Dear co-investor:
When in 2017 we recommenced our activity under the structure of Cobas Asset Management, markets in general, were not cheap, but we were capable of identifying companies trading at a considerable discount. We invested at an average of 8-9 times profits and, now, following
COVID-19, we are trading at 5-6 times, unsustainably low levels. As a whole, our estimated normalised profits have not varied significantly and, hence, target values have not undergone changes either.
In the past, we have faced crises and exceptional uncertainty, which have proven to be source of extraordinary opportunities for those that were capable of resisting and investing. Once again, we are faced with one of these situations. The novelty, as we know, is the health and political uncertainty which has led part of the global economy to temporarily suspend its activity. Faced with this scenario, it is not surprising that the stock markets are functioning especially badly and do not reflect, in many cases, the intrinsic (future) value of the underlying assets.
There are various ways to visualise why this is the case. On the one hand, it is easy to emphasise with the non-professional private investor which, burdened with daily problems (children, sentimental and business partners, mortgages, neighbours, etc.) and uncertainties beyond their control (quarantine, prohibitions, etc) ends up taking investment decisions that are too quick, instinctive, scantly justified and, therefore, wrong. On the other hand, governments and central banks are obliged to save companies to reduce the possible impact of the virus on their economies as far as possible. This is generating higher deficits that are financed by issuing newly created debt and money. This massive emissions policy, which would be considered undesirable in other circumstances, is finding especially scarce political opposition and is, among other effects, distorting asset prices in capital markets.
Money is earned on the stock markets in the long term, maintaining a good psychological state which enables to invest, obtaining more than what we paid, regardless (and frequently to the contrary) of what others do. This is especially important in these circumstances.
The resilience of our portfolios
To help our unitholders to conserve this mental peace in relation to our investments, in March and April, we wrote four letters in which we broke down and estimated an impact of COVID-19 on the values of our Iberian and international portfolios of approximately -13%. During the following months, it is being verified that the impact is small, as we said. Naturally, this is comforting, since it has been a tough test faced with a series of unexpected events and because our companies are better prepared for the possible future impacts.
Later on, we develop examples that prove how irrational it is that our net asset value does not reflect the strength of our portfolios. However, in this introductory part, it could be appropriate to illustrate it by employing the analogy that Warren Buffett (Trades, Portfolio) uses with his shareholders. He explains with didactic spirit that, if we invest in strong companies, and for that he uses the comparison of impregnable castles with wide moats, they will be capable, in the event of unexpected attacks, of coming out of them unscathed. At Cobas AM, we have invested in companies that have defended themselves very well, but their shares (land belonging to the castle) have been abandoned by frightened owners at derisory prices. Result: we had and we maintain good, well-defended business which are now authentic bargains. When rationality eventually returns, in line with the comparison, many will flock to dispute these well-defended fertile lands and their prices (and therefore the net asset values of the funds) will rise, probably quickly, since all of them will want the best ones and nobody will want to go without such evident opportunities.
Sometimes, these opportunities are more evident because investors expect risks to occur that they consider obvious (i.e. second wave of coronavirus) to be able to buy even cheaper. But this is a strategy that may turn out to be expensive. Firstly, because the risks that everyone is aware of are generally reflected in the prices. Secondly, because there will always be risks, which dissuades them from acting. And thirdly and most importantly, because on the stock markets, returns are distributed asymmetrically. In a few days, returns are obtained sown, sometimes over many years, and the opportunity cost of not being invested may be very high.
We are aware of the inconvenience and discouragement that may be caused by such low net asset value levels but, on the other hand, this generates historical opportunities that will be a source of psychological and capital satisfaction in the coming years. Companies analysed over so long, with their strengths proven in an extreme scenario, bought at good prices and which, furthermore, are now trading much more cheaply, are the perfect recipe for extraordinary returns. Accordingly, from the Analysis and Investment team, we have continued to invest in these last few months.
We are not alone
Before commenting on the performance of our businesses, it is advisable to clarify an important point. In talks with co- investors, we have detected that some consider that our shares trade cheaply because they are found in sectors that are not very interesting for third parties. We do not share that view. The shares that we hold have traded above our target values and virtually all of them have comparables that currently trade at higher multiples. Any businessman that wishes to compete with our companies will find it much more expensive to invest in developing businesses than buying them from us through the stock market… If only we, the current shareholders, agreed to sell them at the price at which they were traded!
