My Investment Thesis on Emperor Entertainment Hotel

December 13, 2018 in Best Ideas 2019, Equities, Ideas

This article is authored by MOI Global instructor Brian Grosso, portfolio manager at JBF Capital. Brian will present a new idea (not the idea below) at Best Ideas 2019.

I wrote the thesis below last month. My views on Emperor Entertainment Hotel (HK: 296) remain the same, my position has not changed, and the stock is still available at a cheap price.

I believe Emperor Entertainment Hotel stock is a weighted coin. The stock is extremely cheap — if the assets were sold tomorrow I estimate the proceeds would be four times the recent stock price.

The main reason the stock is discounted is concerns about governance, but if we focus on how insiders have actually behaved, they’ve treated investors well.

That discount has been compounded recently by the bear market in China and Hong Kong, and Macau gaming stocks have declined more than the indices.

Even if Macau gaming activity declines and Emperor’s assets underperform, unless insiders behave unfairly, it’s hard to find downside in the stock and the upside is multiples of the current price.

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Asset-Based Investing in an Earnings-Focused World

December 11, 2018 in Best Ideas 2019, Best Ideas Conference, Deep Value, Equities, Letters

This article is authored by MOI Global instructor Amit Wadhwaney, Portfolio Manager and Co-Founding Partner of Moerus Capital Management, based in New York.

Moerus Capital employs a fundamental, bottom-up investment process, with the goal of investing in assets and businesses at prices representing significant discounts to our estimates of intrinsic value, all the while placing heavy emphasis upon risk avoidance and mitigation. Importantly, the risk that we seek to mitigate is not short-term share price volatility, but rather the risk of a permanent loss of capital. In fact, we embrace short-term share price volatility as a provider of periodic opportunities to invest in what we believe are high-quality assets or businesses at bargain prices. We believe that buying as cheaply as possible is critical both to risk mitigation as well as to the potential generation of attractive long-term returns.

In striving to buy as cheaply as possible, we estimate intrinsic value using very conservative estimates that weigh a company’s balance sheet and what is known today much more heavily than projections of future earnings and cash flow, which may or (may not) materialize. In other words, as a general rule of thumb, we try to buy shares of businesses at sizeable discounts to what we think that they would be worth if they sold their assets today, using conservative assumptions. The asset-based investment approach that we follow at Moerus stands in contrast to the approach of many in the investment community who tend to focus more heavily on earnings and cash flows.

Our estimates of a company’s intrinsic value generally do not heavily weigh forecasts of cash flows years into the future, simply because we believe the future is notoriously, inherently difficult to predict. We are not willing to “pay up” for businesses at prices that would only be attractive under optimistic assumptions of continued prosperity years into the future. By contrast, we believe that a conservative, asset-based valuation methodology often yields a “ bedrock” (lower -bound) valuation, and that buying at a steep discount to such a bedrock valuation provides a cushion that not only provides downside protection, but also offers meaningful upside potential in the event of favorable future outcomes, which typically aren’t “priced in” to the stock at such beaten down levels.

Implications of the Asset-Based Approach

Our approach to investing has several noteworthy implications regarding which type of situations tend to find their way into the portfolio, and why.

What’s the catch?

At Moerus, we search for high-quality, long-term investment opportunities which are available at attractive prices relative to what we believe their net assets are worth today – without attributing any value whatsoever to forecasts of earnings or cash flows, visions of the future which are far too often seen through rose-colored glasses. One implication of our approach is that, at the risk of stating the obvious, such opportunities do not come easily or often – alas, there is usually “a catch,” or something “wrong” which drives pricing down to the unusually attractive levels which pique our interest. Common examples of what might be “wrong” include, among others, a challenging short- term outlook facing a company’s relevant industry or geography, or a company-specific misstep or hiccup that results in share price declines.

For traders and investors with very short time horizons, near-term uncertainty and turmoil might rule out any such investment. But our long-term focus allows us to look past temporary rough patches that render a company, industry or geographic market out of favor in the broader market as they often prove to be interesting sources of longer-term investment opportunity, provided that the turmoil is indeed temporary, and the potential investment has the staying power and wherewithal to survive tumultuous times and thrive if, as and when the situation normalizes.

