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Welcome to the deep dive. Today we're plunging into well a really fascinating world activist investment. We're looking at a specific turning point for Persing Square Holdings or PSH that spans their high growth period in 2019 right through the uh incredible shock of the 2020 global crisis. It's a fantastic case study in conviction.
And for PSH, you know, 2019 wasn't just a success. It was a stunning validation of all the organizational changes they'd just put in place. After a pretty tough period, the fund generated a 58.1% total return on their net asset value. Wait, hold on. 58.1%. Let's just pause on that for a second. The S&P 500 had a fantastic year itself, right?
It returned just over 31%. PSH almost doubled the market. They did and they credit that staggering success directly to you know internal focus and a razor sharp commitment to their core strategy driving corporate change. It really signal that the activist strategy was back and it was working. So our mission today for you the listener is really twofold.
First we need to unpack that specific activist philosophy. I mean how do they find these underperforming giants and actually catalyze change? And then we had to spend some serious time on this surprising multi-billion dollar defensive move they made in early 2020. They basically executed one of the most famous market hedges in history right as the world seemed to stop.
Yeah. And to really understand the gains, we have to start with the strategy. PSH focuses on what they call underperforming great businesses. So, these are established companies, but their stock is trading at a discount because they're um mismanaged or just misunderstood by the market. People often compare this to private equity, but it's fundamentally different, isn't it?
If private equity is, say, buying the house outright, taking it off the market, and fixing the roof, what is PSH doing? Well, they're buying a large influential stake, enough to get on the board and demand changes, but and this is the key, they're buying that stake at a discount precisely because the business is mismanaged.
[snorts] Crucially, unlike PE, they don't pay a massive premium for control, and they don't rely on leveraging up the company's own balance sheet. They gain influence and catalyze change while the company is still publicly traded, which makes those returns even more impressive. Okay, let's look at the results.
The portfolio in 2019 was full of these mega winners, but the biggest contributor by far was Chipotle Mexican Grill, CMG. That's right. CMG alone was responsible for almost 15% of their gross performance in 2019 and the turnaround story there is just exceptional. It was all driven by restoring customer trust and a huge digital transformation.
What were the numbers on that? Same store sales grew 11% powered by 7% transaction growth. And the digital side, digital sales nearly doubled. They hit 20% of total sales. And what's the key takeaway here for an activist investor? It's all about the sheer margin potential once that turnaround is complete.
Absolutely. Chipotle's management estimates their restaurant margins could get to 25% or even more once average restaurant sales return to about $2.5 million. And here's the thing, they had hit that number before, but that was with basically zero digital contribution. Wow. So now with things like the Chipotle digital drive for us and their loyalty program,
Exactly. a loyalty program that signed up over 5 million members almost instantly. They now have the tools in place to drive transactions really efficiently and unlock that 25% margin. And at the same time, they were also a big part of the turnaround at Starbucks, SBUX. Indeed, Starbucks was just firing on all cylinders globally.
Global same store sales grew 6% in the third quarter of 2019. That was actually the first quarter since early 2016 to see growth above 4%. So things were really picking up. Yeah. And positive transaction growth returned in the US and globally. Innovation like the Nitro cold brew platform and you know expanding mobile order and pay especially in a complex market like China.
That was the fuel. But PSH showed real discipline. They sold their stake in January 2020 as it got close to what they saw as its intrinsic value. Okay. And just quickly Hilton Worldwide Holdings HLT also performed really well even in a softening travel market. That really comes down to the business structure.
Hilton's model is asset light. It's feebased, so they weren't exposed to the capital risk of actually owning the hotels. They grew earnings per share by 14% in 2019, driven by high net unit growth and share buybacks. It uh it essentially insulated them from softer rep PR growth. For those who don't know, rep PR is revenue per available room.
It's the standard metric for hotels, right? Okay, let's shift to the long haul plays. These are companies where the whole activist thesis is about multi-year operational margin improvement. and Lowe's. LOW is the perfect example. The core idea here was just closing that massive decade old performance gap with Home Depot.
