This post by Matthew Haynes has been excerpted from a letter of 1949 Value Advisors.
As bottom-up investors, individual security selection is the most important driver of portfolio performance. Positions that had the largest negative impact on performance during the quarter were Birchcliff Energy (-1.5% contribution), Anglo American plc (-0.5% contrib.) and Michael Kors Holdings (-0.2% contrib.). Birchcliff Energy is the single largest position in your portfolio (approx. 9%) and, as a result, has an outsized impact on portfolio performance. This will be a good thing in time but has been a drag so far this year.
The seeds of great investment opportunities are often planted during periods of unfavorable near term business conditions. The current abundant supply of natural gas – and the impact that oversupply has on pricing – is reason enough for most investors to ignore Birchcliff Energy and its entire sector. To wit, natural gas is among the market’s most loathed sectors, which is typically fertile ground for value hunters like us. But as one of Canada’s lowest cost producers, Birchcliff is able to remain cash flow positive even at depressed spot prices. For this reason, we are quite confident in Birchcliff’s financial future. Our thesis is not predicated on a rising natural gas price, although it is not unreasonable to believe that might happen over our investment time horizon. We are instead compelled by Birchcliff’s massive resource base and our confidence in management’s ability to continue to profitably grow production by 10-15% annually for many years. Their low costs are a significant competitive advantage and should help provide a margin of safety against permanent capital loss under almost any pricing environment, especially at today’s deep discount to liquidation value.
Shares in Anglo American plc fell 16% during the second quarter, as the company reported mixed Q1 production results and the South African government released its revised Mining Charter. The Charter updates previous measures intended to benefit the historically disadvantaged black majority with a share of economic profits. It impacts Anglo American more than other diversified miners as it derives approx. 40% of its EBIT from South Africa. During lunch with the CEO of majority controlled Anglo Platinum in June, we had the opportunity to discuss the Mining Charter at length, as well as their ongoing rationalization of South African platinum assets. Anglo American has a unique suite of attractive mineral assets that have greatly benefited from restructuring over the last four years. Overall production is 8% higher over the period, while unit costs are 31% lower, resulting in significant free cash flow generation and a reduction in net debt.
Michael Kors Holdings shares declined 4.9% during the period, as the company reported disappointing quarterly results and lowered expectations for the current period. Same-store-sales declined 13.6% on a constant currency basis, negatively impacting EBIT margins by 6.2%. While this fiscal year will prove difficult for the company as it reduces promotional activity, this should start to bear fruit next year along with increased contribution from the faster growing men’s and footwear segments.
Positions that favorably impacted performance during the quarter include Samsung Electronics (+0.9% contrib.), Western Digital (+0.6% contrib.) and Industrias Bachoco (+0.5% contrib.). Global technology stocks continued their strong year-to-date performance during the period, with shares in Samsung Electronics advancing 15% during the second quarter in advance of the company reporting its highest quarterly profit in company history. Shares in Samsung have doubled in value since our initial purchases in July 2015, but this has been matched by an equivalent doubling in Samsung’s operating profit over the same period. Unusually strong demand for DRAM and NAND flash memory continues to drive pricing, and Samsung’s new Galaxy S8 is helping to lift Smartphone average selling prices (ASP’s) by approx. 30%. In addition, Apple’s iPhone 8 will use flexible OLED (organic light-emitting diode) screens manufactured by Samsung, further driving Samsung’s record profitability. Lastly, corporate governance continues to improve as the company will cancel all shares held in Treasury and announced the return of 50% of its free cash flow in dividends and share repurchases going forward.
Despite the notable strength in Samsung shares, we see 30% further upside to our conservative price target of 10x earnings plus approx. $60 billion in net cash, or 20% of today’s market capitalization.
Shares in Western Digital (+7.9% in Q2) continue to ride the triple wave of strong demand growth and pricing for flash memory, margin expansion from cost synergies being realized from two recent acquisitions, and continued deleveraging of their indebted balance sheet. The company has been engaged in a bitter battle with its JV partner Toshiba Corp. of Japan over Toshiba’s sale of its memory subsidiary. Western Digital has been pursuing legal action to protect its consent rights under the JV agreement, in the event of a sale of the division. Toshiba has announced their preferred bidding group to include two domestic Japanese entities alongside Bain Capital and South Korea’s SK Hynix, which is of grave concern to Western Digital from a competitive intelligence standpoint.
Industrias Bachoco (+8.5%), Mexico’s largest poultry producer, modestly helped Q2 performance after reporting strong results, showing its ability to raise prices to offset rising grain costs. Our meeting with Bachoco’s CEO in NYC in mid-May reinforced our favorable opinion of the company and our belief in their long term prospects. With net cash exceeding 20% of its market capitalization and shares modestly priced for what we believe is one of Mexico’s top food companies, we remain optimistic about Bachoco’s future.
The performance results for the 1949 International Value Strategy set forth herein are model results and not based on the performance of actual portfolios managed by 1949 Value Advisors (the “Investment Manager”). The performance results were obtained through the use of Bloomberg’s proprietary software and represent the simulated returns of a secondary strategy the Investment Manager is honing alongside its primary strategy. The results do not reflect fund or account-level investment expenses, administrative, operating expenses or management fees. A fund or account managed by the Investment Manager will be subject to asset based management fees, and would incur significant investment and administrative/operating expenses; these fees and expenses would significantly reduce the returns of an actual investment due to compounding and other effects. These performance results do not represent actual trading and are not an indication that the performance of any fund or account managed with this strategy will be similar in any way. This summary does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made to qualified investors and only by means of an approved confidential private offering memorandum or investment advisory agreement and only in those jurisdictions where permitted by law. This summary reflects select positions of the current portfolio of a managed account advised by 1949 Value Advisors. There is no guarantee that a commingled investment vehicle or another investment account managed by 1949 Value Advisors will invest in the same investments set forth in this summary. The investment approach and portfolio construction set forth herein may be modified at any time in any manner believed to be consistent with the managed account’s overall investment objectives. While all information herein is believed to be accurate, 1949 Value Advisors makes no express warranty as to the completeness or accuracy nor does it accept responsibility for errors appearing in the summary. This summary is strictly confidential and may not be distributed.