WE INVEST IN QUALITY ENDURING BUSINESSES
STRATEGICALLY POSITIONED IN ATTRACTIVE INDUSTRIES
RUN BY STRONG MANAGEMENT TEAMS.

Our company, Broadview Advisors LLC, is a 100% employee-owned SEC-registered investment advisor based in Milwaukee, Wisconsin.  Established in 2001, our seasoned investment team focuses on core growth strategies through bottom-up fundamental analysis.

We manage assets for domestic institutions and individual investors through our registered mutual fund, the Broadview Opportunity Fund (BVAOX), a private pooled vehicle, and separately managed accounts.

 
 


FIVE PILLAR ANALYSIS

We are opportunistic, special-situation investors.  We believe companies of all sizes and characteristics are periodically mispriced for a variety of reasons.  Repeatedly applying our time-tested investment process, along with a valuation sensitive sell discipline, yields the best opportunity for superior risk-adjusted returns over a market cycle.

  1. STRONG BUSINESS TRAITS

    High level of recurring revenue, return on investment capital, controllable destiny

  2. DEFENDABLE MARKET NICHE

    Strategic value, barriers to entry, difficult to duplicate

  3. ATTRACTIVE GROWTH POTENTIAL

    2-3 year time horizon, company owners not stock renters, across all industries

  4. CAPABLE MANAGEMENT

    History of successful strategic decisions, effective use of free cash flow, aligned with shareholders

  5. DISCOUNT TO PRIVATE MARKET VALUE (PMV)

    Substantial discount at purchase, risk control, requires patience and discipline

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THE BROADVIEW TEAM

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BROADVIEW STRATEGIES

We manage two strategies differentiated by capitalization boundaries.  Both adhere to the same investment philosophy.  Our investment team applies the same rigorous research process to all companies we include in our portfolios.

SMALL CAP STRATEGY

The Small Cap strategy is our hallmark strategy.  This strategy invests in companies with market capitalizations between $500 million and $3 billion at the time of purchase.  The Broadview Opportunity Fund (BVAOX) employs this strategy.  More>>

ALL CAP STRATEGY

The All Cap strategy invests in companies without respect to capitalization boundaries.  This allows us to employ our disciplined approach to investing no matter where we find opportunities.  More>>

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THE BROADVIEW®

THE BROADVIEW:


"Houston, We Have a Problem."
Twenty Years and Going Strong
Realogy Holdings Corp. (RLGY)
Acadia HealthCare Company, Inc. (ACHC)
Veeco Instruments Inc. (VECO)
Disclaimers

"Houston, We Have a Problem." – Jim Wenzler, CFA

“Houston, we have a problem.”  Those famous words were actually misquoted from the April 4th, 1970 mission to the moon’s surface.  The actual quote was “Okay, Houston, we’ve had a problem here” and it was John Swigert, Jr. who said it and not James Lovell who usually gets credit for it.  I use the phrase to describe the current state of the active management industry.  Passive investments have seen a huge inflow of assets over the last decade as witnessed by the record amount of assets moving into Vanguard Funds(1). It is just one anecdotal point to show the popularity of passive investment management.   To put in perspective how much money has poured into passive funds representing the S&P 500, in 2005 S&P 500 index funds owned only 5 companies where they had a five percent or greater control.  By June 30th of 2016 that number had ballooned to 468!(2)  The question that begs itself is whether or not the active management industry has a structural or cyclical problem.  I maintain it’s a little of both.  

As 2016 came to a close I was reminded of the period that ended the Dot-Com era.  From 1996 through 1999 all you needed to do was buy an index fund and forget it – until the Dot-Com market collapsed and passive investments felt the full brunt of the drop.  Today’s market doesn’t resemble the extreme valuations like those in the Technology sector in 1999 but today’s market is not cheap by historical standards either as evidenced by the research done by the Leuthold Group in Chart 1.

