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Intelligent Investing in a Changing World

October 13, 2017 in The Manual of Ideas

The admittedly ambitious title of this issue reflects the focus of Latticework 2017, hosted by MOI Global at the Yale Club of New York City last month. While the enormity of the topic ensured that definitive answers and prescriptions would remain elusive, the participating members and instructors engaged in thought-provoking, valuable dialogue.

Superinvestor Tom Gayner of Markel Corporation surveyed the long history of the firm he has helped build, extracting lessons about the long-term compounding of intrinsic value at any organization. While the world has always been turbulent and technological change has accelerated recently, core aspects of value creation remain constant. Says Tom,

“There was a phrase in the 1995 annual report that speaks to the humanity of Markel, the fun of working on customer problems: ‘We want people who will view their work as something more than a job’—so qualitative factors of what goes on at Markel are critically important. [There was] a lot of talk about ‘relationship’ and that our people are committed to us because we’re committed to them. We can look at a lot of numbers and quantify things, but these are all people businesses, and we operate accordingly.”

In another Latticework session, Josh Tarasoff and Tom Russo explored the durability of global consumer brands. Many brands that had once been considered unassailable have come under attack due to the ease with which new entrants can bring products to market and reach large audiences without reliance on traditional media. States Tom Russo,

“I wrote in an investor letter that in this Amazon-oriented world you have to be careful that assets don’t become liabilities. Gillette had won the razor war at some point. There was absolutely no way anybody could have dislodged Gillette. Wilkinson tried. Schick tried. Unilever tried in partnership with Target; they may have spent $500 million, but none of that could budge the success Gillette enjoyed.

“The trouble was, they fell prey to the standard game on Wall Street, which is driven by short-term results. Gillette asked too much of the brand. They charged too much. The price paid for the razors was so high they had to keep them locked up behind the checkout counter. If you’re trying to sell fast-moving consumer products, the goal isn’t to lock them up. The problem is, they needed to get those prices to sustain reported earnings and have the options used for compensation vest, and to retire rich…

“Along came these kids from a fraternity and created a business called Harry’s, and then another guy came along and did Dollar Shave Club.”

Tom Russo — while pointing out the factors behind the relative downfall of brands like Gillette (Tom is also bearish on Coca-Cola) — expresses confidence in brands that stand for luxury or satisfy long-standing consumer preferences and habits. Tom is a long-term investor in companies such as Nestlé, Swatch, and Richemont.

Latticework instructor David Pakman, a partner in Venrock’s New York office, was an early backer of Dollar Shave Club, putting him in a unique position to observe and influence the disruption in the branded consumer sector. David shared Venrock’s uniquely differentiated investment strategy at the summit, and I am pleased to bring you a glimpse in this issue. Every investor in traditional branded consumer businesses needs to understand what some of the smart people funded by David are doing to erode the competitive position of companies long thought of as wide-moat businesses. I found the following exposé by David fascinating:

“I’ll tell you about a company in New York. Most people don’t know about them, and they don’t have a strong brand. But, this is the ultimate new way to build a consumer products giant. The company is called Mohawk, and they sell consumer products on Amazon only. They scrape the Amazon website, read all the product reviews and ratings, and digest all of the pricing and the rankings. They feed that into an artificial intelligence [system]. The AI says to them, ‘If you make a matte black 1400 W hairdryer with a 1.5 meter cord and price it for $41.87, it will be the number one hair dryer sold on Amazon.’

“Then they have a team in China go to the hair dryer factories and find the two or three factories that make the best hair dryers. They hand them the specs… Then they bring that to market under one of three different brands, which I won’t even bother to tell you because you’ve never heard of them. They launch them on Amazon and — guess what — within three or four days they are the number one product in that category, and they stay there because of the way the Amazon ranking engines work. They immediately displace L’Oreal and all these other companies that have been making hairdryers for a hundred years.

“They have 250 SKUs on Amazon, and they are the top three products in those categories for each of the 250 SKUs. They are absolutely killing it. It is an example of a company that is built for the Amazon era. Their only risk is that Amazon does the same thing to them. Amazon already has the data and can do that. Well, Amazon is doing that. Amazon has thousands of SKUs that are Amazon-branded.”

The other Latticework sessions included in this issue are similarly fascinating. I encourage you to read the transcripts. Whether you are looking to profit from technological change, or simply not get hurt by it, you will likely find the insights of Latticework instructors immensely valuable.

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Highlights from European Investing Summit 2017

October 11, 2017 in Equities, Europe, European Investing Summit, Ideas

The following idea snapshots have been provided by the respective instructors or compiled by MOI Global using information provided by the instructors. The following is provided for educational purposes only and does not constitute a recommendation to buy or sell any security.

DANIEL GLADIŠ, CEO, VLTAVA FUND

BMW (Germany: BMW) is a readily understandable business with a moat, managed in the interest of shareholders and attractively priced. BMW consists of two complementary businesses: automotive and financial services. The company sold 2.36 million cars and 145,000 motorcycle in 2016, up 72% and 45%, respectively, compared to 2006. Net income, EPS, and bo2ok value per share have grown more strongly over the same period, increasing by 140%, 139%, and 147%, respectively. Meanwhile, the price of the common and preferred stocks rose by 104% and 67%, respectively, from 2006-2016. Strong returns on capital and brand value reflect the moat of the business. On the ownership side, majority ownership of BMW has remained stable for a century. The company has done no overpriced acquisitions, taken no large asset write-downs, displayed no excess in terms of management compensation, and capital allocation has been good. Business risks include “peak auto”, BMW bank, electrification, autonomous driving, and interconnectivity.

Daniel’s sum-of-the parts valuation suggests that the vehicle production business recently traded at 3.3x earnings and 48% of book value. Daniel bases this conclusion on a value estimate of €27.30 per share for the BMW bank business (€18 billion total value, or 1.6x book value, justified by an ROE of 18%) and €18.20 per share (€12 billion) of excess cash in the automotive segment. Subtracting the combined value of €45.50 per share from the recent equity quotation suggest a market value of €28.50 per share for vehicles production. Another way to look at the sum-of-the-parts valuation considers brand value of €30 billion, which may be added to automotive book value of €37 billion to imply automotive value of €67 billion. However, valuing the automotive business at 8x earnings suggests a value of €44 billion. As a result, Daniel puts the fair value of the auto business at roughly €55 billion. When added to the value of BMW bank and excess cash, the combined intrinsic value of the equity may be €85 billion, or €129 per share.

