In defense of the Endowment Model

When I began my first job as an investment associate, looking at fund investments, I was told by a senior associate to read “Pioneering Portfolio Management,” by Dave Swensen, the former CIO of the Yale endowment. Swensen and other CIOs who followed the approach detailed in this book, were looking for a long-term, sustainable method to the madness of trying to create value out of something so unpredictable. It was a terrific book, by the way. Despite being written by such a celebrated, famous investor, it was easy to read and understand even for a 22-year-old who has not had any investment experience. Even today (after 5 years of IM experience), I find myself digging it out to re-read select chapters.

In business school, I found that people had all sorts of opinions about the investment model used by endowments – with and without basis. I find myself defending these 3 aspects of the endowment model the most:

1) Discipline, not Dead-set. Other students sometimes tell me that endowment analysts will one day find themselves out of a job, their professions replaced by computers. Underlying this thought is that any machine can be programmed to “follow rules,” and that the endowment model is really just about following some set rules about how much to allocate to particular asset classes of investments, and finding the highest-returning (risk-adjusted or otherwise) managers within each asset class. In my experience, this is far from the truth. While there are strategic allocations by investment class, they are not set in stone. They are framing guidelines and the investment team, using what they know of market sentiments, special endowment needs, and sometimes even a little bit of intuition, looks at a broad array of investment possibilities, and determines the best fit for the portfolio. From experience, this is not necessarily the manager with the highest returns or best sharpe ratio. More than anything, it provides a sort of discipline, allowing the analyst or portfolio manager to gut-check.

2) Flexibility, not Forced allocations. The endowment model is not a fixed, inflexible set of target allocations, but rather, a framework for thinking about tradeoffs. Swensen’s book talked about the importance of maintaining a tactical aspect of asset allocation, and over or under-allocating to targets as needed. This has definitely been my experience at the firm in which I began my career. There were periods of time when the actual allocation was notably different from the allocation targets. Sometimes it was because it was an inopportune time to exit certain investments (e.g., after the market correction of the Great Recession) or there were tremendous once-in-a-lifetime investment opportunities aplenty in one particular asset class. Robots and computer programs certainly can’t replace that.

3) Context, not Constant. Each investment decision and the target allocations are re-evaluated year over year by committees of informed individuals. Many more things come into consideration than just the return profile. Universities are often leaders of thought and the endowment reflects that. For some institutions, this has meant divestment from certain asset classes (in spite of returns or diversification arguments in favor of investing) such as tobacco as a message of its commitment to betterment of the world. For religiously-affiliated schools, this may mean refraining from investments that are in contradiction to their founding missions.

I’m so grateful to my previous job for teaching me these aspects of the endowment model. I may not be returning to asset management in the context of an endowment after my MBA program, but the lessons it taught me about being curious, trusting your gut, and taking pride in my work will frame the rest of my career.

Pitch: UAA (Long)

Under Armour class A share price has come down significantly in the past few months despite outpacing peers and indices since inception as a publicly-traded firm (as illustrated by Fig. 1 in appendix), which could be attributable to a sales growth decline in 2016, a slight decline in operating margin (of 1.6 percentage points from 2015 to 8.7% in 2016), uncertainty about the future of its distribution channels (sporting goods and mall-based stores), and skepticism over its ability to capture additional markets (footwear, connected fitness, women, international). However, I believe that Under Armour’s business prospects and current share price, make it an attractive long investment.

• Wide market opportunity: The market is undervaluing the addressable market that Under Armour has remaining and its growth potential as it becomes a truly global fitness lifestyle brand. At inception, Under Armour addressed an unfulfilled need by the athletic performance market (for sweat-wicking, and heat-retaining fabric) and has since gained an almost “cult-like” brand loyalty particularly among the teenage athletic demographic. Under Armour recognizes its over-indexing on US-based male athletes and has since diversified to women athletes, casual wearers (fashion rather than athletic wear) and internationally. Additional growth areas include direct-to-consumer and connected fitness.

International sales still account for a very small proportion of total revenues (just 17% of sales in 2016) and there remains tremendous opportunity in women’s apparel, particularly with a shift into athleisure. To the extent that Under Armour could penetrate the women’s activewear market dominated by the likes of Lululemon and Gap Inc.’s Athleta, it would be well positioned to expand revenues rapidly due to both higher price points (comparable to LULU and Athleta) and greater addressable population. Many doubters believe that athleisure is simply a fad; however, UA’s competitor Nike showed that with a strong enough brand and proposition to customers, an entire lifestyle change can be built. Before Nike, “sneaker” lifestyle was certainly not nearly as prominent in the US and Europe.