What’s been behind this flood into passive investments?  Investors have a choice between active or passive investing and passive investing has been winning the day.  In fact, the Morningstar Small Blend category where Broadview invests, has underperformed the Russell 2000 on a one, three, and five-year basis for the period ending 12/31/16(3). Emotion plays a big part in investing so when you see something else outperforming you for such a long period of time, you can easily justify a switch into the “past” winner, especially when the fees are lower.  I emphasize “past” since its critical to understand the success of using past performance as an arbiter of future returns.  Charles Ellis wrote in his book Winning The Loser’s Game, “While Morningstar candidly admits that its star ratings have little or no predictive power, 100 percent of the net new investment money going into mutual funds goes to funds that were recently awarded five stars and four stars.  This is too bad for investors because careful research concludes the ratings are not working: There is little statistical evidence that Morningstar’s highest-rated funds outperform the medium-rated funds.”(4)

Should you make investment decisions based upon what worked in the past or what you think will excel in the future?  The past has been a period lead by an artificially low interest rate policy with the intent to stimulate growth.  It was also a period of excessively onerous regulations put on industries across all the US but especially the banking sector from the Dodd Frank Bill.  Companies struggled for top line growth and instead used this period to streamline operations, improve their balance sheets, and hoard cash.  Fortune magazine had an informal online survey recently of CEOs that ask the question, “Do you agree or disagree with the following: It would be easier to manage my company if it were a private company rather than a public company.” In the preliminary results, the message is clear: 77% agreed with the statement(5).

Which brings us to the current environment.  The Trump administration is predicted to be the polar opposite from the last eight years based upon early analysis of the goals and objectives of the new administration.  Some of the key tenets and results if Congress and the Executive branch implement their policies are:

1-reduced regulation on business
2-lower corporate taxes
3-tax repatriation
4-stronger dollar
5-infrastruture spending bill
6-higher interest rates

The last point will be a function of the economy and how well it does with less regulation.  Slowly rising yields and an upward sloping yield curve will greatly benefit banks that rely on profits from net interest margins.  In an environment where the dollar is stronger companies whose revenues are domestic based won’t be affected by a rise in the dollar. Each of the other items above should benefit domestic based companies over companies that trade around the world.  Should some or all of these occur, it should lead to an overweight in small cap companies that are US based and earn their profits from other US based companies.

If this is the assumption, then why not just index in small cap?  Primarily two reasons: liquidity and valuation.  The market for small caps is not cheap by historical standards (Chart 1) so having a nimble stock picker in your camp should help.  While holding cash was a drag on investment return over the last cycle starting in 2009, it invariably will be an asset if the eight-plus year bull market recovery rolls over.  If the market were to roll over, the index funds will have to sell shares of very illiquid individual holdings that make up the index.  An active manager, with a savvy trading desk, can be nimbler when buying and selling positions.  

To summarize, active and passive investing go in and out of favor.  And it is far more prevalent in larger cap companies with little or no liquidity problems.  The challenge for investors is to put emotion to the side and attempt to make decisions based not on past performance but on future expectations.  At Broadview Advisors we have just completed our twentieth year of managing our small cap strategy that has witnessed numerous Presidencies, market cycles, interest rate environments, wars, and recessions.  Our resolve to apply our five pillar analysis hasn’t wavered throughout the duration.  Below is a chart of our performance throughout that entire period we have managed our client’s assets.

Our performance has gone through cycles that have closely correlated to the business cycle.  Towards the end of the business cycle we tend to underperform as markets become more narrow in focus and expensive in price and have extended periods of outperformance after markets have corrected.  Our opinion is that under the new administration, if the items suggested by the Trump agenda were to occur, it will extend the duration of this bull market by recharging the economy and in effect, create a new business cycle.  Meanwhile our cautious approach to valuation will force us to be ever mindful of not overpaying for companies we buy.