FLORIAN SCHUHBAUER, MANAGING PARTNER, ACTIVE OWNERSHIP CAPITAL

PNE WIND (Germany: PNE3) is a leading wind farm developer, realizing and operating wind parks in Germany and abroad, both onshore (pipeline with nominal capacity of ~4,700 MW) and offshore (pipeline with nominal capacity of ~5,000 MW). It also provides operational management services, including commercial and technical operations management for ~1,500 MW. In energy production, PNE derives income from minority shares in wind parks. The company is active in fourteen countries and has 380+ employees. PNE recently sold 80% of a 142 MW portfolio of own wind parks to Allianz for ~€330 million (cash consideration of €103 million). PNE has been “uninvestable” for most institutional investors due to a messy governance situation, bad track record in creating value for shareholders, and perceived share overhang. However, this is changing as Florian and other shareholders succeeded in replacing management and aligning the board with the new strategy for the business. The new CEO, Markus Lesser, is an experienced industry veteran who is operationally focused and can roll up his sleeves. Investors may be overly focused on operational headwinds, including the introduction of a tender process in Germany in 2017, which has led to substantially lower kw/h prices for wind. There has also been unfair competition from Bürgerwindparks, and the future regulatory regime is unclear as Germany transitions to a new governing coalition.

On the positive side, (i) corporate governance has improved, as three of six supervisory board members, including the chairman, changed at the annual meeting in 2017; (ii) small players are likely to be put out of business due to a lack of scale, such that small service portfolios may be acquired at distressed prices; (iii) the levelized cost of energy may fall by another 30+% in the coming years, driven by turbine efficiencies and reduced production costs; (iv) substantial cost improvement potential may be unlocked by PNE in both capex and opex (purchasing and standardization); and (v) continued low interest rates and abundant financing support the business turnaround. Florian believes that investors substantially underestimate the earnings power of PNE due to the volatile nature of the business. The shares recently traded at five-year average EV/EBIT of 5.4x and P/E ratio of 8.6, a substantial discount to peers. Florian expects PNE to generate similar average EBIT over the next five years (€30-35 million annually), but with a higher share of recurring earnings.

FRANCOTYP-POSTALIA (Germany: FPH) is a leading franking machine manufacturer, with global market share of 10% and 45% market share in its home market, Germany. Francotyp has an installed base of ~260,000 machines, of which ~100,000 are in Germany. Other key markets include the U.S., UK, France, Netherlands, Sweden, Austria, and Switzerland. Fourth-fifths of revenue is recurring, and barriers to entry are high due to postal regulation. Florian views Francotyp as misunderstood, as investors mistakenly believe that (i) paper mail is dead; (ii) franking machines are no longer needed; and (iii) the company cannot keep growing the core business. The reality is that (i) 80+% of companies still use letter mail regularly, and paper production has grown from 130 million tons in 1970 to 440 million tons in 2015; (ii) franking machines in the large and medium mail volume segments are in decline, but the small mail volume segment (up to 200 letters per day) continues to grow at a low single digit rate; and (iii) Francotyp continues to grow revenue in the core business in the low single digits through consistent market share gains. Florian expects the company to generate EBIT of €7.4 million in 2017, €10.5 million in 2018, and €12.8 million in 2019. The shares recently traded at 3.1x EV to 2017E EBITDA and 5.2x EV to operating FCF. Florian’s firm is the largest shareholder, and Florian’s partner Klaus Roehrig serves as chairman of the board.

LOUIS D’ARVIEU, FUND MANAGER, AMIRAL GESTION

CRITEO (Nasdaq: CRTO) is the world leader and the last remaining credible player in the field of online retargeting, a niche that looks a lot like Google’s wonderful search business, with economies of scale and barriers to entry. Criteo is the leader in the winner-takes-all niche because of the company’s engineering culture, impeccable sales execution, and early international vision. Management has been focused on the core business and disciplined in terms of acquisitions. The company continues to grow 30+% organically, and the recent market quotation is reasonable at 17x 2018 earnings (including stock-option expenses). The market appears fearful of the “intelligent tracking prevention” tool announced by Apple last June. However, Louis estimates that this factor should reduce the long-term value of the company no more than 10% in a worst-case scenario.

DAVID MARCUS, CHIEF INVESTMENT OFFICER, EVERMORE GLOBAL ADVISORS

DRY BULK SHIPPERS: The low-hanging “easy money” has already been made. However, dry bulk names are coming off an extremely low base. David has higher conviction today than when his firm started investing in the space in light of the lower risk profile today: (i) secondhand asset values and charter rates (spot and one-year time charters) have both increased; (ii) the new vessel order book is historically low; and (iii) there is supply visibility. David also sees improvement in structural demand. Despite fears of China slowing down, dry bulk demand has been growing steadily. Demand growth is underpinned by domestic Chinese stimulus (One Road and One Belt) and regulatory policies that favor low-cost suppliers of high‐quality iron ore and coal. Australian and Brazilian iron ore exporters still have cost advantage over Chinese producers. Longer ton miles bode well for dry bulk. In general, management insiders have been recent buyers of dry bulk shippers’ shares.

SCORPIO BULKERS (NYSE: SALT): Founded in March 2013, Scorpio owns and operates modern mid‐ to large‐size dry bulk vessels (Kamsarmax and Ultramax). The company is incorporated in the Marshall Islands, headquartered in Monaco, and also based in New York. Management has attempted to replicate with dry bulk its past successes in tankers and LNG. The company was making vessel acquisitions into a worsening dry bulk market, leading to covenant breaches. Scorpio has one of youngest fleets of fuel efficient, mid‐size vessels. All vessels are eco‐design (20% higher efficiency, lower bunker consumption, and high cargo intake). The company has a strong, proven management team, led by chairman and CEO Emanuele Lauro and president Robert Bugbee. A March 2016 equity raise, in which David’s firm participated, provided a two‐year liquidity runway to weather the downturn. Bleak sentiment has led investors to overlook Scorpio’s balance sheet strength. Evermore also participated in a June 2016 equity raise at $3.05 per share alongside management. Proceeds were used to take advantage of compelling secondhand vessels coming to the market from distressed sellers, and extend liquidity to 2020 (more as a preemptive measure vs reaction to market direction).