A recent interesting piece of news is the investment that Berkshire Hathaway, the holding company of Warren Buffett (Trades, Portfolio), has just made to acquire a natural gas transportation business for 10,000 million dollars. According to our estimates, Buffett would have paid 8 times profit, undoubtedly an attractive price, but significantly more expensive than our shares of Teekay LNG trading at 4 times profit, for example. For us, it is much easier to invest in better multiples because we manage much lower capital.
Buffett, is not the only one interested in similar businesses to ours. In December 2019, in an interview with the prestigious magazine Barrons,* the legendary fund manager Peter Lynch made comments on where it found value:
“There’s a real shortage now of growth companies. That is a red flag, because all the money is flowing into [a few companies]. There’s an end to that game. It will scare me if this trend continues for a couple more years.”
“I’m looking at industries that are doing badly; that for some reason will get better. Shipping. If you want to buy a ship, it’s a two- or three-year wait. People haven’t ordered ships for a long time, because by the time one comes in, prices may be down again.”
“Energy services is awful; that could have a major turn in the next year or two. Oil is interesting. Look, longer term, solar, windmills really work. But you need natural gas and oil to bridge to this. Everybody’s assuming the world’s going to not use oil for the next 20 years. […] I’m buying companies that I don’t think will go bankrupt.”
That investors that we admire so much, such as Warren Buffett (Trades, Portfolio) or Peter Lynch, coincide with Cobas Asset Management in where to “hunt”, is not a coincidence. These are exceptional opportunities.
Our international portfolio
Before commenting specific investment cases, it is advisable to take into account that all our businesses are real and tangible and many have been declared to be essential by the governments during this pandemic. Significant examples are our energy businesses (Teekay, Golar LNG and Hoegh), the management of care homes for the elderly (CIR), defence (Babcock), the transportation of crude (International Seaways and Diamond Shipping) or technology (Samsung Electronics). We have only had two companies with problems of little importance (Valaris and Petra) which we liquidated and in the few cases in which the coronavirus had a greater impact, our business have had the support of governments in the form of stimulation and liquidity lines to soften the temporary fall in demand (Renault, Porsche, Hyundai and BMW). It is also interesting to mention the performance of our retail sale companies (Dixons, G-III, Matas, Fnac and OVS), which, during the coronavirus outbreaks, have offset their lower sales at stores with higher online sales and they have improved their competitive position.
During this quarter, the breakdown of the international portfolio has not varied significantly. The listings of our main defensive positions (Teekay, Golar LNG, CIR and Babcock) have traded as if they were cyclical and, therefore, it was not advisable to rotate the portfolios. Below, we offer greater details in this regard.
We have explained the investment theory in Teekay LNG (TGP, Financial) (5.6% of the portfolio), engaging in the maritime transportation of liquified natural gas through long-term contracts, on numerous occasions since it commenced in 2017. In recent months, progress in the execution of the company has been notable and completely according to plan. The main progress was:
- Completion of the growth programme, which increased the size of the company by approximately 60%, all with very long-term contracts
- Beginning of accelerated debt repayment due to the substantial increase in cash generation once the growth phase has been concluded.
- An increased quarterly dividend from $0.14 per share to $0.19 in May 2019 (+35% rise), and more recently to $0.25 per share in May 2020 (+31% rise), a cumulative dividend rise of 78% in a little more than a year.
- The simplification of the corporate structure with the recent elimination of the “IDRs” (asymmetric remuneration mechanism in favour of the parent, which was not considered by the market).
Accordingly, Teekay LNG is nowadays a very different company in comparison with three years earlier, although the market has not yet reflected it in the valuation. Let us also recall that this company is very different to the remaining listed alternatives, since its long-term contracts, protected in volume and price, have not suffered the impact of COVID-19 in any way. While many companies on the market cut back or suspend dividends, Teekay LNG has the visibility and trust to continue to increase them, while it reduces its debt. Currently, its earnings per dividend were 9% with a PER of 4x.
With respect to Teekay Corp (TK, Financial) (2.9%), the parent of Teekay LNG, the investment theory has also progressed materially, not only due to everything that affects its participation in Teekay LNG (42% following the conversion of the IDRs into shares), but also due to the progressive divestment of its FPSO platforms, and also due to the significant improvement in the balance sheet of its investee Teekay Tankers (TNK, Financial). The latter has benefitted from the extraordinary increase in daily fleet rates. Our investment theory in crude tankers (also applicable for our investment in International Seaways) envisaged an improvement from such depressed levels in recent years, but the levels reached in the last three quarters have been extremely good, which enabled them to reduce their debt by over 20% in the first semester of the year. This accelerated deleveraging is occurring in the whole maritime sector, which for the time being remains very disciplined (they do not order new boats), which foretells a good business in the coming years, as we expected in our original theory. Even so, the sector continues to trade below the net asset value.