Twenty Years and Going Strong – Rick Lane, CFA

On December 31, 2016, the Broadview Small Cap Composite celebrated its twentieth anniversary. At its launch, I had no idea what a wild ride this would be. The Composite’s first full year, 1997, proved particularly strong as our major holding, Bucyrus International (Milwaukee based mining equipment manufacturer) was bought out at a substantial premium.  We were off to a great start, and as they say, the rest is history.

Along the way, we faced many market and economic challenges: the “Asian Contagion” and fallout from the Long Term Capital collapse in 1998; “Y2K” hysteria heading into the year 2000; the bursting of the internet bubble in 2001; the general outsourcing of manufacturing to China and IT to India; the 2002 recession; the financial meltdown and subsequent recession in 2008-2009; and regulatory over-kill in many industries, particularly financial services over the last decade. We endured the financial fallout from the terrorist attacks on September 11, 2001 and two wars in the Middle East. A President was impeached. Oil prices spiked to $145 a barrel in 2008, only to plunge to $26 in early 2016.  During this time, the S&P 500 suffered a 47% decline (2000-2002), a 101% increase (2002-2007), a 57% decline (2007-2009), and a 236% increase (2009-2016).

The various events and calamities highlighted above certainly challenged the Broadview Team, but I am quite proud of the way we responded. This has been a team effort all along. Building the team and watching them perform has been one of the most satisfying facets of my life. They helped me refine our process and philosophy over twenty years. All four portfolio managers are owners of the business. I feel they have inherited and embraced my passion and will carry it on long after I retire (no time soon, I hope).  On behalf of the team, I would like to take the occasion of the twentieth anniversary to make a few very important, long-term observations.

Our first observation is styles come in and out of vogue. In some years, growth investing outperforms and in other years, value investing does.  In some years, small capitalization investing outperforms and in other years, large capitalization investing does.  Many investors, professional and otherwise, chase what is working at the time. That typically ends in disaster, as no one proves prescient enough to consistently make these calls. The market often behaves like a tornado, twisting and turning, crushing those in its way. Only those with disciple, patience, and a solid philosophy can avoid the market cyclone.

The Broadview team embraces these principles even when it means being out of favor. Often, being out of sync with the market can last two to three years. That has certainly been the case recently with us. Our outperformance over the past twenty years notwithstanding, we have suffered a handful of such periods. Yet, since inception, it has worked out well for our investors.

The second observation concerns what investors should know about us and rightly expect from us. We expect to outperform our benchmarks over the course of one or two cycles. There is a nuance which is a direct manifestation of the fifth pillar of our Five-Pillar investment process (discussed below). This pillar states that we seek new portfolio candidates selling at a significant discount to private market value.

Private market value is our estimate of the price a company would likely receive in a buyout. In the early and middle stages of a business cycle, we can always find plenty of candidates to fill our portfolio. But as the cycle matures, our valuation discipline makes it challenging to replace the holdings we sell because they have reached their price objectives. Another way to think about this is that we love buying in economic downturns, when investors lose faith and are willing to sell for less. Late in a cycle, as we reach the peak of an upturn, equities tend to get expensive.  During this time, our cash position builds as a byproduct of our valuation discipline. This has historically left us in an advantageous position as the market rolls into a downturn. The upshot is that we tend to outperform quite strongly in the early and middle stages of a cycle, and then tend to lag as the cycle matures.

The third observation is that we have a very opportunistic mindset and contrarian bent. Expectations—both good and bad—get built into stock prices and are often overdone. After two strong quarters in a row, Wall Street is typically convinced a stock is a perpetual growth stock. However, the opposite is equally true, which typically leads us to opportunity. We consider Wall Street the “straight line extrapolators.” We look to exploit that short-term view. We focus on what we expect the business will look like several years out, not next week. This approach means that we often buy a company after a disruption to their business that our research suggests is not permanent, but merely temporary.

The fourth and final observation is really a review of our Five-Pillar process. Iterative in nature, our process has been refined and improved over time, but the modus operandi has not changed throughout our history.

