In January the Forager International Shares Fund invested in venerable fine art auctioneer Sotheby’s (NYSE: BID). Mostly thanks to the power of American capitalism, the investment played out much faster than expected.
Sotheby’s provides a marketplace for unique art. Sellers are assured of receiving their sale proceeds and buyers about the authenticity of their purchases. Sotheby’s also advises sellers on complex transactions, such as liquidations of large estates, and provides financing services to buyers. Its only major competitor is Christie’s.
Network effects are a meaningful source of competitive advantage in this industry. Sellers auction their items at Sotheby’s because of the large number of bidders attending its auctions. Bidders flock to Sotheby’s because that’s where they can find the best items. Scale is also important as this is a global market.
Not surprisingly, Sotheby’s and Christie’s each have a 30% share of the US$20bn art auction market (ex-China). This cosy duopoly should ensure that competition remains tame and profits high. While those dynamics contributed an average return on equity of 20% over the past decade, returns have deteriorated recently.
Stupid Competition and a Dormant Board
Both companies have been battling hard for market share, in particular through the use of auction guarantees, where the auction house promises sellers a minimum price no matter what the outcome of the auction. As the accompanying chart shows, losses on these guarantees contributed to a decline of Sotheby’s commission margin. The margin declined from a peak of 20.7% in 2009 to 14.7% in 2014 despite a buoyant art market. While the company generated a profit of $2.50 per share in 2011, it made only $2 in 2014, and that’s after adjusting for ‘one off’ costs.
If this weren’t enough, expectations of a cooling art market weighed on the stock too. Sotheby’s share price halved from $50 in 2014 to about $25 at the beginning of this year.
When Forager invested in it, Sotheby’s had a market capitalisation of US$1.5bn. Its net tangibles assets were US$1.1bn, mostly in the form of cash and prime real estate in New York and London.
Sotheby’s competitive advantage in art auctions arises from its client lists, brand name and expertise, none of which are accounted for on its books. So those tangible assets looked superfluous and potentially able to be returned to shareholders.
We also believed that the shrinking margin was self-inflicted and easily fixable as a result. And that the business’s flexible cost base meant it could withstand a severe correction in the art market. The $400m excess over its tangible assets looked a steal for such an entrenched business.
The Power of Capitalism
The stock was clearly cheap. Nevertheless, a low valuation never guarantees a great investment return (though it usually helps). For the investment to succeed, we needed Sotheby’s management to lift its game. And for the board to consider capital management actions.
We took a measure of confidence from the involvement of two activist funds, Third Point and Marcato Capital, which collectively owned 20% of the company and were pushing for board and management change.
That confidence was well founded.
Since June last year Sotheby’s has repatriated some of its overseas cash to the U.S. and suspended its dividend to focus on an accelerated share buyback. The company had to pay some tax, but the share count has decreased by a whopping 22% as a result. Concurrently, activist-backed CEO Tad Smith seems to have put an end to the abuse of auction guarantees. The commission margin has recently recovered to 16.4%.
The combination of a lower share count and margin improvement enabled Sotheby’s to earn a profit of $1.52 per share in the second quarter of 2016, well above Wall Street’s expectation of $1.05.
As a result, Sotheby’s stock price has recovered significantly. The Fund recently crystallised a 65% return on its investment in just over six months.
More Activism is Welcome
This investment illustrates why there’s little room for lazy balance sheets, poor management and complacent boards in America. In the land of shareholder activism, leveraged buyouts and spin-offs, capitalist forces quickly locate and eradicate sources of inefficiency.
Unfortunately we don’t see enough of this in Australia. Institutional investors are reluctant to rock the boat. Sandon Capital has had some successes, such as with Bluescope Steel. But in general there is too much value locked up in companies where management is apathetic.
While this is true of the Australian market, the situations in Europe and Asia are even worse. In our Investing in Asia blog series, we lamented the lack of activism in Asian markets and highlighted this as one of the reasons for the large number of ‘value traps’ in those markets.
While a substantial proliferation of investment activism can paradoxically decrease the number of investment opportunities available to value investors like Forager, we’re a long way from that happening anytime soon here in Australia. Let alone in Europe and Asia where an increase in investment activism would be most welcome.