With respect to Golar LNG (GLNG, Financial) (7.6%), the theory is possibly also familiar, but it is still a relatively complex company which perhaps it is worth recalling with 3 main blocks as sources of value:
- FLNG floating liquefaction (long-term contracts).
- LNG maritime transport.
- Marketing of LNG (long-term contracts), nowadays in Brazil.
Given these blocks, Golar LNG participates in the LNG value chain, the energy of the transition towards a future of reduced emissions, in a diversified manner. This protects it against variations in its value sources: when the low price of LNG discourages new liquefaction projects, in turn, it favours marketing and vice versa. Golar LNG has also made material progress in some of its fronts over recent months, despite COVID-19:
- Beginning of Sergipe in Brazil, the largest thermal plant in Latin America, with the accompanying generation of FCF.
- Signing of an exclusive contract with Petrobras Distribuidora for the sale of LNG at petrol stations.
- Progress of other LNG projects in Brazil (Barcarena, Suape…).
However, COVID-19 has delayed the progress of certain FLNG projects. These delays do not affect the current business, rather the generation of additional value in the future. In any case, Golar LNG is nowadays a much richer company with less uncertainty than two years ago when our investment commenced. Its vision is already tangible, with FCF flowing increasingly stronger each quarter, and the growth in EBITDA, in accordance with that planned, it is evident and sustainable. The market however not only does not recognise the improvement, rather it values it at a higher discount than before. The greatest concerns continue to be the complexity (something which Golar LNG LNG is working to improve) and the availability of liquidity to finance growth (Gimi project). However, the company has shown its great performance capacity and its growth plans are very attractive.
Our natural gas infrastructure companies (Teekay, Golar LNG, Hoegh, Exmar y Dynagas) ) are backed by around 100 long-term contracts. Despite COVID-19, only two of them have performed differently to that envisaged. One was delayed, as we mentioned in the previous quarter's letter and in the other (at Exmar) a non-payment was declared by YPF, one of our weaker counterparties. Even in these two contracts, we consider that the impact will be limited. This reflects the robustness of these contracts, which are not being renegotiated despite the significant fall in the price of gas. We have a good example of its quality at Dynagas LNG, which succeeded in being refinanced at 3.5% despite being the most indebted company in our portfolios. As a reaction, its listing rose from $1 to more than $3 per share in the quarter.
CIR (MIL:CIR, Financial) (8.0%) is one of our main positions because it has close to 70% of its capitalisation in cash and because its main asset, KOS, geriatric homes and rehabilitation hospitals in the north of Italy, is in a sector in which the prospects are favourable.
Following the initial negative impact of COVID-19, the situation in the care homes now seems to be under control, but little by little, the number of active cases of COVID-19 is decreasing and new patients are being readmitted. This company proves the resilience of the sector, since the populational pyramid is being increasingly inverted and the service provided by KOS is basic and highly necessary, now and in the future. By way of an example, to cite simple number, in Spain there are approximately 3 million people over 80, there are 373 thousand beds in care homes and the deficit is estimated at around 70 thousand beds. This situation is similar in the whole of Europe.
This pandemic has proven the wise move of the management team in the diversification undertaken last year by entering into Germany, a country which has scarcely had coronavirus cases and whose virulence has been much lower. No one could have imagined a perfect storm such as that experienced by KOS: a virus which attacks its target patients in the geographical area in which it has most of its operations.
With respect to the future, we believe care homes will have to assume certain additional costs and there will be small operators that cannot assume such costs due to their size. We believe this situation will accelerate the concentration of the sector (at more reasonable prices) and KOS will be one of the companies leading this concentration.
Meanwhile, the price of CIR shares has scarcely rallied from minimums, unlike what happened with shares of Orpea or Korian, , its main rivals, which rallied from minimums by ~40% and ~20%, respectively. These companies are trading at higher multiples in comparison with our valuation of KOS.
Naturally 2020 will be a difficult year for KOS and the sector, but we are optimistic for 2021 and onwards. Once again, a good business, well managed, which trades at very attractive prices due to a clearly temporary problem.
