How would you rate this quote?
“You have to be confident as you face the world each day, but you can’t be too cocky. Anyone who thinks he’s going to win them all is going to wind up a huge loser.”
Pretty good, right? It’s no Lincoln.
“Better to remain silent and be thought a fool than to speak and remove all doubt.”
Or Kennedy.
“Ask not what your country can do for you but what you can do for your country.”
What if we told you the first quote came from the 45th President of the United States, Donald Trump. How would you rate the quote now?
Did your rating change for the better? For the worse? If it changed one way or the other, then you have likely fallen for the Halo and Horn effect.
Halo
When you like some aspect of a person you tend to like all other aspects of that person and overate their abilities. Even if you’ve never witnessed these attributes.
You meet Jane at a cocktail party. Jane is personable and easy to talk to. You enjoyed your brief time with Jane. Then later on someone running a charity asks you how generous Jane is and how likely Jane will donate to their charity. You will most likely rate Jane as very generous and very likely to donate to the charity.¹
But how do you know this?
You know nothing about Jane’s generosity. You only really know that Jane was friendly and personable. You overrated Jane’s level of generosity because you liked her.
Horns
The opposite is the horn effect. You tend to underweight someone’s abilities and dislike all other aspects of a person based on one trait.
A perfect example comes from the book Good Advice from Bad People: Selected Wisdom from Murderers, Stock Swindlers, and Lance Armstrong.
“The day you take complete responsibility for yourself, the day you stop making any excuse, that’s the day you start to the top.” — O.J. Simpson
We immediately discount what these people said because of the person who said them.
Tom Brady is an all-time great NFL quarterback. No quarterback has won more Super Bowls than Tom Brady. Go ask a die-hard New York Jets fan what they think about Tom Brady. You’ll likely hear how overrated Tom Brady is. That he isn’t that good and he benefits from the Patriots’ “system”. And you’ll most definitely hear, “He’s a cheater!”
Now, what do you think the comments from Jets fans would be if Tom Brady were on the Jets?
Tom Brady’s only transgression against the Jets is that he plays for a hated rival.
Halo, Horns, Politics, & Your Portfolio
The halo and horn effect happens a lot in politics.
If you like a President’s politics and party affiliation you tend to like the way they dress, how they speak, and how they carry themselves in public. If you don’t like their politics you tend to dislike everything about the President.
Your political affiliation also has an unintended consequence on your portfolio.
From the paper Political Climate, Optimism, and Investment Decision.
In our main empirical analysis, using the Gallup data, we show that Democrats (Republicans) become more optimistic about the stock market and the overall economy when Democrats (Republicans) come to power and there is a decline in optimism when the opposite party comes to power.
Investors tend to increase their exposure to risky, more volatile, assets, when their political party is in power and decrease their exposure when the opposite party is in power. This has the effect of increasing the investors’ returns over time, but not for the reason they think. The casual investor will attribute the performance to their political leader. In reality, increasing their risk exposure simply increases their odds of having higher returns in their portfolio, regardless of which political party is in power.
It’s not just the average investor that falls prey to the Halo and Horn effect. It can happen to us all.
Whitney Tilson runs a small hedge fund but he is a tireless self-promoter and has made a name for himself. You may have seen him on 60 Minutes during their Lumber Liquidators segment. Mr. Tilson spent considerable effort campaigning for Hillary Clinton and spilling a large amount of digital ink deriding “Con Man Don”. After Donald Trump won the election Whitney Tilson sold more of his equity positions into the market rally.
By Wednesday morning, as stocks made a big comeback rally after a near-800-point plunge late Tuesday night in pre-market futures trading on the prospects of a Trump victory, Tilson was busy unloading shares into the rally.
“I was at 60 percent cash coming into today, and I’m selling stocks today,” he told the New York Times.
Mr. Tilson may have let his political affiliation determine his market perception. In Mr. Tilson’s defense, a couple months later he realized he acted on emotion and added equities back to his portfolio.
The Halo and Horns effect is another mental heuristic we use to make quick decisions. It is a form of pattern recognition that often produces irrational and heavily biased decisions.
It is hard for us to tell when we are making an irrational decision based on simple heuristics like the Halo and Horn effect. There is no easy way to counteract this effect. We always advise slowing down your decision making steps and reviewing your process. When truly in doubt, it never hurts to enlist a trusted friend or confidant to play devil’s advocate.
Dividend Stock in Focus
Hilton (HLT): $65.49*
*price as of the close May 24, 2017
We build our dividend growth portfolio on three categories.
