The other risk-preference data point worth highlighting is market breadth, and specifically the advance/decline line. This line indicates how many of the underlying stocks are participating in a market (or index) move. It is possible (and common at significant market peaks) for a market capitalization weighted index (e.g. the S&P 500) to make new highs while a majority of securities in the index are beginning to decline. When this occurs, it is a warning sign. Conversely, when a new index high is confirmed by the advance/decline line, it indicates investors are broadly willing to engage in risk taking and no particular market segment is sounding an early warning. In fact, when the S&P 500 made a new high on September 20, 2018 the advance/decline line also made a new high.

Given the weak caution from credit spreads and an “all clear” signal from the advance/decline line (among many other factors that would overcomplicate this explanation), we felt comfortable using the fourth quarter sell-off to increase our equity exposure. Fortuitously, we had raised significant cash earlier in the year when our investments in both Express Scripts and Zoe’s Kitchen were acquired. Further, as we describe below, we also raised cash by trimming our TripAdvisor position after excellent earnings and a 125% price increase from the last 2017 low.

Portfolio Update

During the quarter, company specific developments, as well as, the significant market volatility created opportunities for us to adjust our portfolio. For the most part, we added to existing positions that we know well and believe have the opportunity for positive near-term developments.

Partial Sale – TripAdvisor (TRIP); Sold 60% of Approximately 10% Position

On November 8, TripAdvisor reported financial results for the third quarter of 2018. The stock reacted positively to the news and was up over $10/share and 17% that day. We took the opportunity to trim our position – selling approximately 60% of our 10% position at $68.60/share. Our return on those shares was approximately 47% over a period of roughly twenty-two months.

It is important to note just how bumpy the ride was. From our first purchase at $49.52/share (already down 55% from its July 2014 high), the stock proceeded to drop to a low of $30.52/share in November of 2017. It then advanced almost 125% in just under a year to the point where we made our partial sale.

When we initially purchased TRIP shares in the first half of 2017 our thesis (articulated in our Q4 2016 letter) was that recent difficulties were masking the value of TRIP’s network of travel listings and unique visitors. We were not exactly sure how TRIP would improve site economics and monetization of visitors, but we knew they had a history of navigating challenges in the past and a good idea in the Instant Book product they had recently introduced. We were also optimistic about their nascent attractions business. In the end, Instant Book was not as successful as we hoped, but the value (and ongoing growth) of the network (the core of our thesis) proved itself after a few product and user interface iterations. The attractions business, where they are now the clear market leader, is doing even better than we might have hoped.

Buy – Jefferies Financial Group (JEF); added 2.5% to existing position

On December 13, 2018 we increased our position in Jefferies Financial Group by 2.5% to 12%. At $18.62, JEF was trading at less than 75% of what we believed would be year-end tangible book value of approximately $25/share. In addition, as we have pointed out before, the current JEF is the most diversified it has ever been (we believe greatly mitigating risk of permanent capital impairment) and in the process of executing transactions that have the potential to catalyze a valuation improvement while continuing to grow book value.

Indeed, on January 10, 2019 JEF reported year-end results for their 2018 fiscal year ended November 2018. Net income was $2.90/share. The company repurchased 50 million shares and paid dividends combining to return 17% of tangible common equity to shareholders. Through operating earnings and gain on investment sales, fully diluted tangible book value grew 22% during the year to $24.90.

Additional Buys and Position Increases

Given the information we were getting from credit spreads and market breadth, we used the sell-off to add to several other positions, besides Jefferies. On November 12, we initiated a position in Caesar’s Entertainment (CZR). The stock is cheap relative to other casino operators, they have a long pipeline of property sale leasebacks that should be accretive, and activist investors (Tilman Fertitta and Carl Icahn) have shown interest in acquiring stock. On November 20, we added to our Allergan (AGN) and Booking.com (BKNG) positions. We continue to believe AGN has a solid portfolio and is particularly cheap with a price to earnings ratio under 10. With its focus on European hotels, we believe Booking.com has the best assets of all the online travel properties. On November 28, we added to the MSCI Momentum ETF (MTUM). The majority of our individual security holdings are “value” oriented and this ETF helps diversify our market exposure. Finally, on December 6, we added to Labcorp (LH), the largest player in the critical diagnostic area of healthcare. In total, we increased equity exposure by approximately 17% during the fourth quarter.

It seems to us, the fourth quarter sell-off was a Fata Morgana. At first blush, it looked like the beginning of a new bear market. Like the unique conditions caused by rays of light bent through layers of different temperature air, modern market structure – increased programmatic trading, decreased relevance of market makers, and the growth of indexing – is adding volatility to what historically were shallower market corrections.

From a superior vantage point, the mirage dissolves. Market internals provide additional, critical information that the price indices leave out. As we wrote last quarter, despite the recent market volatility, nothing that has proven useful historically is signaling we should become significantly more defensive. This could change quickly – even in the next few weeks. The recent volatility created an opportunity to add to many of our favorite positions. We still maintain modest exposure to long-dated US Treasury bonds and gold, as well as, hold some cash as portfolio ballasts. In general, we are relatively neutral – cautious on valuations, but constructive regarding signs of investors’ willingness to continue to take risk in the near-term.

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