In the session, David also commented extensively on three other companies owned by his firm, SAFE BULKERS (NYSE: SB), NAVIOS MARITIME PARTNERS (NYSE: NMM), and SONGA BULK (Norway: SBULK). In response to a question, David also briefly discussed his positive view on John Fredriksen’s FRONTLINE (NYSE: FRO).

THOMAS KARLOVITS, CEO, BLACKWALL CAPITAL INVESTMENT

RIB SOFTWARE (Germany: RIB) is a German building and construction software vendor with a market capitalization of about EUR 750 million (EUR 150 million net cash), operating in the field of building information modeling, adding “time and cost” (“5D BIM”) to traditional 3D CAD software. The sector benefits from structural growth due to 1) the construction industry’s need to invest more in IT to correct massive historical underspending (causing productivity growth to lag other industries), and 2) EU regulatory changes taking effect in 2020 that require 5D BIM software for public buildings with the use of such software mandatory in Germany from 2020. Although still in the early stages, the BIM software market recently passed the point of inflection. We anticipate significant acceleration of growth going forward. Thanks to three major strategic steps last year, the management team has repositioned the company, and while investors have not given the company credit for this, industry participants already consider RIB a pioneer in modernizing the construction industry. At recent multiples of 14.5x EV to EBITDA and 5.6x EV to sales (both for 2017E), Thomas views RIB’s quotation as based on past assumptions and perspectives that are no longer valid.

CHRISTOPHER ROSSBACH, MANAGING PARTNER, J. STERN & CO.

ESSILOR (Paris: EI) is the leading global prescription lens producer with a vertically integrated supply chain and 41% market share (more than 3x that of the next competitor). The company owns advanced lens technology backed by €200+ million per annum R&D spend. Essilor has significant growth opportunities in Europe, the U.S. and Asia from socio-economics (growing population, ageing, higher incomes) and technological innovation (varifocals, coatings). The pending merger with Luxottica creates a global leader cross the value chain (lens, frame and sunglasses, retail, online) and synergies of €420-600 million. Essilor and Luxottica are highly complementary businesses due to minimal overlap in ophthalmic lenses (Essilor) and sunglasses/frames (Luxottica). The combined company possesses strong competitive advantage, participates in good and growing markets, has strong management, and solid balance sheet, setting the stage for long-term compounding. Essilor shares recently traded at a pre-synergy 2017E P/E of 26x and a post-synergy 2020E P/E of 18x, based on conservative assumptions on synergies.

ROSHAN PADAMADAN, CHAIRMAN, LUMINANCE CAPITAL

FIDESSA GROUP (London: FDSA) is a leading provider of sell-side trading software. MiFID II is changing the way trading and research will be done in the future, making it more important to have provable information on what was spent on execution and what was set aside for research. With a dividend yield of 3.5+% and close to 90% in recurring revenue, Fidessa has a stable base, with potential for growth. Economies of scale apply to software service providers, as the players with relatively large market share enjoy abnormal profit margins due to fixed development costs being spread over a large user base. Cloud and SaaS make such software easy to deploy and monetize. The moat is in the switching cost (due to inconvenience) and efficient scale as well. The market is not large enough to entice a large player to try to displace Fidessa. The entry barrier of high one-off software development costs, and getting customers to re-train, makes it hard to unseat Fidessa, which enjoys a defensible position in sell-side trading software.

ANTONIO GARUFI, PORTFOLIO MANAGER, DECALIA ASSET MANAGEMENT

WIZZ AIR (London: WIZZ) is a low-cost carrier with a strong competitive position in Central and Eastern Europe, where it is a market leader. Listed on the LSE, it has a market cap in excess of 2 billion pounds. The company is on a path of future growth due to the following factors: (i) it has the lowest operating costs in the industry; (ii) it has market leadership in the CEE region; (iii) it has the best operating fleet in the area; (iv) it is taking market share from poorly positioned companies in the EU and CEE; (v) it has an outstanding management and track record of growth. Wizz trades at an affordable valuation and generates robust cash flow. It is a takeover candidate in light of its competitive position and outlook — a high-quality business with long-term potential, available at an attractive valuation based on estimates for 2018: EV to EBITDA of 4.1x, EV to EBIT of 5.3x, and FCF yield of 12.6%.

ADAM CROCKER, CHIEF INVESTMENT OFFICER, LOGBOOK INVESTMENTS

BORUSSIA DORTMUND (Germany: BVB) has a unique franchise in German and European soccer, with recognized commitment to building a competitive, financially sustainable operation. Management has developed Dortmund into a key destination for top young talent to develop and compete at the highest level. The company has significant optionality from geographic expansion, growing popularity of the sport, the sale of emerging stars (such as Dembele), and from further monetizing the BVB brand. The shares recently traded at 10x trailing EV/EBITDA, an attractive valuation for a company with a clean balance sheet, a 100+ year history, a passionate and growing fan base, improving fundamentals, high-quality management, and multiple sources of near-term optionality.

CHRISTOPHER SWASBROOK, PORTFOLIO MANAGER, ELEVATION CAPITAL MANAGEMENT

TOD’S (Italy: TOD) is a leading global players that produces and sells shoes, luxury leather goods and casual wear. It is 61%-owned by Diego Della Valle. Tod’s has underperformed in recent years due to management’s poor execution and a failed change in strategic direction, which sought to increase the fashion component of Tod’s business. We expect margins to improve as management refocuses efforts on creating products that truly reflect Tod’s core proposition: Made in Italy, Italian quality, and Italian lifestyle. Chris believes the stock to be significantly undervalued, either (i) if it remains a standalone company and delivers a turnaround by 2020 that improves EBITDA profitability to the FY12 level of €250 million (intrinsic value estimate of €113.50 per share), or (ii) if Diego Della Valle sells Tod’s (in the price range of 15-17x EV/EBITDA) to a large luxury conglomerate such as LVMH or Kering for family estate planning and succession planning purposes (intrinsic value estimate range of €115.77-130.88 per share, based on successful turnaround efforts to return EBITDA back to the FY12 level of €250 million).