THE FIVE PILLARS

STRONG BUSINESS TRAITS  Companies with high level of recurring revenue, return on investment capital and can control their own destiny (i.e. not overly regulated or commodity-centric).
DEFENDABLE MARKET NICHE  Companies with strategic value, high barriers to entry and business lines that are difficult to duplicate.
ATTRACTIVE GROWTH POTENTIAL  Companies with growth potential over a two to three-year time horizon. We prefer to own (long-term investment) rather than rent (short-term investment) companies.
CAPABLE MANAGEMENT TEAM   Companies with management teams with a history of successful strategic decisions that employ effective use of free cash flow.  We value management teams whose interests and compensation are aligned with shareholders.
DISCOUNT TO PRIVATE MARKET VALUE Companies that are trading at a substantial discount to our calculated private market value (i.e. what someone would pay to purchase the company) at the time of purchase.  This is our most important risk control, demanding patience and discipline.

We continue to employ our disciplined Five-Pillar process in managing accounts in the Broadview Small Cap Composite and believe it yields solid opportunities such as the companies discussed below.

Realogy Holdings Corp. (RLGY) – Sam Koehler

Realogy Holdings Corp. is a new financial sector holding that operates the nation’s largest residential real estate brokerage and real estate brokerage franchisor.  The company’s well-known brands have a deep history and include Century 21, Coldwell Banker, Sotheby’s International Realty, Better Homes and Gardens Real Estate, and ERA Real Estate.  Owned brokerage operations are focused in higher value metropolitan real estate markets that offer significant operating leverage.  The franchise services division has a broad, nationwide footprint and earns high margins due to the low cost franchise structure.  Additionally, relocation services and title settlement and services are two ancillary business operations that are highly complementary.  

Realogy has struggled in recent times due to two main headwinds: a slower high-end housing market and simultaneously competitive recruiting pressures.  While lower and mid-value housing markets have performed well over the past year, Realogy’s owned brokerage network is heavily skewed toward higher priced real estate in the broader New York metropolitan statistical area, California, and Florida markets that have had slower sales.  With election uncertainty behind us, we believe there is a more business-friendly environment, potential for lower taxes, and higher equity valuations.  These should assist the high-end housing market.  To combat competitive recruiting headwinds, management has become more aggressive in response to competitor agent poaching.  Investments to retain top agents will cause some margin split degradation, but should result in greater agent retention and revenue stability over time.  In addition, Realogy has added several new executives focused on driving better recruiting, growth, and efficiency.  The stock return will depend significantly on these efforts to return the owned brokerage network back to EBITDA (earnings before interest, tax, depreciation and amortization) growth.

With a deep-rooted history as a leader in real estate brokerage, Realogy has a durable position but continues to innovate with strong technology offerings.  The most recent example is the roll-out of ZipRealty’s fully integrated Zap platform that features locally branded websites, a customer relationship management system, digital marketing, and more tools that are at the forefront of residential real estate brokerage.  While potentially higher future mortgage rates could constrain home sales growth, Realogy only has exposure to the purchase market, not mortgage refinance market.  Home sales are still significantly below the historical peak and we feel there is strong potential for higher future home sales, regardless of moderate changes in rates.  Financially, Realogy is non-balance sheet intensive and we believe generates strong free cash flow.  Cash is being used to reduce leverage, execute small bolt-on acquisitions, pay a dividend, and repurchase stock.  The management team’s long history, including CEO Richard Smith who has been with Realogy since inception at Realogy’s former parent company, gives us confidence that the right team is in place to weather the recent storm and return to strength.