That was the entire point of the investment. They believed new management could finally narrow that gap and Lowe's began a multi-year transformation in 2019. They focused on improving customer service, merchandising, and you know, aggressively cutting costs. US same store sales grew 3%. But the sources did mention some legacy pricing system issues that squeezed their gross margins that year.
That seems well, it seems counterintuitive if you're trying to push a successful turnaround. But that's exactly where the opportunity is. That inefficiency. Lowe's EBIT margin guidance for 2019 was about 9%. Home Depot was at 14.5%. That's a huge gap. It's enormous. That five and a half percentage point gap signals that there are hundreds of millions, if not billions, in untapped profit just waiting to be harvested through better internal operations.
The activist is investing in the certainty that management can capture that latent value. Right. Okay. Next up is Restaurant Brands International QSR. They own Burger King, Popeye's, and Tim Hortons. What was the strength in their model? Again, it's that royalty-based Capital Light franchise model. It delivered a really solid 7% organic IBITA growth in 2019.
Burger King got a huge boost from its international strength and all the buzz around the Impossible Whopper. And then there's Popeye's. I mean, that wasn't just a successful product launch. That was a genuine cultural moment that completely changed the chicken sandwich game. It was credited as one of the most successful product launches in the history of the quick service industry.
It really showed QSR's ability to drive these high impact innovations across its brands. Now, Tim Hortons did struggle a little bit, partly due to a redemption headwind from launching their new loyalty program, but the overall franchise engine just proved incredibly resilient. Okay, so that covers the wins, but now we need to shift focus to disciplined portfolio management, which is really about knowing when to get out.
PSH strategically sold two major positions in late 2019 and early 2020, right? First was automatic data processing ADP. And that was a massive activist victory for them, wasn't it? Hugely successful. They generated a 64% total shareholder return over two years, which was double the S&P 500. They got out because their activism had worked.
It catalyzed this business transformation that pushed ADP's earnings guidance up 85% over 3 years. The job was done. The value gap was closed and, you know, future returns were looking more modest. But the United Technologies UTX exit was a different kind of lesson. It was more of a tactical retreat.
Yes, PSH got out of UTX for only a modest 3% gain. They invested hoping for a three-way business separation that would unlock a ton of value. But then UTX announced a stock merger with Rathon, which PSH saw as um fundamentally value destructive for shareholders. They chose not to get into what would have been a long, messy, and uncertain proxy fight.
So discipline meant admitting the original plan was dead and just redeploying the capital. Exactly. And that discipline capital landed in a new giant Bergkshire Hathaway BRKB, right? They started buying in 2019. They saw BRKB as trading at one of its widest discounts to intrinsic value in years. And this is a company that so many people misunderstand.
They treat it like a big mutual fund full of stocks. Why did PSH see it as an activist opportunity? because half its value is in its insurance subsidiaries and the other half is in these highly diversified, whollyowned operating companies. The big structural advantage is the insurance float, all the premiums they collect up front that the company gets to invest before it has to pay out claims.
So, it's essentially free capital to invest better than free because of their consistently profitable underwriting. PSH calculated that their average cost of that float over the last decade was actually a negative 2%. But the activist angle is the operational lever. PSH noted that Burlington Northern Santa Fe, the railroad, one of Bergkshire's biggest companies, had operating profit margins almost 5 percentage points below its North American peers.
So this wasn't just a passive investment. It was a bet that the new management structure under AJ Jane and Greg Ael could finally take these huge established companies and squeeze out those five points of profitability that had been missed before. It was a classic great business underperforming management thesis just applied to one of the biggest holding companies in the world.
This all brings us to late February 2020. And this is the moment of really extreme foresight that defines PSH's agility. They looked at the emerging coronavirus reports and made a massive strategic pivot. They recognized that even though their core holdings were high quality, a global pandemic would just shatter short-term cash flows and cause this huge indiscriminate market panic.
They actually considered liquidating the entire portfolio. Oh wow. But they realized a hedging strategy was a better fit for their long-term ownership philosophy. So instead of selling the companies they believed in long-term, they bought insurance against the market seizing up. That's a great way to put it.