SAMUEL WEBER, FOUNDER, SW KAPITALPARTNER

DEUTSCHE BANK (Germany: DBK, NYSE: DB): New CEO John Cryan is transforming Deutsche into a “safe” bank that focuses on providing value-added products and services to a diversified client base. The bank’s recent market capitalization does not reflect its potential future performance. Cryan is a credible, capable, and humble CEO with high integrity, a focus on value creation, shareholder orientation, and a long-term business outlook. He wants to make the bank simpler and more efficient, less risky, and better capitalized, with more disciplined execution. He has replaced one-half of the top 200 managers and reassigned another 20% to new positions. He stopped business with high-risk clients and has continued to strengthen internal controls. He has resolved nine of the top twenty litigation issues, comprising 90% of litigation provisions. He has also aligned compensation with performance. In 2016, Cryan earned €3.8 million in total compensation; no manager was paid a bonus, and variable compensation was reduced by 77%. In 2Q17, Deutsche’s liquidity coverage ratio of 144% was higher than that of most peers. If Deutsche generates revenue of €30 billion in 2018, it should earn €8 billion in income before income taxes. This figure should increase to €11+ billion by 2021. Net income should therefore be around €4 billion in 2018 and €5.5+ billion in 2021. Applying a P/E ratio of 15x suggests intrinsic value of €60 billion in 2018 and €82 billion in 2021, compared to a recent equity market quotation of less than €30 billion.

PAOLO CIPRIANI, FOUNDER, CP CAPITAL

GRUPPO MUTUIONLINE (Italy: MOL) is a small-cap with favorable long-term prospects and a strong competitive position, trading at a reasonable price. The company has a broking business (online comparison of mortgages, insurance, personal loans, etc.) and a business process outsourcing business (outsourcing of core processes for banks, insurers, and asset managers). In the broking unit, competitive advantages include search engine optimization, brand recognition in the mortgage segment, and scale. In the BPO unit, competitive advantages include unique know-how, low cost structure, and high switching costs. Management as a group is the largest shareholder with ~33% of the equity. The two founders have been good capital allocators, including through share repurchases.

JEAN-PASCAL ROLANDEZ, FUND MANAGER, THE L.T. FUNDS

DISTRIBUIDORA INTERNACIONAL DE ALIMENTACIÓN (Spain: DIA) is a $4 billion Spanish mid-cap with a free float of 100%. Basically, DIA is the “Aldi/Lidl” of the Iberian world. It used to be owned by Carrefour, which spun it off to shareholders after bleeding it with a EUR 1 billion dividend payout. The company, which has its own formats and corporate culture, is diligently paying down that debt and has finally reached the point where it is able to invest again in stores and develop new formats. Carrefour dragged DIA into several countries in which the format did not work for various reasons. DIA is now refocusing on Spain (81% of sales), Portugal (4%), Brazil (10%), and Argentina (4%). Jean-Pascal expects 6% annual organic growth in EBITDA. Meanwhile, the stock recently traded at a 20% discount to European food retail peers, which exhibit average organic growth of ~2%. DIA shares recently traded at 7x EV 2017-18E EBITDA compared to 11x for Portuguese rival Jeronimo Martins (same 6% growth rate derived from Portugal, Poland and Colombia, with no debt). DIA is a terribly boring company (you probably would not like to shop in most of its stores) in one of the few growing retail segments (discount food retail). It is cheap and unloved (one of the most heavily shorted mid-caps in Europe). However, DIA should deliver, thanks to multiple growth drivers.

ALEJANDRO ESTEBARANZ, CO-INVESTMENT ADVISOR, TRUE VALUE FUND

PROTECTOR FORSIKRING (Oslo: PROTCT), with a market value of ~€600 million, is a low-cost insurance company growing ~20%, focused in the Nordics, with expansion potential in Europe (opened offices in Finland and the UK in 2017, with plans for expansion into Belgium, Holland, and Germany). Commercial and public insurance account for 61% and 24% of the business, respectively. The company has only 3% market share in the Nordics, providing ample runway for continued share gains. Protector has ~60% lower costs than rivals in the Nordics and ~80% lower costs than “old” European companies such as Zurich, Axa, and Allianz. The company has a strong culture, and its investment approach is similar to that of other great insurance companies, such as Markel, Leucadia, Berkshire, or Fairfax. Recent statistics include a combined ratio of 92%, ROE of 20+%, and a solvency ratio of 185%. The shares recently traded at estimated P/E ratio of 13x for 2017 and 11x for 2018. Alejandro estimates intrinsic value at NOK 120 per share today, with potential for value to grow to NOK 280-320 over the next five years (compared to recent market quotation of NOK 80 per share).

PUBLITY (Germany: PBY) is a German real estate asset management company with three lines of business: retail, mid-size, and institutional. The company generates a blended management fee of around 1.3% (retail is higher, institutional is lower). They seek to invest like value investors, buying undervalued assets and waiting three years, on average, to sell them at a premium. In the meantime, they collect rent. Publity focuses on the German commercial real estate market, mainly offices. Founder Thomas Olek owns 49% of the shares. He is an experienced investor and cares about shareholders. Olek has good relationships with the German regional banks, the Landesbanken, and the company gets attractive bulk prices. Alejandro estimates fair value at €85 per share, or a P/E ratio of 12x at the end of 2018, plus €4 in dividends.

JOSÉ ANTONIO LARRAZ, FOUNDING PARTNER, EQUAM CAPITAL

ARCUS (Oslo: ARCUS, Frankfurt: A48) is a Nordic branded consumer goods company which produces, imports and distributes wine and spirits in the Nordic region, holding leading positions in various markets. The company operates an asset-light business model, which allows for a high return on capital and strong cash flow generation. Following an IPO at the end of 2016, the company recently traded at an attractive valuation, as suggested by FCF yield of 8%.