Unappreciated, Misunderstood, or Event-Driven

In addition to situations involving short-term (but temporary) turmoil, asset-based investing has also often led us in the direction of two other scenarios that sometimes lead to atypically attractive investment opportunities. First, companies that are underappreciated, underfollowed, complex and/or misunderstood occasionally provide interesting opportunities, in part because fewer eyes are examining and recognizing the value that may (or may not) be present within the business in question. Second, opportunity periodically can be found in situations in which there is hidden value that could potentially be unlocked through event-driven scenarios; examples of these include liquidations, corporate reorganizations, mergers and acquisitions, and changes in industry or shareholder structure, among others.

Deep Value and Emerging/Frontier Markets: Compatible… at Times

Another implication of our asset-based investment approach is that while opportunities to implement it in emerging and frontier markets are apt to be sporadic and infrequent, occasionally compelling balance sheet-based investments can and do become available at attractive prices in even these markets, which traditionally have not been considered a welcoming destination for deep value investors. Notwithstanding the bloodletting currently taking place in many emerging and frontier markets, in general these markets have historically appealed to growth investors due to their attractive growth potential relative to that offered by more mature markets. Simply put, many investors have historically been willing to pay up for the future – in the form of expected future growth – in emerging and frontier markets, whereas at Moerus we look for bargains here and now, based on our estimates of the net assets on the balance sheet today. Partly as a result of this dichotomy, the predominance of investors who are willing to pay for projected future earnings growth in emerging markets has, in our view, generally translated into less frequent opportunities for the asset-based value investor such as Moerus.

However, the very fact that these markets are heavily populated by growth investors provides us, from time to time, with intriguing investments that fit our approach. Examples of situations that could create such opportunities include the following:

• Quarterly earnings disappointments, or revenue growth figures that fall short of what had heretofore been lofty expectations – the kind that are typical of many emerging market securities during the good times – might result in growth investors heading for the exits, leading to a plunging stock price.

• Broader macroeconomic slowdowns and turmoil could be particularly punishing to investors in emerging markets given the growth bent of many who typically invest there. Amid the ensuing rubble, even previously well-loved gems can sometimes become available at compelling prices.

A final important point to make on this subject is that share price declines in emerging and frontier markets could be and often are exacerbated by the relative illiquidity of many of these markets. When investors flee illiquid markets, dramatic share price declines could result, potentially turning a stock that used to trade at a sky-high valuation a year or two ago into a bargain today. In sum, the main point which we’d like to make clear is that although emerging and frontier markets have traditionally been considered the preserve of the more adventurous, growth-oriented investor, we believe that compelling asset-based, deep value investment opportunities periodically can and do become available there, albeit perhaps more sporadically than in developed markets.

Patience

Given the nature of these sources of opportunity, patience is indeed a virtue when it comes to implementing an asset-based investment approach. Patience is needed to hold cash in the absence of attractive pricing and wait for quality investments to become available at truly modest prices. Once a promising long-term investment becomes available at a price that is cheap enough, patience is often required to hold (or add to) the investment, as the poor near-term conditions that contributed to the deep discount continue to run their course. Of course, patience must go along with and be backed by conviction – developed through research, analysis, and considerable reflection – that such a prospective investment has the staying power (financial, operational and otherwise) to navigate its way through temporary difficulties until its underlying value is ultimately realized.

Not for the Fashionable

The asset-based investment approach requires patience because investment opportunities available at the type of valuations we seek do not make themselves available frequently, and when they do, it is usually at a point in time in which the assets in question are underappreciated and/or out of favor. Attractive value investments, particularly those at the deep discounts to conservative intrinsic value estimates that we require, are not available whenever they are “in fashion.” In that sense, we often find ourselves looking for bargains in some of the most far-flung or “out-of-fashion” places, to which many others in the investment community for various reasons are biased against venturing. Importantly, the “far-flung places” in which we often find ourselves are not always specific geographic locations, but also include classes of companies that, for any of a host of possible reasons, by and large fall under the radar of many analysts and investors who are more earnings- based.

