Author: Patrick Larkin
Covestor model: All Cap Value
The All-Cap Value fund outperformed the S&P 500 during January’s market rally. Most of my positions participated in the upswing, with top holdings Microsoft (MSFT) and Almost Family (AFAM) leading the way. While January’s results are encouraging, it is important to keep in mind that returns to sound value strategies tend to be “lumpy.” No one really likes “lumpy” returns, but if you aim to build real wealth in the stock market, the best advice that I can give you is to learn to love them. The time that it takes the market to recognize value is unpredictable, and efforts to mitigate the angst produced by this state of affairs are generally costly and futile.
The only addition to the portfolio in January was a small position in DreamWorks Animation (DWA). I am normally skeptical of glamorous names. Yet given my entry price of $17.84, it is clear that DreamWorks had fallen out of favor with the market.
The company is facing a number of challenges, notably a declining DVD sales market and an impasse over future distribution after its current agreement with Paramount expires later this year. I see these as challenges that the company is very much up to. They have already partly addressed the issue of lost revenue from declining DVD sales by inking a $30 million per picture agreement with Netflix, and they have been laying the groundwork for self-distribution for quite some time in the event that the Paramount deal is not renewed. Self distribution involves risks but also the potential for very substantial cost savings. A good deal of the bull case for DreamWorks can be found in a write-up by Andrew August that first appeared on his blog “The Frog’s Kiss.”
DreamWorks is simultaneously becoming less risky and more profitable as licensing and other revenues from its library of completed films continue to grow larger. A careful look at the numbers provides some support for this thesis, but other explanations for the recent pattern of revenues can’t be ruled out.
One thing that can’t be denied though is that there were approximately 135 million babies born worldwide in the last year, and virtually none of them have seen Shrek I, I, III, or IV. Improvements in the 3D viewing experience are another potential driver of high margin incremental revenues.
At bottom, DreamWorks produces a great product, demand for that product should continue to rise throughout the world, and there are substantial barriers to entry. The “friendly oligopoly” nature of the animated film business is illustrated by the fact that DreamWorks has already announced the opening dates for all of its pictures through June of 2014. To paraphrase Andrew August, the author of the report referenced above, do you think that these dates are set so far ahead of time for the benefit of moviegoers who like to plan ahead or for rival studios who want to avoid direct competition around their own film’s opening windows?
Since I was almost fully invested and I only use margin to work around regulation FD requirements, I had to sell a small amount of Berkshire Hathaway (BRK-B) and The Howard Hughes Corporation (HHC) to open my DreamWorks position. This move does not reflect any deterioration in my confidence in those names: I chose to raise cash from those particular stocks because they were both large positions in the portfolio and because the tax implications were favorable.
I mostly reject the current conventional wisdom that an investment manager should hold substantial cash balances. Those who have been around long enough remember that the opposite view was once considered to be a foregone conclusion. Clearly, taking advantage of Mr. Market is the name of the game, but a manager can just as easily seize opportunities that arise when quality securities plunge in price by trading out of other fairly valued or slightly undervalued securities.
While I suspect that most managers who are hoarding cash in expectation of another broad market debacle like late 2008 to early 2009 are fighting the last war, I don’t view it as unwise for individuals to maintain whatever strategic cash cushion helps them to sleep well at night. And if the market does crash again, the individual can put that cash to work himself or give it to his manager to deploy on his behalf. But he doesn’t need his investment manager to decide how large his cushion should be in the first place.