SIMON CAUFIELD, MANAGING DIRECTOR, SIM LIMITED

THE AUTOMOBILE ASSOCIATION (London: AA), with a market cap of £1 billion and EV of $3.6 billion, is a high-quality business trading at 5.3 times Simon’s conservative estimate of normalized owner earnings. Founded in 1905, the AA is the UK market leader in the provision of roadside assistance and recovery services. It also acts as a broker for auto insurance (14% of revenue) and manages driving schools (7% of revenue). With a membership/subscription-based business model, revenue is highly predictable and cash-generative. The market is consolidated, with just three main players and high barriers to entry. Returns on capital are above 25%. Following ten years of private equity ownership, the business IPO’d in June 2015 and is two years into a three-year program to modernize the product and infrastructure, improve productivity, and pay down debt. This is masking the underlying profitability of the business. That’s why the shares trade at a low multiple of normalized earnings. Yet, the program is starting to work.

SÉBASTIEN LEMONNIER, FUND MANAGER, INOCAP GESTION

BARCO (Brussels: BAR) (€1.1 billion market cap) is a Belgium company providing visualization solutions for selected professional markets. It holds significant market shares owing to its competitive edge. The new CEO, who joined in late 2016 after almost a decade of mismanagement, is leading a pragmatic, disciplined, and business-oriented strategy to expand into growing niches with higher-value products. Management is putting in place a culture of organizational and production efficiency. Overlooked by investors and undervalued, Barco offers an investment case based on improvement in both growth and margins. Consensus expectations remain conservative given the last decade of low achievement and are well below mid-term management targets, providing potential for upside surprises. Despite growing 3-5% on the top line, with 12-14% EBITDA target and good FCF conversion, the shares trade at only ~9x EBIT in 2018-19E. Sebastien considers the valuation attractive in light of Barco’s brand recognition, strong position in niche markets, and unique global knowhow in its business areas.

STUART MITCHELL, INVESTMENT MANAGER, S. W. MITCHELL CAPITAL

AP MOELLER MAERSK (Copenhagen: MAERSK) is the world-leading Danish container shipping and energy group. The business is split into four key divisions: container shipping (56% revenue), oil and gas (14% revenue), terminals (11% revenue), and drilling (6% revenue). In the wake of the dramatic decline in shipping rates, the group has embarked upon a bold strategic plan to refocus the business on container shipping and improve profitability. First, management has decided to separate out the energy business through a sale or public listing. A complete sale could raise $12 billion, which would cover both the recent purchase of the container shipping group Hamburg Sud as well as enable $6 billion or so in further acquisitions in the container shipping space. Management is rightly keen to take advantage of the process of consolidation within the industry. The integration of Hamburg Sud, furthermore, could yield roughly $1 billion in cost synergies. Second, capital expenditure will be more tightly controlled across the company, most notably in the terminal division, where no further expansion is expected.

Finally, management aims to increase return on invested capital by 2% over the cycle, through increased terminal utilization, selling more inland services, and cross-selling. After two years of declining freight rates, the outlook for the container market appears to be improving. The recent collapse of Hanjin, which removed 3% of supply from the market, may well have marked the turning point. At the same time, scrapping rose to the highest level in 2016, removing a further 3% capacity from the fleet. While deliveries will remain high in 2017, adding some 4% to the world fleet, this should be largely offset by scrapping. The fleet could indeed decline in 2019. Trading on a trough valuation of 0.8 times EV to invested capital, the shares appear attractively valued considering the depth of the restructuring program and the apparent improvement in the container shipping market.

MAX HU, PORTFOLIO MANAGER, TYEE CAPITAL GROUP

INDITEX (Spain: ITX) is the biggest fashion group in the world. It operates 7,200+ stores in 93 markets. The flagship brand is Zara. Max views Inditex as one of the highest-quality businesses in Europe, with a long growth runway ahead. Inditex has been a disruptor in the fashion industry for decades and appears likely to be the only long-term survivor with decent profitability in the fashion industry. The shares recently traded at a 30x P/E for the ongoing year and a forward P/E of 26x. The valuation is not cheap in absolute terms, but it compares favorably to the company’s historical range. The company is likely to keep growing in the double-digits for a long time to come. The consumer discretionary retail sector has been depressed due to the impact of Amazon.com. Max favors investing in long-term winners such as Inditex over single-digit P/E “value traps”. Despite the prominence of Inditex, many investors may still underappreciate the strength of the business model going forward. The recent share price pullback may provide a decent entry point.

ODDMUND ENAES, PORTFOLIO MANAGER, PARETO ASSET MANAGEMENT

NEXT (London: NXT) is a UK-based retailer. UK retailing has been hit by an almost perfect storm: Brexit, channel shift from store to online, and devaluation of the British pound. This macro environment has brought the share price to less than ten times free cash flow for what Oddmund believes to be one of the leading retailers in Europe with one of the best management teams in the business.

GREGOR SAMPSON, INVESTMENT ANALYST, BRAUN, VON WYSS & MÜLLER

RANDSTAD (Amsterdam: RAND) was founded in 1960 by Frits Goldschmeding who remains the largest shareholder. RAND is one of the leading global staffing and recruiting companies. It has grown EPS at a CAGR of 13.7% since 2003, driven by strong M&A execution and organic growth. In Gregor’s view, risks related to the level of hiring activity in Europe and North America are outweighed by a continued long-term shift to variable cost bases and outsourcing. Trading at ~12x 2017 estimated earnings and with a forward-looking FCF yield of 8.4%, Gregor considers RAND shares quite cheap.

SAFILO (Italy: SFL) is the number-two producer of sunglasses and optical frames. SFL generates the bulk of revenue through licensed brands (including Dior, Boss, Tommy Hilfiger) but also has proprietary in-house brands. The company has made strategic mistakes over the decades and risks losing licenses. Nonetheless, at 0.4x enterprise value to sales, the market potentially prices an excessively negative scenario. SFL could benefit from long-term margin normalization by completing its ERP implementation and achieving further cost savings.