One such class of companies is made up of those which, at some point, execute a sale of their principal operating business (and thus their principal source of earnings), thereby becoming cashed-up in the process, but often also falling off the radar of many earnings growth-oriented analysts and investors as a result of the sale. While infrequent and sporadic, in select cases “falling off the radar” could contribute to such a dramatic effect on a company’s stock price that the business could become available at a meaningful discount to the current value of its primarily liquid net assets. A company that builds cash on its balance sheet by selling its main assets might offer an intriguing investment opportunity over the years that follow the transaction, but on the other hand, in many other cases such a transaction raises a host of red flags that must be identified in order to avoid impending investment disappointment, if not disaster. And this specific class of companies, in general, brings with it a lot of baggage in the form of issues that must be thoroughly considered and vetted before daring to invest

Summary Conclusions

• The deep value, asset-based investment approach that we apply stands in stark contrast to those of many/most investors who tend to be heavily earnings-focused.

• We believe that buying at a substantial discount to a bedrock valuation, one which is estimated using a highly conservative, asset-based methodology, provides downside risk mitigation while also offering attractive upside potential, since favorable scenarios typically are not priced in at such depressed levels.

• Attractive investment opportunities that become available at sizeable discounts to conservatively estimated, balance sheet-based intrinsic values are unusual. Typically, there must be “a catch,” or something “wrong” that has created bargain pricing.

• Common “catches” include short-term turmoil affecting a company, industry or geography, a situation that is complex or underappreciated, neglected, or misunderstood by the broader market, or event-driven scenarios which cause a business to become “unfashionable” in the minds of most market players.

• Although sporadic, compelling asset-based value investments can and do become available even in emerging and frontier markets, which have traditionally been considered the stomping grounds of growth investors.

• Companies which have sold their principal operating business(es), thereby cashing-up but losing the attention of heavily earnings-focused analysts and investors, represent one class of “unfashionable” companies that have historically offered compelling asset-based investment opportunities from time to time.

• However, a company’s sale of its primary operating business adds significant uncertainty regarding the loss of recurring income, the eventual use of sales proceeds, and the timing and nature of any potential payoff.

• Further, the ability and willingness (or lack thereof) of management to redeploy the proceeds prudently and profitably, in the best interest of all shareholders, is critical to the ultimate success or failure of any such investment. As a result, a thorough assessment and appraisal of management is critical to the due diligence process.

• Unusual bargains can sometimes be found in corners where, in our opinion, many market participants are biased against looking. Asset-based investment opportunities, in the form of companies that create value by means other than recurring earnings from continuing operations, are at times neglected in an earnings-focused world.

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Disclaimer: Any investments discussed in this letter are for illustrative purposes only and there is no assurance that Moerus Capital will make any investments with the same or similar characteristics as any investments presented. The investments are presented for discussion purposes only and are not a reliable indicator of the performance or investment profile of any client account. Further, you should not assume that any investments identified were or will be profitable or that any investment recommendations or that investment decisions we make in the future will be profitable. There is no guarantee that any investment will achieve its objectives, generate positive returns, or avoid losses. THE INFORMATION IN THIS LETTER IS NOT AN OFFER TO SELL OR SOLICITATION OF AN OFFER TO BUY AN INTEREST IN ANY INVESTMENT FUND OR FOR THE PROVISION OF ANY INVESTMENT MANAGEMENT OR ADVISORY SERVICES. ANY SUCH OFFER OR SOLICITATION WILL BE MADE ONLY BY MEANS OF A CONFIDENTIAL PRIVATE OFFERING MEMORANDUM RELATING TO A PARTICULAR FUND OR INVESTMENT MANAGEMENT CONTRACT AND ONLY IN THOSE JURISDICTIONS WHERE PERMITTED BY LAW.

Iván Martín sobre la inutilidad de las predicciones

December 10, 2018 in Miscelánea, MOI Global en Español

NOTA DEL EDITOR: Este texto es obtenido de una carta trimestral a los inversores de Magallanes Value Investors.

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Un mes antes de la celebración de la Copa del Mundo de Fútbol, aparecía un artículo en Bloomberg donde se anunciaba que Alemania ganaría la Final con un 24% de probabilidad, según el banco de inversión UBS Group [UBS].