Acadia HealthCare Company, Inc. (ACHC) – Aaron Garcia, CFA

We recently initiated an investment in Acadia Healthcare Company, a health service company that provides behavioral healthcare in the United States and the U.K.  Acadia, based in Franklin, Tennessee, is the market leader for behavioral health services in both of these geographies, with a sizable and growing geographic footprint across each platform. With a large addressable market, strong industry tailwinds, and an aggressive merger and acquisition strategy, we believe Acadia is poised to grow faster than private peers, thereby generating positive returns for investors. In the U.S., Acadia owns and operates acute inpatient psychiatric facilities, specialty treatment facilities, residential treatment centers, and outpatient community based services. These segments are broken down by the severity of the patient’s situation. Within the U.K., Acadia owns and operates a general healthcare segment which combines rehab, recovery, and acute services; adult care for those suffering from mental illness; education and childhood services; and a general elderly care segment.

In 2016, Acadia’s stock underperformed due to a weakness in the British pound and the delay of cost synergies associated with a large acquisition. Despite these issues, we believe the company’s vision remained intact. Acadia’s UK presence will continue to benefit from the outsourcing of behavioral health services. In the U.S., there remains a growing need for more beds. Expanding organically within existing facilities generates high returns on capital employed, with little operational risk.

Acadia has seen average revenue growth over 60% during the last four years, as they have positioned themselves as the market leader in the “pure play” behavioral health industry. Finally, the management team is capable in our opinion and has a long tenure in the industry. We believe they are positioned for a successful return in 2017.

Veeco Instruments Inc. (VECO) – Faraz Farzam, CFA

The investment case for Veeco is centered on a dramatic shift in the global lighting industry.  Veeco is currently our largest investment in the Information Technology sector.

“After the electric light goes into general use, none but the extravagant will burn tallow candles.”

I was struck by one of Thomas Edison’s least well known but rather clairvoyant quotes as I came across a Pomegranate Noir Luxury Candle by Jo Malone London on Bloomingdale’s website priced at $470. One of the luxuries of modern civilization is the availability, abundance, and ubiquity of lighting. None of us think much about it until an incandescent bulb inevitably and inconveniently burns out.

Edison patented the incandescent bulb in 1879, revolutionizing industry and, indeed, everyday life. It was not until 1939 that the next great innovation in lighting appeared at the New York World’s Fair, the fluorescent lightbulb. These lamps lasted longer and were three times more efficient than the incandescent bulb.  According to the Department of Energy (“DOE”), by 1951, more light was produced by linear fluorescent lamps than by incandescent bulbs. It wasn’t until the 1980s that compact fluorescent lights (CFL) were available for residential applications. Which brings us to the LED or Light Emitting Diode. Invented in 1962, LEDs are essentially semiconductor-based technology that turn heated diodes into light. The first LEDs emitted Red light followed by pale yellow and green diodes.

Initially, LEDs were used in calculator displays and other small electronic goods in the 1970s. To make LEDs an option for general lighting, researchers had to first develop white LEDs and then drive down cost and efficiency. According to the DOE, since 2008, the cost of LED bulbs has dropped more than 85%. Today, LED bulbs are six-to-seven times more energy efficient than incandescents and cut energy use by more than 80%, lasting 25-times longer in the process.  

LED chips used to be relegated to such things as traffic signals, car tail lights, videogames and refrigerator case displays. Now there are nearly 500 billion LED chips produced annually. We believe LED chip demand today is driven by LED lighting applications, which consume roughly 40% of total LED chip demand. Another 40% of demand is driven by display and backlight applications for devices such as LCD TVs and mobile phones. The other 20% of demand comes from applications such as signage and automotive lighting. We estimate the global lighting market today is roughly $80 billion to $100 billion, with LED lighting representing roughly 22% of the market.

We expect LED chip demand to grow at low-double digit pace for the next five years, driven primarily from LEDs used for lighting applications. We believe robust demand for LED lighting units will offset LED applications that have already reached almost 100% penetration rate in display applications for cell phones, smart phones, PCs, notebooks and LCD televisions.