MUSTAFA HIDIR, INVESTMENT MANAGER, EHRKE & LÜBBERSTEDT

MTU AERO ENGINES (Germany: MTX) develops and manufactures components for civil and military aircraft. The business model of MTU is structured in such a way that no or negative margins are accepted when selling an engine. In return, MTU achieves an EBIT margin of 8-10% through contractual exclusivity in the service of the turbines and significantly high double-digit margins through the sale of spare parts. With the turbines V2500 (mainly Airbus A320) and GTF (mainly Airbus A320neo), MTU has two blockbuster products in the portfolio, which in the coming years will gradually become maintenance-prone and thus should increase the profitability of the group sustainably.

RICHARD SIMMONS, SENIOR PORTFOLIO MANAGER, THE CREDO GROUP

DAEJAN HOLDINGS (UK: DJAN) is a property-owning company (75% UK, 25% US; 54% residential, 46% commercial). Property is primary or secondary, often in central locations and almost all freehold or long leasehold. Daejan is a gradual grower, relying on rent increases, upgrades in the existing estate, small acquisitions, and limited development. Over a full cycle it returns 10-12% in NAV growth, dividends included. The balance sheet is extremely conservative. Daejan is priced at 58% of NAV, a discount of 42% to its fully realizable immediate value. Daejan has an inside value because one might sell it if it traded up to NAV, leaving only the ongoing 10-12% return on NAV.

S & U (UK: SUS) is a used car finance company. It has a long history and a long runway. Used car finance is currently in bad taste because of the belief that there is a consumer debt bubble, partly concentrated in the auto market. S & U is UK-only and does not write personal contract purchase (PCP) loans, so it is somewhat isolated from the main issues. Through cautious underwriting it manages an ROA of 10+%, compared to a very good bank target of 2%. Leverage, as measured by total assets to total equity, is below one-and-a-half times, compared to a very good bank ratio of ten times; but this is enough to push ROE to 15%. S & U trades below ten times forward earnings. S & U has an outside value because even if the share price doubled, bringing the forward P/E to less than 20x, the ongoing 15% (and growing) return on NAV would still be attractive.

MARKUS MATUSZEK, CHIEF INVESTMENT OFFICER, M17 CAPITAL MANAGEMENT

KRUK (Poland: KRU) is a long-term earnings compounder in the European debt collection and NPL investing market. The company so far has acquired NPL portfolios worth PLN 55+ billion across seven countries at an average of 7% of nominal claim value and able to generate 3.5x on invested capital from its NPL portfolio over the life of these investments so far, allowing Kruk to continuously grow EPS ~15% annually. Since all nominal claims compound at a statutory interest rate of 7.3-11.8% and payment interrupts the statute of limitation, Kruk’s NPL portfolio possesses significant upside optionality which is not considered by the market. Kruk’s debt collection services for third parties and credit bureau activities allow the company to gain early insight into overdue payments of retail and corporate customers, enabling it to leverage that knowledge when considering the purchase of portfolios. In Markus’ view, reinvestment and regulatory risk are addressed by expanding into related activities (e.g., high-interest short term loans) and new countries. Markus’ base case valuation of Kruk is PLN 450, offering upside of >50% from recent levels with an investment horizon of up to two years.

MALLIKA PAULRAJ, PRIVATE INVESTOR

AUTOLIV (NYSE: ALV), headquartered in Sweden, is an automotive safety systems specialist. Products are both “passive” (useful in an accident, e.g., seat belts) and “active” (sensor-driven prevention of accidents). World-leading clients include Volvo and BMW. Autoliv shares have recently traded in a P/E range of 15-20x. The company’s major competitors are in flux, providing an opportunity for Autoliv. The company is the leading supplier of safety systems for the “future car”, i.e., well-integrated with autonomous driving.

DOMINIC FISHER, DIRECTOR, THISTLEDOWN INVESTMENT MANAGEMENT

DIXONS CARPHONE (London: DC) is a retailer with sales of 10 billion pounds, deriving revenue from UK electricals, UK mobile, Nordics, Southern Europe, and services markets. Brands include CurrysPCWorld and Carphone Warehouse. The management team has deep industry expertise and has in the past generated significant value from capital allocation. The latter has weakened following the merger of Dixons and Carphone Warehouse in 2014, as working capital has increased and the company has invested in the remodeling of stores. The founder of Carphone Warehouse, Dunstone, owns 12% of the company, giving him an incentive to maximize shareholder value, either through a combination of organic growth and return of capital to shareholders or through an outright sale of the company. The shares appear attractively valued at a forecast P/E of 7x.

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Man-with-a-Hammer Syndrome

October 11, 2017 in Human Misjudgment Revisited

“What made these economists love the efficient market theory is the math was so elegant. And after all, math was what they’d learned to do. To the man with a hammer, every problem tends to look pretty much like a nail. The alternative truth was a little messy, and they’d forgotten the great economist Keynes, whom I think said, ‘Better to be roughly right than precisely wrong.” –Charlie Munger

This article is part of a multi-part series on human misjudgment by Phil Ordway, managing principal of Anabatic Investment Partners.

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Update

As the world’s professions and businesses get ever more specialized, there is still considerable value to a broad, multi-disciplinary frame of mind. It is especially helpful in avoiding man with a hammer syndrome.

“Just as many smart people fail in the investment business as stupid ones. Intellectually active people are particularly attracted to elegant concepts, which can have the effect of distracting them from the simpler, more fundamental, truths.” – Peter Cundill[32]

False precision is an especially dangerous kind of error, as we’ll see below in a couple of cases. Just think of all the nonsense that gets spewed in models, forecasts, and target prices, always down to the last degree or two decimal places. Not only does it convey confidence that shouldn’t be there, and build up that overconfidence internally, it also destroys credibility among anyone on the receiving end who happens to know better.

Hardly a week goes by that I don’t marvel at some case of man with a hammer syndrome. It is especially prevalent in the investment business. What do analysts know how to do? Create models, run DCFs, and write memos. That is the kind of rote behavior – and what Howard Marks would call “first-level thinking”[33] – that is and should be replaced in large part by algorithms.

Weather and climate is an interesting area in this regard. The long-term climate models have not, by and large, held up well over the past 20 or 30 years. They’ve improved a lot and they’re directionally right, but because they called for exactly X degrees of warming by some specific date, and the result was far less than X, the whole framework is being cast into doubt. Had the scientists made more of an effort – some of them may not want to make an effort, while others’ efforts may have been thwarted by noise in the world – to convey reasonable uncertainty and avoid false precision, the result would have been more credibility and a better outcome.