- Dividend Stalwarts: Companies that have paid and grown their dividend over several decades
- New Dividend Payers: Companies that recently initiated a dividend and can grow their dividend at above average rates for many years.
- Special Situations: Companies that pay a dividend and are undergoing a corporate restructuring.
Hilton Inc. has been around for a long time. The company started in 1919 when Conrad Hilton bought the Mobley Hotel in Cisco, Texas. In the last few years, Hilton has undergone several ownership changes, corporate restructurings, and Paris’ new DJ career. This is why we classify Hilton as a new dividend payer.
In the fall of 2007 Hilton went private through a leveraged buyout by Blackstone. Then in December 2013 Blackstone took Hilton public again as Hilton Worldwide Holdings (HLT).
In January of 2017 Hilton underwent another corporate restructuring. Hilton Worldwide split into 3 different companies.
- Hilton Grand Vacations (HGV) is now focused on Hilton’s timeshare business.
- Park Hotels and Resorts (PK) is a REIT that owns the hotels and other properties.
- Hilton Inc (HLT) retained the franchise and hotel management business.
It was after the three-way spin-off that we took interest in Hilton Inc. (HLT). As we’ll discuss further below, Hilton is now operating as an asset light business. We expect Hilton’s profit margins to increase and, more importantly, its return on invested capital (ROIC).
Did we mention that Paris Hilton is now a DJ?
Dividend History:
Hilton Worldwide Holdings started paying a dividend of $0.14364 per share a year ago. Post spin-off, the new Hilton Inc. continued to pay the dividend and slightly increased it to $0.15 per share.
We’ll further discuss Hilton’s capital return plans below.
Catalysts for Dividend Growth and Price Appreciation:
Asset Light Management & Franchise Model
By jettisoning the timeshares, hotels, and other properties Hilton became an asset light business. Less assets mean less capital needed to maintain and grow the business. Margins and return on invested capital (ROIC) should both increase. This leads to excess capital available to return to shareholders.
Increasing ROIC
Building hotels requires a lot of capital. Managing hotels and licensing your brand does not. Reducing its capital needs will drive Hilton’s return on capital higher. Increasing returns on invested capital is a key driver to building shareholder value.
Pre-spinoff Hilton’s ROIC reached a high of 9%
Marriott International (MAR) has undergone a similar transformation. In 1992 it spun-off the hotels they owned in to a Real Estate Investment Trust (REIT). 19 years later Marriott International spun-off its time share business, Marriott Vacations Worldwide (VAC). Marriott International retained the franchise and management contract business. Return on invested capital for Marriott International improved greatly since then*.
*The drop in Marriott’s ROIC was due to the completed merger with Starwood Hotels in 2016. Click image to enlarge.
We expect a similar improvement in ROIC for Hilton as they are now in a similar position as Marriott International was in 2011.
Increasing Market Share
The new Hilton generates revenue in two ways. The first is through management contracts with the following set-up:
- a base fee, which is a percentage of each hotel’s gross revenue
- Outside of the U.S., fees are often more dependent on hotel profitability measures
- One-time upfront fees upon execution of certain management contracts
- A monthly fee based on a percentage of the total gross room revenue that covers the costs of advertising and marketing programs; internet technology and reservation systems expenses; and quality assurance program costs.
The second way Hilton generates revenue is through Franchise agreements.
- Franchisees pay franchise fees which consist of initial application and initiation fees for new hotels entering the system and monthly royalty fees, generally calculated as a percentage of room revenues
- Franchisees also pay a monthly program fee based on a percentage of the total gross room revenue that covers the cost of advertising and marketing programs; internet, technology and reservation system expenses; and quality assurance program costs.
Both revenue streams are driven by total rooms available, the average daily rate, and the occupancy rate. Adding more rooms while maintaining the average daily rate and occupancy rate will increase Hilton’s revenues.
Currently, Hilton has a 4.8% global market share of hotel rooms. Of the hotel rooms under construction Hilton has a 21.5% market share. Hilton’s overall room count is growing and its global market share is increasing.
From Company Presentation March 1, 2017. Click image to enlarge.
Large Capital Return to Shareholders
An asset light business does not need a lot of capital reinvestment to grow the business. This is a very attractive feature for investors because the company returns excess capital to shareholders through dividend increases and share buybacks.
From Company Presentation March 1, 2017. Click image to enlarge.
Right after the three-way spin-off transaction, Hilton Inc. announced its first buyback program. Hilton will buy $1 billion worth of shares. At Hilton’s current price, this about 5% of shares outstanding.
