



Earnings season is over. And Woodlock’s portfolio companies made it through all right. I had no palm-sweating, thesis-killing moments when I realized “I gotta get out of this thing… preferably yesterday.”





Macro worries, though, sent a couple of my names to 52-week lows in August.

I don’t know about you, but I find it much easier to hold on to a stock when it’s a macro worry weighing it down versus something stock specific. Macro sentiments tend to ebb and flow. Company specific problems, though, can be fatal to a thesis. At least, that’s been my experience.





Both of these ideas, which I discuss below, are pretty decent-sized positions (~7%). So, they’ve taken a bite out of my return year-to-date. But longer-term, there is no impairment and I think both will still work out nicely over a period of years. We’ll see.





Let’s take a brief look…





Fairfax India (FIH-U:TSX)





When Modi won re-election in May, Fairfax India rallied 6% in a couple of days. Most people viewed Modi’s win as good for business. But…





“Two months later, the elation is gone. Despite an uptick in August, Mumbai’s Sensex stock index is about as close to October’s lows as it is to June’s highs. In July foreigners pulled more money out of Indian equities than they put in. India’s cautious business press has begun to criticize the government.”





(The Economist, “ India Inc. is growing disenchanted with Narendra Modi .”)





You can read the article yourself. The basic idea is that people reacted negatively to Modi’s budget, which they thought would bring less red tape, lower taxes, etc. And they got the opposite. Meanwhile, there are worries growth is slowing in India. The macro uncertainty around Kashmir probably doesn’t help either. And, just to add to it all, the rupee has weakened against the dollar by 4.5% since July.





Fairfax India hit a high of $14.25 in May after Modi’s re-election. At that point, I was feeling pretty good. I had a decent unrealized gain and had visions of making a run at the 2018 high of nearly $18 per share.





It was not to be. The shares trade for about $11 as I write. That’s a tumble of more than 20% from its May high. The stock trades for 84% of book value, which is arguably depressed. (Book value declined 4% this year to June 30).

Meanwhile, the firm itself seems to plug along okay. Fairfax India is a holding company with a mix of private and public investments in India. I’ve written about the company before on this blog ( here , for example) .





The crown jewels are two: the Bangalore airport and IIFL, a financial company that recently split into three pieces. These two make up about 70% of the NAV.





Part of the problem here is that only one piece of the three pieces of IIFL currently trade, which leaves a bit of a mystery as to what the other pieces are worth at the moment. But that gives us a nice catalyst for the back half of the year. We may see a boost in net asset value for Fairfax India when these do trade.





Also, Fairfax India has a 50.1% stake in a bank (CSB) that will go public soon. It’s not big enough by itself to move the needle. But what it could do is highlight the value added by Fairfax India since it’s initial investment. That might get people more interested in what else Fairfax India has in its portfolio. We’ll see how the IPO goes.





I’ve followed Fairfax India for a few years, attending their annual meetings. I like the management team and I like what they’ve done. I’ve also been to India twice. The first time was a long (21-day) trip where I traveled fairly extensively on the western half of the country. The second was a weeklong trip to Mumbai where I met with analysts and companies. I think there is a lot of opportunity in India and I want to have some exposure there.





But I can’t buy stocks listed in India, which are the most interesting opportunities to me (as opposed to the US-listed ones). So, that’s where Fairfax India comes in. They can buy both private and public companies.





It’s not perfect. For example, some people don’t like the hedge fund like fees that Fairfax India pays to Fairfax Financial. (Of course, you could also own the mother ship. The shares seem cheap, too, trading below book). The incentive fees are paid every three years in shares. I’m okay with it, because I expect the performance will make it worth it. (There’s crazy growth on tap. The airport, for example, may handle three times more passengers over the next ten years). We’ll see.





Interactive Brokers (IBKR)





IB’s second quarter results were fine – I’ll get to them in a minute. But macro fears about lower interest rates have hit all the brokers. Schwab, TD Ameritrade, E*TRADE – all hit 52-week lows in August. Interactive Brokers, too. Bummer.





Brokers make a lot of money holding customer cash. Last year, for example, about half of IB’s net revenue was net interest income. So, the market thinks, “Jeez, interest rates are heading lower, nuking IB’s earnings power. I’m out!”





Last year, the effective fed funds rate increased about 70%. And IB’s net interest income increased about 36%. But the relationship is not that simple. For one thing, IB continues to bring on new accounts. And the mechanics of IB’s interest margin involve several moving parts.





I can do no better than Nancy Stuebe (Director of IR) in summarizing how broker cash and net interest margin work. Here she is on the last call, answering a question about interest rate fears:





“Well, the way a broker balance sheet works is that your client cash is on one side. And then your client margin loans and then your segregated cash are on the other. What we pay and our customer cash balances is known. What we will get on our margin loans is not only known, but they're both tied to fed funds. We pay fed funds minus 50 on customer cash and we charge fed funds plus 30 to 150 on margin loans.





“Those are pretty predictable in terms of our net interest margin. It's the segregated cash and how we invest it that we can manage. And we invest in treasuries, treasury repos. On our last call, we said that it's about a 60-day duration. A couple of years ago, it was closer to a year. So what we would end up doing is stretching out the duration with a flattening yield curve of -- we're not going to take risks and go out on duration if we're not going to be getting a return for it.





"Obviously, if interest rates are to fall again, we would go out longer and manage it that way since we really can't manage what customers are borrowing from us and then what size. And we really can't manage what they're keeping in cash versus what they're keeping in securities.”





So, IB has some levers to pull. I’m not saying lower rates won’t pinch net interest income. I’m saying it likely won’t be as drastic as the market seems to think given the levers they pull and the cash they have coming. Besides, the extra volatility of late has certainly helped commissions, which helps overall earnings power.





Besides, I don’t want trade IB based on what I think interest rates might do for the same reason I don’t want to get a root canal I don’t need. It’s a pain. I’ve taken the position IB is a very good business, with no debt and a decent shot at doubling in size over 5 years. The interest rate story will probably shift three or four times over the course of my ownership. Or not. We’ll see.





As for those second quarter results: Unless you’re a hedge fund manager worried about what your next quarter’s performance will look like, this is not a business you sell.





A few highlights:





· Total accounts grew by 19%, or more than 100,000 net new accounts from last year

· Client equity increased 14% from a year ago.

· DARTs grew by 4% since having more accounts and more clients on the platform leads to more trades.

· Brokerage revenues adjusted for treasury marks were up 6% versus last year

· Net interest margin was 1.66%, up from 1.61% a year ago

· Pretax income of $225 million. Adjusted for the non-operating items, pretax income was $299 million, up 3% and represented a 61% pretax margin.

· Comprehensive diluted earnings per share, which includes all currency effects, were $0.46 for the quarter versus $0.39 last year. Without the impact from non-operating items, diluted earnings per share would have been $0.57 versus $0.58 last year on the same basis.





Not bad. As a long-term owner this business, it’s okay. I think the market zeroed in on the fact that overall earnings didn’t grow that much and the market sold it off. But again, as an owner of the business, I’m not going to sell because we had a slow quarter.





The stock has become a reasonable value. At $46.50 per share, it trades for about 20x 2018 earnings per share. In this market, that seems a fair price for a capital-light, cash generative business, even if growth slows for a bit.





That’s all for now. Thanks for reading and enjoy your weekend!





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Published August 22, 2019

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