Think of just meteorology on a local scale. Contrary to popular belief, weather forecasting (as distinct from long-term climate modeling) has improved by leaps and bounds in the past few decades. With plenty of rigor, a 24-hour forecast is now as accurate as a three-day forecast was a decade or two ago. Hurricane tracks can be reliably forecasted down to a few dozen miles up to a week in advance; more than 24 hours was a miracle 30 years ago. But these facts are lost on the public for many reasons, and a big one in my opinion is the communication of forecasts. Meteorologists have math/science backgrounds and now have access to supercomputers that can produce pinpoint forecasts for any location down to a certain zip code. And so what do they do? They issue precise, pinpoint forecasts even though they are totally useless. The average forecast reader/listener is clueless – they often don’t know the first thing about what the forecast is even trying to say – but they’re not that dumb. The forecast itself is communicated with certainty when no such certainty exists, and so most people lose faith in the forecaster. Why on earth does almost no one issue a forecast that has a range (even a small range) of temperatures throughout the day along with a range of probabilities for storms/precipitation?

Buffett in 1997 wrote a reinsurance policy for the California Earthquake Authority, risking about $600 million of BV and ~1.5% of Berkshire’s market value. Buffett’s notes that its securities portfolio has subjected the company to far greater volatility. The deal involved $1 billion of risk after $5 billion of aggregate insured losses had been incurred, and was being shopped at a price of 5 times the estimated actuarial value, but it found no takers. That is because the quantitative analysis at other firms ran into a dead end upon realizing the true odds could not be precisely estimated. The 1994 Northridge quake also loomed large in many people’s memories: it had “laid homeowners’ losses on insurers that greatly exceeded what computer models had told them to expect. Yet the intensity of that quake was mild compared to the ‘worst-case’ possibility for California.” Unsurprisingly, Buffett stepped in. “So what are the true odds of our having to make a payout during the policy’s term? We don’t know – nor do we think computer models will help us, since we believe the precision they project is a chimera. In fact, such models can lull decision-makers into a false sense of security and thereby increase their chances of making a really huge mistake… Even if perfection in assessing risks is unattainable, insurers can underwrite sensibly. After all, you need not know a man’s precise age to know that he is old enough to vote nor know his exact weight to recognize his need to diet.”[34]

Extrapolation is a derivative of this tendency too. As Kahneman and Tversky have found, people often use heuristics to help them make decisions, but a special problem develops when people often extrapolate heuristics from situations that are appropriate to situations where they simply do not work. As always, there must be a robust and multi-disciplinary latticework of mental models – the use Munger’s preferred phrasing – if there is going to be any success in the real world. It doesn’t take much search to find business leaders who attach themselves to one idea or framework and try to apply it in the wrong area.

There may not be a single trait more effective in countering man with a hammer syndrome than simple intellectual curiosity. And “Curiosity Tendency” is its own tendency in Munger’s revised framework. The curiosity trait may be partially or mostly innate, but it can also be cultivated. I remember going to the library in college and, to the detriment of my grades, spending four, six, sometimes eight hours completely lost in something that had absolutely nothing to do with my courses. Ted Weschler recently said, “I spend the vast majority of my day reading. I try to make about half of that reading random.”[35] I don’t know how to quantify the benefit of such an approach, but I think we’ve all experienced the opposite when a strict, narrow, stifling atmosphere acts as a constraint.

“The secret to doing good research is always to be a little underemployed. You waste years by not being able to waste hours.” – Amos Tversky[36]

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[32] There’s Always Something to Do: The Peter Cundill Investment Approach by Christopher Risso-Gill: https://goo.gl/aMK2A0
[33] https://www.oaktreecapital.com/docs/default-source/memos/2015-09-09-its-not-easy.pdf?sfvrsn=2
[34] https://www.hks.harvard.edu/fs/rzeckhau/InvestinginUnknownandUnknowable.pdf and http://www.berkshirehathaway.com/letters/1996.html
[35] https://finance.yahoo.com/news/warren-buffetts-money-managers-todd-combs-ted-weschler-speak-142643892.html
[36] The Undoing Project by Michael Lewis.

Some Thoughts After Five Years of Discretionary Management

October 10, 2017 in Letters

This article is authored by Alain Robitaille of Le Groupe Robitaille at Desjardins.

We began discretionary management of our portfolios on July 1, 2012. Many clients had already invested in our different models before that date, but we had to contact each of them for each transaction before I obtained my licence. As shown on the chart on the first page, the average annual return of our equities portfolio has been 19.10%, which is 4.55% better than the market average.

As you undoubtedly already know, as a faithful disciple of Warren Buffett, my goal is to beat the market over a long period of time. Fanie and I believe it is possible to continue to do so for many years to come. Of course, “possible” does not mean “easy,” but Warren Buffett and many managers who follow his principles have managed over the long term to prove that work, discipline and working in very small teams can produce great results. I know some of the “superinvestors” who are followed each quarter by several publications. Generally, they are managers like us, who act alone, without a team of analysts and without an investment committee, who think for themselves and who make investments for the very long term. For us it is a constant challenge and highly stimulating.

Is it common to beat the market?

According to Standard & Poor’s (SPIVA Canada Scorecard 2016), over the past five years, only 5.43% of Canadian managers who use our benchmark indexes outperformed the index.

So for the past five years, a little less than 6% of managers “beat the market.”

According to the Morneau Shepell publication which calculates the performance of Canadian managers on a quarterly basis, a manager would have had to generate an annual return of 18.45% or better over the past five years to rank in the first five centiles at June 30, 2017.

We have produced an average annual return of 19.10%.

And we did it without a management committee and without a team of analysts, by employing the good old method used by Buffett and Munger since 1956, that is, a lot of reading and thinking, and few trades. And don’t forget that our fees, which come to an average of 1% per client, are very competitive.