Pre-Mortem (Potential Risks to our Thesis):
Cyclical
Travel, both for leisure and business, tends to follow the business cycle. One of the first costs to get reduced during a recession is travel costs. Individuals will take fewer and/or less expensive trips. Companies will look to scale back how many people in their organization will travel and how much they will spend on business travel.
By spinning off its real estate holdings and focusing on franchise fees and the management contract. Hilton has removed some of the cyclicality of its earnings. The restructuring smooths its revenues out over the full business cycle but a portion of Hilton’s revenues is based on the gross dollar volume from each room. Less travelers leads to less gross dollar volume spent and less revenue for Hilton.
The current bull market is in its 8th year along with the current economic expansion. Any upcoming downturn will affect our recent investment in Hilton but a recession will affect all of our positions. If the company is a high-quality business that generates high returns on capital over a full business cycle, then we would likely seek to add to the position during any prolonged downturn.
AirBnb
AirBnb is a platform from which homeowners can rent out a room or a whole house to travelers. The concern and/or the current hype is that AirBnB will disrupt hotel businesses in the same way that Uber and Lyft are disrupting the Taxi business.
There is a big difference between platforms like Uber and Lyft versus AirBnb. The car share platforms are competing against a business, Taxis, with high prices and terrible customer service. The hotel industry, especially companies like Marriott and Hilton, already offer great service and at various price points.
Cities that are tourist destinations make a good portion of their tax revenue from hotels. For example, San Diego’s third largest driver of tax revenue is its Transient Occupancy Tax (TOT). The TOT accounts for 6% of San Diego’s tax revenue.
Taxis have their lobbying groups trying to get cities to push back against Uber and Lyft with limited success. But as soon as you mess with a city’s revenue source then the cities start pushing back. Cities are now passing legislation to limit short-term rentals like AirBnb. Cities and states are also passing laws that AirBnb has to collect taxes on the short term rentals offered on their platform. This is driving up the cost of short-term rentals and making them more in line with the cost of hotel rooms.
Short-term rental owners are trying to maximize their profits too and are pricing their rentals at rates only slightly below average hotel room rates.
AirBnb’s success is from group travelers looking to stay together and with very cost conscious travelers that are willing to stay in someone’s extra bedroom. Business travel is a large part of Hilton’s business and currently AirBnb does not target business travelers. If or when AirBnb does we’ll have to assess the effect on Hilton’s business.
Travel Bans
Hilton’s business is heavily tilted towards travel within and to the U.S. Before the spin-off transaction, the U.S. business represented over 75% of Hilton’s rooms and 60% of Revenue from Owned or leased hotels according to the 2016 10-K.
Click image to enlarge.
And 70% of Hilton’s EBITDA comes from its U.S. business.
Click image to enlarge.
If travel to the U.S. became less attractive and more restrictive then Hilton’s earnings will likely suffer.
A recent travel ban by President Trump is having a spillover effect on potential travel from other countries.
President Donald Trump’s immigration stance has begun to discourage foreign visits to major U.S. cities, threatening to cost billions of dollars and thousands of jobs.
New York, the nation’s most visited city by people overseas, predicts such trips will drop more than 2 percent this year to 12.4 million, the first decline after eight consecutive annual increases. Los Angeles and Miami may also experience decreases.
According to Adam Sacks president of Tourism Economics, Foreigners spent $250 billion in the U.S. last year. If travel drops by 4.3 million visitors as expected by Mr. Sacks then the U.S. travel industry may lose $7.4 billion in revenue.
It is still too early to assess the actual effects of the proposed travel bans (as of this writing the bans are tied up in federal courts). However, given the importance of US hotel traffic to Hilton’s business model, we must include this in our Pre-mortem assessment of risks.
Valuation:
We used an economic profit model to value Hilton Inc. since a main part of our investment thesis is a rising return on invested capital. An economic profit model is driven by Returns on Invested Capital, Invested Capital and the Cost of Capital.
Economic Profit = Invested Capital * (Return on Invested Capital – Weighted Average Cost of Capital)
First, we estimate Hilton’s capital need for the next 10 years. Then we use Hilton’s current capital structure (debt and equity) to derive their Weighted Average Cost of Capital. From here we use our base case estimate of return on invested capital (30%) for Hilton over the next 10 years and calculate each year’s expected economic profit. Finally, we discount back each year’s economic profit and sum it to arrive at a present day value.
We then do a couple balance sheet adjustments, add cash and remove debt, to arrive at a per share equity value.
Using our economic profit model we estimate Hilton’s fair value per share to be $70. This is our base case. If Hilton can increase its ROIC further then Hilton will be worth even more.
All previous letters are archived here.
¹Example from Thinking, Fast and Slow by Daniel Kahneman