We believe LED lighting will become more widely adopted as prices decline, efficiency improves, and smart lighting helps improve the long-term payback. In turn, we believe the LED lighting market will be driven by the speed of converting the existing installed base to LED lights and new construction opportunities that support demand for LED lighting. We believe LED lighting demand will come from applications for indoor locations such as offices, schools, and hospitals, and outdoor locations such as street lights and parking garages. In 2012 alone, more than 49 million LEDs were installed in the U.S., saving about $675 million in annual energy costs. As prices continue to drop, LEDs are expected to become a common feature in homes across the country.

LEDs have rapidly commoditized. The price declines required for large scale adoption of LEDs in new builds and replacement in the sizeable installed base of CFL and incandescent bulbs places the industry at odds with our first two investment pillars (Strong Business Traits and Defendable Market Niche).  However, the investment case for the equipment makers is vastly more interesting.  The last major equipment vendor is Long Island, New York based Veeco Instruments.

Veeco makes Molecular Oxide Chemical Vapor Deposition (“MOCVD”) reactors. Although a mouthful, an MOCVD reactor is the essential capital equipment, or tool, in the complex process of making LEDs. We could “get into the weeds” of this process, but we will spare our readers. What is critical to understand is that Veeco is soon to be the dominant player in the industry. In December 2015, Veeco’s main competitor, German conglomerate Aixtron SE, received an unprecedented order cancellation for 50 of its MOCVD systems from Chinese LED equipment maker San’an Optoelectronics due to the system’s failure to meet qualification requirements. Shortly after this cancellation, Aixtron put itself up for sale in the wake of financial distress.

Although Chinese investor Grand Chip Investment Fund LP was able to acquire the company in May 2016, as of our writing this piece, it appears the German government may not allow the sale for national security reasons. In either case, we expect Veeco’s market share to grow from an already dominant 65% to as high as 85%! This is Intel-like market dominance. We also believe, based on the preliminary fourth quarter results, that the long depressed market for MOCVD reactors is about to begin a new cycle. Furthermore, Veeco is well into a cost cutting and manufacturing rationalization initiative that should drive profitability as revenues recover.

In our opinion, the company has a solid balance sheet with nearly $400 million in net cash and we believe substantially higher earnings power than Wall Street expects. At the peak of the last industry cycle in 2011, with Veeco at 40% market share, the company earned over $5.00 per share. We conservatively estimate earnings power to be roughly $2.00 per share in this cycle. With no competition to speak of, this estimate may prove to be overly conservative. Even assuming $2.00 however, we believe that places the private market value for the company in a takeover at roughly $40 per share.  The stock currently trades around $27.


1  “Vanguard Group’s Passively Managed Mutual Funds Dominate Net Inflows for 2016”, Lipper Alpha Insight, 1/20/2017, Patrick Keon.  “Morningstar Direct Asset Flows Commentary: United States”, 8/12/2016, Alina Lamy

2  Wall Street Journal analysis of data from Morningstar (fund and stock ownership)

3  Morningstar database, small blend category vs the Russell 2000

4  “Winning the Losers Game”, Charles Ellis, 2013, p. 126

5  Fortune Magazine, May 17th, 2016, Geoff Colvin, “Take This Market and Shove It”

Disclaimers – Broadview Advisors, LLC

Broadview Advisors, LLC is an SEC-registered investment adviser.  The information contained herein is for general informational purposes only and does not constitute a solicitation or an offer to sell investment advisory services in any jurisdiction.  The views and information discussed in this commentary are as of the date of publication, are subject to change due to shifting market conditions and other factors, and may not reflect the writers’ current views.  The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding particular investments, sectors or markets in general.  Specific securities discussed herein are intended to illustrate our investment style and do not represent all of the securities purchased, sold or recommended for client accounts.  Such information does not constitute, and should not be construed as, a recommendation to buy or sell specific securities.  Past performance does not guarantee future results and it should not be assumed that any investment will be profitable or will equal the performance of any securities or sectors mentioned herein.  Certain information contained herein may be derived from third-party sources and is believed to be reliable and accurate at the time of publication.

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