Here is a reminder of our investment philosophy:

  • We try to beat the market over a long period without incurring the risks of market timing or speculation.
  • We look for companies that have a sustainable competitive advantage and operate in sectors that we consider essential to
  • We want to invest at the lowest possible price and for a very long period of 10 years on
  • We choose business managers who have a substantial ownership interest and who manage their shareholders’ capital with a view to long-term

An interesting discussion with a client

A client recently mentioned to me that a competitor’s fund portfolio that he heard about had a return similar to that of our equities portfolio. We checked the numbers together:

  • Average annual return of the competitor’s equities portfolio over five years: 9%
  • Average annual return of our equities portfolio over the same period: 19%

I was somewhat disappointed that my client used the term “similar.” Since the difference can be hard to grasp as a percentage, here it is in dollars, using a hypothetical amount:

Initial capital: $1,000,000
Value of the capital after five years with the competitor: $1,565,681
Value of the capital after five years with Groupe Robitaille: $2,395,900

Both of the portfolios concerned are indeed equities portfolios, and although the competitor claims that he takes fewer risks, this is probably not the case. Past performance is no guarantee of future results, but we will continue to strive to achieve the first of our objectives mentioned above.

Interesting questions from our clients at our annual meeting

Here is a retrospective of the interesting questions that investors asked us (some several times) at the reception we organized in May in three cities in Quebec, as we do each year.

Do you intend to continue doing this job for a long time?

A very appropriate question from many clients, considering that you generally entrust us with most of your financial assets and that you believe in our investment philosophy. I like to think that this question suggests an intention to retain me as a manager for a long time, but it is difficult to answer. I’m still passionate about my job, and each day, without exception, I look forward to going to the office, working with an efficient team, and taking up intellectual challenges. You have probably guessed that Warren Buffett influences my way of thinking. I wonder what drives him to go to work each day at age 86, when he has a personal fortune of about $77 billion… The answer probably has to do with passion. My father worked all his life, seven days a week. When he reached retirement age, he said jokingly that for him, this stage simply meant that he stopped getting paid to work (he hasn’t slowed down much). He passed on to me his passion for work, and I’m going to try to be a better capitalist and avoid retirement!

What explains the underperformance of our portfolio in 2016?

I knew that my clients had a good memory! Our portfolio is partly invested in U.S. stocks without currency hedging, so the appreciation of the Canadian dollar had an impact on returns. However, the main reason for the underperformance was the rise in the energy and materials sectors in Canada, in which we were not invested. Consequently, the index performed better than us. This was our second year of underperformance in the past eight years. In other words, there have been two years where we didn’t “beat” the market. The first time, in 2010, it was for the same reasons, i.e. a rapid rise in resources, a sector absent from our portfolios.

Will President Trump have a negative impact on the markets?

He certainly does not leave anyone indifferent! Changing presidents can radically alter the image of a country, since it can greatly influence foreign policy, taxation and many laws. We also realize that the American political system is designed to prevent a single individual from taking control of the political apparatus. Wishing to avoid the effects of a monarchy, the founders of the U.S. constitution divided powers between the president and the two houses – the Senate and the House of Representatives. Every two years, elections are held to elect some members of these houses. So although the president (Republican) is from the same party as the current majority in both houses, in one year, things could change. For the stock market, the impact could be positive and result in more moderate taxation and regulation. The stock market is unpredictable and I would not bet on one man influencing it for long. This reminds me of a quotation:

“Go for a business that any idiot can run, because sooner or later, any idiot probably is going to run it.” — Peter Lynch

What was your worst investment mistake?

That’s rather hard to answer, because I must humbly admit (investing teaches humility) that I’ve made many mistakes, which is normal. No manager is always right, it’s impossible. I could generally classify mistakes in two main categories:

Mistakes of omission: We studied a company and agreed that it met our criteria; however, for a reason that still escapes us, we didn’t buy it. Of course, the shares of that company subsequently rose sharply. These are indelible memories for me that would take too long to enumerate, but ask Fanie this question: she’ll have some stories to tell you.

Lack of respect for the circle of competence: The mistakes in this category have not to do with buying a company that we failed to study, but where we failed to understand its future challenges and how its environment would likely evolve.

The key, of course, is to recognize one’s mistakes and to learn from them. Selling at a loss is not the worst thing; stubbornly holding on to a losing company can be much more costly. Ask the shareholders of Nortel!

Thank you once again to all our clients who came to our meetings and who asked questions. Answering them cold was very stimulating!

An inspiring read…

I recently read a very interesting book: the autobiography of Edward O. Thorp entitled A Man for All Markets. I recommend this book, whose main focus is not on the investment, but rather on effort and using your abilities to succeed.

From a modest background, Edward Thorp managed to become a university professor of mathematics. He subsequently tried to prove that it is possible to use the law of probabilities to win at games of chance. (Don’t try it: casinos have adapted!) To do this he invented the first portable computer. He then used statistics to “invent” quantitative investing. The book contains some interesting thoughts, including on the importance of being generous when we are successful, a notion dear to my heart.

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Disclaimer: The results shown are before management fees. This data reflects past performance and is not indicative of future returns. This document may contain statistical data cited from third-party sources believed to be reliable, but Desjardins Securities does not represent that any such third-party statistical information is accurate or complete, and it should not be relied upon as such. Alain Robitaille and Fanie Ouellet are registered as portfolio managers with self-regulating organizations. They are authorized under IIROC Rule 1300 to make investment decisions and to give advice on securities for managed accounts. With the exception of Alain Robitaille and Fanie Ouellet, no member of Groupe Alain Robitaille may exercise discretionary authority with respect to a client’s account or approve discretionary orders for a managed account, or participate in the formulation of investment decisions made on behalf of or advice given with regard to a managed account. Each Desjardins Securities advisor named on the front page of this document, or at the beginning of any subsection hereof, hereby certifies that the recommendations and opinions expressed herein accurately reflect such advisor’s personal views about the company and securities that are the subject of this document and all other companies and securities mentioned in this document that are covered by such advisor. It is possible that Desjardins Securities has previously published other opinions, including ones contrary to those expressed herein. Such opinions reflect the different points of view, assumptions and analysis methods of the advisors who authored them. Desjardins Wealth Management Securities is a trade name used by Desjardins Securities Inc. Desjardins Securities Inc. is a member of the Investment Industry Regulatory Organization of Canada (IIROC) and the Canadian Investor Protection Fund (CIPF).

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