They purchased large notional hedges using credit default swaps or CDS. You can think of a CDS as basically an insurance contract against major companies defaulting on their debt. They bought these policies against credit indices in the US and Europe, essentially shorting credit and betting the corporate debt market would freeze.
That sounds like an enormously complex highstakes bet against the entire corporate debt structure. How did they justify taking that kind of systemic risk financially and philosophically? Financially, they justified it because the cost of the hedge was actually pretty low compared to the notional value.
They didn't really see it as a reckless systemic bet. They saw it as the cheapest, fastest way to protect their core holdings from short-term hysteria. It gave them asymmetric risk, huge upside if credit markets collapsed, but a limited cost if they didn't. And the mechanism worked perfectly. It worked perfectly.
As markets plummeted, those hedges just soared in value from basically zero to a peak of $2.7 billion in gross proceeds. For PSH, that translated to $2.1 billion. And this perfectly offset the huge marktomarket losses on their equity portfolio. But the ultimate expression of conviction wasn't just buying the hedge.
It was what they did next. The massive reinvestment. Precisely. PSH unwound those hedges entirely by March 23rd, 2020 and redeployed all of those staggering proceeds back into their existing portfolio or what they call deeply discounted prices. They increased their stake in Berkshire Hathaway by 39%, Hilton by 34%, Lowe's by 46%, and restaurant brands by 26%.
They were trading the profits from their temporary pessimism directly into the long-term optimism they had for their own businesses. They even reestablished a 10% position in Starbucks. And they went really big on real estate, investing $432 million in a secondary offering for Howard Hughes Corporation, HHC, which increased their stake by 158%.
The analysis was clear. companies with strong digital platforms like CMG and QSR and fortress balance sheets like BRKB and Lowe's, they would emerge stronger and that justified deploying massive capital even if short-term cash flows were disastrous for businesses like Hilton or Howard Hughes. This incredible sequence of hedging and reinvesting.
It raises a key question. Why is the PSH corporate structure so uniquely suited to pull off a move like this compared to say a traditional private fund? While the corporate structure gives them several key advantages. First, much lower fees than traditional private equity. Second, because PSH is publicly traded, there's no limit on how long they can hold something.
They are never forced to sell a great business just because a 10-year fund is maturing. And they also use modest leverage, which must have helped them maintain and even amplify their positions right when the market was collapsing. That's right. They use lowcost unsecured leverage like a $400 million bond they issued at 4.95% to enhance long-term returns.
But they keep their net debt to capital ratio very conservative, only around 4%. Yet, even with this incredible performance and these structural advantages, PSH shares have historically traded at a discount to the actual net asset value of the companies they hold. If the manager owns over 22% of the shares, and they're constantly buying back stock to close that gap, why does that market doubt persist?
That is the persistent paradox, isn't it? The market's discount signals that they're pricing in either execution risk or maybe structural complexity. PSH addresses this by viewing buybacks. They've repurchased $650 million a share since 2017 as a very attractive use of cash. They're basically buying back dollar bills for less than a dollar, but the discount it remains a hurdle they're constantly battling.
So if we connect all these pieces, the long-term activist strategy, the operational fixes, and that rapid 2020 pivot, the fundamental lesson the sources reveal about true business value becomes crystal clear. Yeah, the sources really drive home a powerful concluding thought. The value of any business is based on the present value of the cash it will generate over its entire life.
the temporary loss or massive disruption of the first one or two years of cash flow during a crisis that generally only destroys about 5% to 10% of that total intrinsic value. That is a staggering claim when you think back to March 2020. Highquality stocks plummeted 30, 40, even 60%. They fell four to six times faster than the actual calculated long-term loss of value.
The core lesson here seems to be the power of combining long-term corporate change with the unique ability to pivot and pivot decisively during extreme market stress. And this raises an important question for you, the learner. If strong companies with dominant market positions are only temporarily disrupted by a crisis, yet their stock prices fall far more than the calculated loss of cash flow.
Does the strategic value in an activist approach come less from finding the undervalued company and more from having the necessary financial structure, the confidence, and the sheer capital firepower to deploy billions when the entire market is focused only on short-term fear and pain? It's a question of conviction, meaning opportunity.
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