts to 11.7% of its outstanding shares — is a massive vote of

confidence in the company and its management. Given his value-based investment philosophy, it also suggests that Marks believes that Vistra is significantly undervalued.

Let’s take a closer look at Vistra.

Vistra is an energy company focused on energy and power generation markets in Texas via its two subsidiaries, Luminant and TXU Energy.

Luminant generates and sells electricity from its fleet of generation facilities. These facilities produce approximately 17,000 megawatts of energy in Texas.

TXU Energy sells retail electricity and services to approximately 1.7 million residential and business customers in Texas.

There is a symbiotic relationship between the two parts of the company. Luminant’s largest customer is TXU. That ensures that TXU’s income is sticky. Vistra also can offer customers better prices through vertical integration of what otherwise would be competing companies.

Much like you have seen in several of your other Smart Money Masters holdings, such as Restaurant Brands International (QSR) and Kraft Heinz (KHC), Vistra is the product of a private equity-style restructuring of its operations.

In fact, the company recently emerged from bankruptcy. Vistra was formerly known as TXU. In 2007, it was taken private, that is delisted from the stock market following a leveraged buyout that left the company with more than $40 billion in debt.

Even Berkshire Hathaway (BRK-B) invested $2 billion in the debt. By 2013, Berkshire had lost nearly half of its investment. By 2014, plunging natural gas prices forced TXU into bankruptcy.

After the company restructured its assets and liabilities, the new Vistra emerged from the ashes of TXU last year.

The Investment Case for Vistra Energy

Let’s now look at what I think makes the company so attractive for Marks.

First, Vistra Energy has a strong balance sheet. Its debt-to-equity ratio stands at 69%. By way of comparison, peers such as NRG (NRG), Dynegy (DYN) and Calpine (CPN) have debtto-equity ratios of around 400% or more. That makes Vistra much more resilient to changes in market conditions.

Second, Vistra generates a robust free cash flow. Estimates for free cash flow stand between $745 million to $925 million for 2017. It already reached $621 million by the end of Q2. Free cash flow yield could hit 12.2% at the current highend estimates.

Finally, any recovery in energy prices will be a boon for Vistra. Electricity is around $25 per megawatt/hour in Texas. The 2017 average is expected to be about $30. A $5 per megawatt/ hour, or 16%, increase in Texas power prices would lift Vistra’s annual EBITDA by a whopping $270 million.

As one of the world’s leading experts in distressed debt, Marks has seen stories like Vistra play out profitably dozens of times before. Marks’ willingness to bet over 20% of his fund on Vistra is reason enough to ride Mark’s coat tails by investing in Vistra Energy.

So buy Vistra Energy Corp. (VST) at market today and place your stop at a wide $15.00. I have given this recommendation a risk rating of 3.

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