• Brand power/partnerships: The market is also undervaluing Under Armour’s brand is built on its reputation for high-quality performance materials that can weather wear and wash. Indeed, in the Q4’16 earnings call, CEO Kevin Plank remarked that while they are strategically moving into apparel at large, “performance” quality is still something that is very much expected of them. Through this enduring commitment to quality products, Under Armour has been able to garner value-additive partnerships, including one with Samsung to develop connected fitness applications. Connected Fitness is a binary bet for Under Armour. Though currently small, if it does take to market, it could follow on the success of devices such as the Apple Watch and FitBit. It could be revolutionary: UA’s existing R&D in materials technology could enable it to incorporate fitness tracking into clothing and accessories in ever novel ways. On the flip side, even if it does not take off, UA’s business prospects are virtually unharmed since it is such a small part of their business (1.7% of revenues for FY 2016).

• Channel/omnichannel: The opportunities for Under Armour to expand via channel opportunities is tremendous. In the FY15 shareholder letter, management pointed out the desire to provide products at multiple price levels and offer superior alternatives to competitors. UA has delivered on this by distributing through wholesale, opening its own retail stores, and more recently, offering outlet alternatives. This allows UA to effectively price discriminate. In addition to marketing through several fitness arenas, UA is also unique among its peer group in its aggressive pursuit of the direct-to-consumer channel through online. Unlike Nike and Adidas, UA has fewer physical stores, so it does not bear as tremendous a restructuring cost as the two larger players would in converting to e-sales. Interestingly, UA also has far more factory stores (151 as of 12/31/16) than house retail stores (only 18 as of 12/31/16). I believe that they are astutely using house retail stores only as a “seat saver” (a la Warby Parker model) in major athletic cities like Boston, but using factory stores to rid excess inventory without affecting pricing through its other channels (profit-maximizing price discrimination).

• Execution: Under Armour has been successful in expanding its product offering and customer base. For example, in 2016, its newly-minted footwear segment grew 49.1% to $1.0B in net sales, led by running and basketball. The basketball sales give credibility to UA’s sponsorship of the NBA and illustrates that such marketing efforts are bearing fruit. But what is more impressive is its penetration into the running population, an area once well-guarded by the two major US shoe-dogs, Nike and Adidas. This gives me high conviction that Under Armour would be able to expand its brand reach to geographies where brand perceptions matter (e.g., East Asia, Europe) and technology via connected fitness.

Valuation: Based on a 15-year DCF, Under Armour has a fair price of about $28/s, which represents 40%+ upside. This intrinsic valuation acknowledges a continuation of its current high growth in apparel, footwear and accessories for the next 5 years, then tapering off to a 3.0% growth rate which it will continue beyond the explicitly modeled period. This 3.0% reflects long term GDP growth of the global markets and productivity gains.

Pitch: GILD (Long)

Gilead Sciences is a research-based pharmaceutical company that develops and commercializes drugs in high-impact therapeutic areas, including those treating chronic immunological diseases, oncological indications, and inflammatory and cardiovascular illnesses. Gilead is known for its portfolio of effective antiviral HIV/AIDS and hepatitis treatments, developing its treatments both internally as well as through select acquisitions of existing competencies. Gilead is underpriced, because the market fails to recognize the value of its current and future therapeutic (and therefore revenue) power, and because it holds too much weight on short-term news about downward pressure on its treatment pricing.

Investment Thesis
Gilead’s key competitive advantages lie in its structural advantages and leadership in pharmaceutical development and commercialization across a vast array of therapeutics addressing unmet needs.

Drug portfolio: Gilead’s approved (and future approved) drugs are by nature long-term revenue generators, because the majority of them aim to treat chronic illnesses. The development has also been focused on life-critical treatments, so price elasticity of demand should be very low. Gilead has shown this through its leadership in HIV treatment and prevention (Truvada and Atripla). Gilead has also found a viable cure for Hepatitis C with its Sovaldi and Harvoni drugs, as well as its newest single-dose Epclusa (approved in 2016) and Vemlidy (approved 2016).

Beyond its current slate of impactful treatments, Gilead has a valuable array of drugs in progress, including hematological/oncological, inflammatory/respiratory candidates in phase 3 clinical trials. For example, Idelalisib would address patients with relapsed leukemia, and an investigational antibody, GS-5745, would treat gastric cancer. Both are increasing in prevalence today.

Partnership/Scale: Being a larger player in the antiviral and antiretroviral (and increasingly, chemotherapeutic) space affords Gilead the ability to acquire competencies, assets and talent to fuel research and development. The Gilead team has shown capability in making value-additive acquisitions. For instance, its acquisition of Triangle Pharmaceuticals enabled development of HIV treatments, and its 2006 acquisitions of Corus Pharma for $365M paved the way for entry into the respiratory space. By acquiring Pharmasset in 2011, Gilead capitalized on existing R&D at the firm to develop its acclaimed Sovaldi.

Finally, Gilead is able to capitalize its reputation to partner with other companies on higher-risk drug development. Last year, Gilead closed on a collaboration and licensing agreement with a clinical stage firm, Galapagos, to develop a phase 3 drug with three potential indications: rheumatoid arthritis, Crohn’s disease, and ulcerative colitis, all three of which are markets with expansion opportunity.