El artículo describe cómo el banco había empleado a un equipo de 18 analistas que llevaron a cabo unas 10.000 simulaciones empleando métodos cuantitativos de computación, con el objetivo de predecir el resultado de la competición. Alemania, Brasil y España, por ese orden, formaban el trío de selecciones favoritas. Todo ello recogido en un informe de análisis de 17 páginas, donde se explicaba a todo color y detalle las técnicas y métodos utilizados en el proceso.

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Best Ideas 2019 Preview: Why We Are Short Bond ETFs

December 9, 2018 in Best Ideas 2019, Best Ideas Conference, Fixed income, Ideas

This article is authored by MOI Global instructor Adam J. Schwartz, Chief Investment Officer of Black Bear Value Partners, based in Miami, Florida.

We are short a variety of bond ETFs (exchange-traded funds) encompassing high-yield, investment grade, emerging market, emerging market high-yield and bank debt. Structures with daily liquidity were not created for illiquid securities such as bonds and bank debt. The underlying assumption is the market-marker will stand in the middle to provide liquidity. Systems/markets have an underlying “trust” component to them. It is hard to predict how things play out if the market makers lose confidence in the liquidity of the underlying cash bonds.

As a lender with limited upside bond investors should be exercising caution and prudence when possible returns are low. Unfortunately, this is the opposite of human behavior and as investors stretch for yield, they expose themselves to potentially catastrophic risk. Recent fixed-income investors may be borrowing from tomorrow to have their coupons paid today.

Two charts from Moody’s that highlight some of my concerns are below. In a nutshell we have:

  • more debt
  • with an expectation for historically low corporate defaults
  • and are taking reduced returns as compensation

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What Matters in Banking

December 8, 2018 in Best Ideas 2019, Best Ideas Conference, Equities, Featured, Financial, Ideas

This article is authored by MOI Global instructor Brian Pitkin, Managing Member of URI Capital Management, based in Indianapolis.

We remain steadfast in our belief of the value of JP Morgan and Bank of America as superior long term investments for our partnership. They have the scale, best in class deposits, and breadth and depth of consumer, commercial and institutional products and services to continue market share gains. They continue to maintain record high levels of both capital and liquidity and they each have much more earnings power in front of them than behind them. They are enduring businesses investing aggressively for the future all while posting record earnings and strong returns. And, they are each still trading at only just above 10x earnings (JP Morgan) or just below 9x (Bank of America) coming year 2019 earnings. They remain our top two holdings by a wide margin.

We now however want to talk about our thoughts on the banking business more broadly. While there are countless variables in the banking business, we will touch on a few that will have outsized impact on long term value creation: deposits, scale, reach and diversity. We will discuss the sea change in capital and liquidity levels throughout the banking system which now provide an undeniably strong foundation to invest upon. We will also touch on a couple risks to pay particular attention to in this still historically low rate environment.

Deposits

Deposits are a key fuel source for value creation in banking.

Deposits show up, appropriately, on the liability side of a bank’s balance sheet. In contrast to their accounting however, a low cost deposit franchise is a bank’s single greatest asset, not a liability.

The cost and stability of funding is the most significant long run differentiator in the banking business. No other funding source comes close to the long run advantages of having a low cost and stable deposit franchise. It is often stated that online lenders “can” give consumers higher deposit rates because they lack the costs associated with a branch banking system. This is a total misunderstanding of what it means to have a high cost versus a low cost deposit franchise. Those that provide higher deposit rates do so because they have to in order to attract deposits.

High deposit rates are a sign of deposit franchise weakness, not strength. And being able to attract and grow deposits while paying essentially nothing is a sign of great franchise strength.

In a world of still historically low interest rates, the value of best in class deposit franchises is not fully “seen” in reported results or bank valuations. With rates low across the spectrum and financing markets highly accommodative, investors are blinded to the intrinsic value of strong deposit franchises. But just because their value is not “seen” today does not mean the value is not there.

Scale

Scale brings significant advantages in banking. Scale brings the resources needed to fully accommodate the costs and complexities of technological and regulatory change. And regulation, over the long run, tends to favor scale and incumbency, even if that is the opposite of its original intent. By elevating the basic cost structure needed to operate and compete, regulation creates wider barriers to entry.

