- Our intrinsic value framework helps us make rational decisions that are not influenced by day-to-day market fluctuations.
- Even as some cable stocks experienced 30% to 55% peak-to-trough declines this year, we believe their intrinsic values steadily grew.
- For cable companies, we believe the market’s concerns about cord cutting and 5G competition are misplaced.
Investors today have been inundated with alarming headlines. Unemployment has soared, high-yield spreads have widened, oil prices recently turned negative for the first time in history, and many companies are filing for bankruptcy. Some economists believe GDP will decline at its steepest pace since the Great Depression. Against this gloomy macroeconomic backdrop, it is not surprising that the equity markets have been volatile.
All too often, investors allow short-term stock price fluctuations to influence their opinion of an underlying company. After a steep share price decline, a business that was considered attractive last month may suddenly be deemed too risky to own. Putnam’s non-U.S. small-cap team has a different perspective. We believe that every company has an intrinsic value, and our goal is to acquire stocks at a meaningful discount to their inherent worth. This philosophy can serve us particularly well in times of market stress. Volatility is not something to be feared, but rather an opportunity to find quality companies at bargain prices.
Assessing intrinsic value in cable companies
Our holdings in the communications sector, the portfolio’s largest active weight, help illustrate this principle. As of March 31, 2020, we owned four cable companies: Cogeco Communications (Canada), Liberty Global (United Kingdom), Liberty Latin America (Caribbean and Latin America), and Megacable (Mexico). We believe they share several attractive characteristics:
- Recurring revenue
- Limited macroeconomic sensitivity
- Good returns on tangible capital
- Decent long-term growth prospects
- High free cash flow yields
Even as these stocks experienced 30% to 55% peak-to-trough declines this year, their intrinsic values steadily grew. Indeed, the COVID-19 pandemic has further demonstrated the importance of high-speed internet access. When we believed that market prices had become disconnected from intrinsic value, we added to these positions opportunistically.
The railroads of the 21st century
Today’s vast fiber optic and coaxial cable network is analogous to the railroad infrastructure built in the 19th century. It is both critically important to society and virtually impossible to replicate from scratch. While the rail industry carries 1.8 billion tons of freight at an average speed of 25 miles per hour, cable’s fiber optic “rails” move information and data as fast as 70% of the speed of light.
Today’s vast fiber optic and coaxial cable network is critically important to society and virtually impossible to replicate from scratch.
We estimate that it would cost well over $250 billion to replace the broadband infrastructure that connects more than 185 million homes and businesses throughout North America. To put this in perspective, the five largest companies in the S&P 500 spent an average of $16 billion on capital expenditures in 2019. Even if one FANG company reallocated 100% of its time and energy to fiber, it would take 10 to 15 years of capital expenditures to build a comparable network.
Based on current publicly traded valuations, North America’s cable industry is worth roughly $750 billion of enterprise value. Less than half of this would accrue to a hypothetical new entrant, given the inevitable price war that would follow. In summary, a $250 billion capital investment might result in $375 billion of value, a meager 2.5% annualized return over 15 years. It’s no wonder that only 15% of households in the United States have access to more than one provider of 100-megabyte-per-second internet speeds. There is limited economic incentive to overbuild homes that already have access to high-speed internet.
The cable industry has historically earned high, but not egregious, returns on tangible invested capital.
Because of these unique characteristics, the cable industry has historically earned high, but not egregious, returns on tangible invested capital. Moreover, the share prices of cable companies have outperformed the broader market for multiple decades.
Why, then, are cable stocks valued at such low multiples of free cash flow today? We suspect investors have two key concerns. One is cord cutting — the fast-growing trend of customers canceling their pay TV subscriptions in favor of Netflix, Hulu, or other streaming options. The second is 5G cellular technology, which some believe could eventually compete with broadband internet. We believe the market’s fears are misplaced in both cases.
Cord cutting is not as scary as it sounds
Many investors worry about the impact of cord cutting on cable companies. However, due to the high programming fees that are paid to content providers, profit margins from pay TV are low. An overwhelming majority of the cable industry’s profits come from broadband internet, which cord cutters need more than ever due to the high download speeds required to stream videos.
A good case study is Cable One, which several years ago intentionally de-emphasized pay TV bundles in order to focus on its high-speed internet offering. Even as video subscribers declined by nearly 50%, the company’s free cash flow more than doubled as profit margins expanded and capital intensity declined. Arguably, this demonstrates that the value of an internet-only subscriber is not materially different from that of a bundled internet and TV subscriber.
5G: More evolutionary than revolutionary
Some investors worry that 5G cellular technology could eventually compete head-to-head with broadband internet. While wireless speeds will inevitably improve, we believe it is highly unlikely that cellular technology will displace cable. Consider that the average household consumes over 200 gigabytes of data per month from its cable provider. Many cellular carriers begin throttling speeds in excess of 15 gigabytes per month. Moreover, while some cellular companies boast that 5G speeds could exceed 1 gigabyte per second, at the same time, cable companies are racing ahead toward 10 gigabyte-per-second offerings.
5G technology is no more likely to replace cable internet than cars are likely to replace houses. Each product serves a distinct purpose.
In summary, we do not believe that 5G is any more likely to replace cable internet than cars are likely to replace houses. Each product serves a distinct purpose, and both will continue to be used in complementary ways.
When markets are volatile, it can be challenging to separate the signal from the noise. Stocks are not just pieces of paper or numbers on a computer screen that bounce around. They represent partial ownership stakes in real businesses with inherent worth. We believe our intrinsic value framework helps us make rational decisions that are not influenced by day-to-day market fluctuations. When a stock price decouples from our estimate of intrinsic value, we view this as an opportunity to add to our position.
As of March 31, 2020, Cogeco, Liberty Global, Liberty Latin America, and Megacable accounted for 2.64%, 1.49%, 1.58%, and 2.08%, respectively, of the Putnam Non-U.S. Small Cap Equity Strategy. The companies presented as investment examples represent the largest positions in the largest sector active weight (Communication Services) as of March 31, 2020. Additional companies mentioned were deemed most relevant to the applicable investment themes being discussed. Investment examples were selected without regard to whether such investment themes, or relevant securities, were profitable and are intended to help illustrate the investment process. The inclusion of holdings information should not be interpreted as a recommendation to buy or sell or hold any security. It should not be assumed that investment in the securities mentioned was or will be profitable. Holdings are for a representative account and are shown for illustrative purposes only. Each account is managed individually. Accordingly, account characteristics may vary.
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