Cheap option: Gilead is trading at such a cheap multiple that it is akin to paying a small premium for the optionality of the next blockbuster. From a policy perspective, the new administration may be more open to M&A activity, which would benefit Gilead’s business model.

Valuation
Gilead Sciences is currently undervalued at $67.10/share, representing a $87.7B market capitalization (as of April 3, 2017 market close). This reflects a 6.8x P/E ratio, which is extremely low compared to its peers of similar size and therapeutic areas (including Amgen, Celgene, Novo Nordisk, Biogen, Shire, CSL and Regeneron) as seen in Fig. 1. Gilead is favorably positioned to continue growing in the therapeutic areas for which it has market power, as well as in transformative new pipeline drugs that could prove to be blockbusters. Even with a sizeable discount to peers, Gilead should trade at least in the 10-12x range or about $96.27/s - $115.52/s.

Pitch: NYSE:GPS Long

Gap Inc. is a global apparel retailer with five active brands: Gap, Banana Republic, Old Navy, Athleta, and Intermix. GPS is known for its high-quality, dependable apparel and affordable prices. GPS is underpriced, because the market fails to recognize its staying power and discounts its prospects per the backdrop of the rise of eCommerce and fast fashion in apparel, as well as the high profile distress of well-known US department stores.

Gap Inc.’s key competitive advantages lie in its structural advantages and leadership in retail across a vast variety of demographics as well as its management and operational advantages.

Brand portfolio and trademarks: Gap Inc.’s brands can be disaggregated into two distinct categories: tried and true household names (Gap, Old Navy, and Banana Republic) and newer high-quality brands to compete with up and coming trends (Athleta and Intermix). With most of its brands, Gap Inc. has full operational control. The exception is Intermix, for which Gap controls all aspects of brand development other than product design related to third party products. Gap is known to exhibit ultimate flexibility when it comes to managing its brand and was willing to shutter its Piperlime line (mix of private label and branded apparel and accessories) when it saw that this e-commerce focused line has become a drag on its performance. Its mix of brands gives it a competitive moat by targeting different price levels and apparel styles. In general, Gap Inc. is seen as both high quality and affordable, straddling the dual advantage zone. It has an established brand name which allows it to command a price premium and take wallet share from consumers.

Omnichannel: Gap Inc. maintains flexibility in its operations through its omnichannel management. Currently, Gap Inc.’s brands have retail stores that sell its own goods through both company-owned and franchise stores. Its ownership of majority of stores (88% as of Jan. 2016) allows Gap Inc. to maintain control over the inventory management, feel, and aesthetic of stores in its core geography of North America. Selectively, GPS is exploring and expanding across other geographies through franchising affiliates in Asia, Australia, Europe, Latin America, Middle East, which gives it an edge in local international markets. As Zara has shown in its local store front customization, adhering to local tastes is critical in apparel.

Gap Inc. is effectively able to price segment its customer base through its separate brands as well as through its retail vs. outlet stores. Selling through its own stores also affords GPS real-time monitoring of its inventory and feedback collection of data on its classic as well as trendier items.

Scale: As of fiscal year 2015, Gap Inc. operated 3,721 brick-and-mortar stores across six continents. Gap Inc.’s vendors number over 1,000 in over 40 countries, and vendors do not have significant supplier power, because the top 2 were only 5% of purchases by dollar volume. Twenty-four percent of purchases were from factories in China. Gap is a major employer of 141,000 employees worldwide (as of Jan. 30, 2016) and its large base allows it to cherry pick and train top talent across functions. Furthermore, its scale is an advantage in this uncertain climate for apparel retail because it allows Gap’s brands experiment without giving up too much brand identity.

Valuation
Gap Inc. is currently undervalued at $24.10/share, representing a $9.64B market capitalization (as of Mar. 17, 2017 market close). This represents a 14x P/E ratio, which is on the low end of its peers (including RL, AEO, ANF, PLCE, EXPR, and GES). Gap Inc. has a more favorable earnings profile and future prospects, so a fair valuation range is closer to 15x – 20x, which represents a price range of $25.35 - $33.80. The midpoint price of $29.58 is more reflective of where GPS should trade given its competitive advantages vs. peers and its potential over the near future.

A change in direction

Hello Blog Fam! It has been a loooong time since my last post, and I really do apologize. I have been extremely busy in my MBA program (more on this later!) and I am excited by the opportunity to share all of that with you here. I have some big news coming up and still a lot of moving parts to wrap up in the next couple of weeks, but I just wanted to provide quick update.

Over the past couple of months, I have learned a lot about different parts of business and have – to my best effort – attempted to remain open-minded about what I would like to pursue after my MBA degree. But it seems that what I have wanted since my very first day of work at 22 is still what I want today – to move into the world of direct investing.

Accordingly, I have been taking some security analysis and finance classes to build a knowledge base. Since that is such a big part of my life now, I would like for it to be part of this blog as well. I will still be posting updates about career, recruiting and experiences, but I will also be incorporating some of the things I am working on for class and extracurriculars, including investment pitches.

Stick around for more!

- The closing belle