Who today can either start from scratch or combine existing businesses to form a new national or global banking giant? I would argue this cannot and will not happen for the foreseeable future. The largest franchises operating globally, even nationally, are protected by collective aversion to any new forms of bigness. In fact, the universe of globally capable banking franchises keeps getting smaller year by year. Formerly global giants are retracting towards home and pulling back from many of the products and services needed to fully satisfy a large multinational client. The universe of banks able to service global businesses across products and services has shrunk to a very small number creating a distinct long term advantage for those who remain.

It is also increasingly costly to be relevant to consumers and corporate clients, particularly from a technology perspective. The cost to compete for ease of use when it comes to consumer or commercial banking has risen dramatically in recent years. Consumers demand seamless technology that allows for in branch and branchless banking including full mobile banking services such as deposits and money transfers. Corporate technological demands are even greater.

It is no accident that the largest banks have grown in size and market share in recent years. They have the scale and resources to meet experience expectations while improving margins through operating leverage.

Reach

As economies and businesses continue to globalize, there are increasing competitive advantages to offering a full suite of products, services and geographies served.

If a multinational company wants to move money, store money, raise capital, manage risk and execute M&A across every major market in the world in every major currency around the world and wants to do it all with one bank, there are less than a handful of financial institutions that can serve those needs. Having that full suite of capabilities has become a distinct competitive advantage.

The universe of banks that can fully service those multinational clients has shrunk significantly since the crisis and continues to shrink as more and more global banks further retrench from certain products, services and geographies. The powerful competitive positioning of those who have maintained and grown their franchise is not fully apparent today given headwinds faced in the banking business but the power of these globally dominant franchises will ultimately shine through.

Now consider the small to midsized manufacturer who has a lending need. It would not be uncommon for as many as twenty lenders to be able to service that business ranging from a one branch community bank all the way to the local branch of a large money center bank with every iteration in between, including credit unions, local banks and regional banks. Many bank executives have gone on record to say that a middle market loan is not a profitable loan unless it is packaged with a range of other services a customer may need.

Part of the lack of attractiveness in that market stems from the low level of interest rates but much of the challenge also lies in the enormous number of potential lenders vying for a largely commoditized loan. To earn proper returns, a full suite of products and services must be provided to the middle market. And in much the same way, a retail consumer is much more profitable and also more likely to remain a client when an institution serves their checking account, savings account, credit cards, mortgage, investment advisory and maybe even their small business banking needs.

Great reach and scale bring the resources needed to stay at the forefront of bringing to bear all the technology and services small and large customers will increasingly demand. How can a one branch bank or even a large local bank keep pace over the longer term with the scale of dollars being spent on payments technologies, new state of the art ATMs, mobile banking, mobile deposits, digital banking, increased cybersecurity, increased controls, branch refurbishing, and all the new offerings that we have not even considered today? Scale matters for cost competitiveness and for keeping pace with business, technological and regulatory change. And a full breadth of products, services and geographies brings further competitive advantages in a world where many financial institutions are retrenching.

Diversity

An underappreciated benefit to a global banking business is the diversification that comes from providing a wide range of products and services to a wide range of customers and industries across a broad dispersion of geographies. A large money center bank should not carry undue exposure to any one industry, or to any one geography.

Large, deposit based franchises are better able to withstand geographic or industry specific challenges than those lenders with outsized concentration towards a city, town, state or region or any particular industry that will inevitably face their own economic cycle. Large banks also have exposure to a wide range of fee based businesses that ebb and flow at different times, and much of this fee based revenue is recurring in nature.

Capital and Liquidity

It is almost impossible to understate (1) the importance of capital and liquidity levels and (2) the dramatic change that has occurred with bank balance sheets. Capital levels are at their highest levels since the 1930s and liquidity levels are at levels never seen before.

These substantially higher levels of capital and liquidity across the banking system create a strong foundation for investment and provide a wide margin of safety against the inevitable unforeseen economic and financial disruptions.

In many cases, liquid assets comprise as much of 25% of total assets. Combining these enormous levels of liquidity with essentially no short term wholesale funding removes much of the shorter term liquidity risk that caused much of the initial disruptions of the financial crisis. We have moved from a system that required new funding nearly every single night to a system where the banking system has sufficient liquidity to last for years without any new funding.

It is hard to overstate how much more durable the large banks and the banking system have become in recent years.

Asset/Liability Sensitivity

The persistent low rate environment has caused tremendous challenges for all banks. Revenue, earnings and returns have been under constant pressure from prevailing low rates.

The important question at this point is how has each individual bank reacted to these pressures? Have they extended duration risk in order to increase earnings or have they maintained asset sensitivity so as to not take undue interest rate risk? From our perspective, the only course of action is to lessen the risk to rising rates even while that hampers current earnings and returns.

Most banks report their asset sensitivity on a quarterly basis and, while overly simplified and laden with assumptions, these disclosures present important information about the tolerance for interest rate risk. We, as long term investors, are willing to endure lesser results today in order to reduce generationally high interest rate risk while also being positioned for much stronger results as rates begin to normalize.

While much of the discussion surrounding asset sensitivity relates to earnings power, we must not lose sight of the associated risk dynamics. Given memories of the S&L crisis have faded over time, it is easy to forget that crisis was largely created by banks holding long term, fixed rate assets against funding liabilities (including deposits) that moved up in cost as rates moved higher. They were liability sensitive rather than asset sensitive. And many were wiped out.

So, carrying higher levels of asset sensitivity not only allows for greater earnings power as short and long rates move higher, it also, and arguably more importantly, protects against the dire scenario where increasing funding costs eat away profits and capital when the asset side of the balance sheet is not able to reprice based on its long duration.

Credit Box

The highly challenging banking environment has caused many lenders to reach for yield by adding duration creating risk as described above. But lenders have also reached for yield and growth by expanding their credit box, or the credit parameters and risks they are willing to take in making new loans.

A tough interest rate and banking environment has created pressure to find growth and earnings. The best course of action however is to accept the environment for what it is, recognizing the lower level of earnings that implies. It is far better to not reach for greater earnings by putting the institution at significant duration and/or credit risk.

Shareholder pressure is strong so it is imperative to carry heightened sensitivity to these risks given the difficult environment by monitoring credit disclosures throughout company filings and executive presentations. It is particularly important to be mindful of those lenders that are not heavily scrutinized by strong third party groups, including regulators. In a low rate, low growth world it is those banks posting outsized growth that should raise alarm bells.

This is not meant as a fully exhaustive discussion on what matters in banking but we hope it has described what we view as several of the key variables to consider for the long term investor.

And, below are a few summary comments specific to JP Morgan and Bank of America:

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Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment adviser as to the suitability of such investments for his specific situation. A comprehensive due diligence effort is recommended.

Emérito Quintana sobre Texas Pacific Land Trust

December 7, 2018 in Ideas de inversión, MOI Global en Español

NOTA DEL EDITOR: Esta idea de inversión es obtenida de una carta semestral a los inversores de Numantia Patrimonio Global.

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Texas Pacific Land Trust [TPL]: una empresa desconocida, aburrida, nada seguida y muy difícil de valorar. Una tesis poco obvia donde la paciencia es clave. El Trust se creó en 1888 a raíz de la quiebra de un proyecto para construir un ferrocarril, financiado con una emisión de bonos. Al quebrar la Texas & Pacific Railway Co, los bonistas recibieron en contraprestación certificados del recién creado Trust, que poseía 3,5 millones de acres de tierras en Texas, además de royalties perpetuos sobre el petróleo y el gas del subsuelo. Desde entonces lleva más de 100 años liquidándose y comiéndose a sí misma, vendiendo paulatinamente terrenos y cobrando royalties para recomprar certificados de acciones.

Este proceso es similar al de una tontina, donde un bien queda disponible tras el paso de muchos años sólo para los supervivientes que firmaron el acuerdo, por lo que ha sido enormemente rentable para los inversores a largo plazo. Los poseedores de los últimos certificados de acciones serán enormemente ricos. Probablemente sea la inversión con horizonte de mayor largo plazo que existe en el mercado, pero la paciencia requerida frustra a la mayoría, y provoca que el descuento aplicado sobre el valor de los terrenos y los royalties siempre haya sido muy alto, favoreciendo la creación de valor de la estrategia de recompra.

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