Babcock International (LSE:BAB, Financial) (3.9%), the second largest supplier of defence services in the United Kingdom and leader in emergency services through aircraft in Western Europe, Canada and Australia, is a company with clear competitive advantages (unique assets, exchange costs and economies of scale) and scantly cyclical (with 80% of its contracts at long term), which was affected in 2020 by the obligatory stoppages imposed by the governments.
In emergencies, with governments asking their citizens not to leave their homes, the number of accidents fell and the use of salvage, rescue and health services dropped. Consequently, margins will shrink this year, because they have had to continue paying the helicopter leases. Fortunately, per contract they receive compensation for installed capacity and value will be destroyed. Also, in defence services, part of the military training was postponed and in the maintenance services for military assets, productivity has fallen. This will have an impact on the savings which Babcock traditionally obtains from the British Defence Ministry and, consequently, margins will also be reduced in this business this year.
Once again, the important thing here is to discern that they are not cyclical businesses, although as a result of the quarantine periods they may seem to be at first sight. This market is reacting in an exaggerated manner to temporary problems that clearly do not affect their business in the medium term: there will continue to be accidents and it will be necessary to continue maintaining the armed forces. Accordingly, while our valuation falls by 10%, Babcock listing has fallen by 50% this year, from already cheap levels. Currently, companies with businesses comparable to those of Babcock, which, in our opinion, are not expensive, are trading at multiples between two and three times higher. We consider that Babcock listing should more than triple in the coming years.
We can therefore conclude that, given the sound employer performance of the most stable businesses, and the non-recurring nature of the negative impacts that have arisen as aresult of the coronavirus, and since these facts have not been appropriately reflected in the listings, it was not appropriate to substitute the companies that we have with the new ideas already prepared to be included in the international portfolio.
Our Iberian portfolio
At the end of the last quarter, we began to sell shares of the Spanish banks that we had in our portfolio, because their prospects of generating profit and the quality of the information that we obtained was deteriorating significantly. Fortunately, there were shares of less affected companies, with greater visibility and more tangible, which saw their listings fall the same or more than banks and we took the opportunity to substitute them. Some of these companies are: Applus, Atalaya, Meliá and Metrovacesa, among others.
Applus (XMAD:APPS, Financial) (1.1%), one of the new companies in the portfolio, stands out for being the world leader in terms of the inspection, verification and control of infrastructure related with oil and gas, with special implementation in North America and Europe. Also, in the vehicle inspection business (known as ITV in Spain), Applus is one of the global leaders, with strong positions in Ireland, the United States and Spanish-speaking countries, such as Spain, Costa Rica, Chile and Uruguay. Also, Applus integrates other quality businesses, such as the supervision ofinfrastructures that produce and distribute energy, and the testing of the development of new vehicles or pharmaceutical products. All the businesses have competitive advantages, with their good reputation being the most important (Applus earns money because its “stamp” grants security to its customers, not because it is the cheapest). When we bought Applus, the valuation of the ITV business alone, which generates 40% of operating profit in the absence of coronavirus, was already greater than its stock market capitalisation. We obtained the remaining 60% virtually free, something not very frequent in a company of these characteristics. In this case, the market has already recognised part of Applus's value, and its listing has risen by 40% since we bought it.
Atalaya (LSE:ATYM, Financial) (5.0%), owner of the millennial Riotinto copper mine (Huelva), succeeded in being listed at the beginning of the quarter at less than the investment made in the last two years to expand its production (from 9.5 to 15 Mtpa). Something totally out of place in our opinion. We had the value of the mine free before the expansion, the probable success of extending its useful life following the investments in exploration and the optionality of the mining project in Touro, among other options. Even undeveloped copper mining projects with a comparable capacity were trading at more expensive prices. We took advantage to buy more shares and since then their price has doubled, backed by the sound performance of the price of copper. Despite this, it continues to be very cheap and we feel very comfortable with its management team, which has the habit of achieving what it promises and often more.
Meliá (XMAD:MEL) (4.0%). In our letter for the first quarter, we indicated that Meliá was one of the companies most affected at short term, but the impact at long term would be limited, since it has a moderate debt and owns unique real estate assets with a valuation in normal circumstances of approximately 16€ per share and a family with a future vision.
Here the key factor is what its resistance capacity will be before its value decreases below the listing price (for example, assuming that there are no earnings due to closure, maintaining staff costs, leases on the hotels it does not own, etc.). The reality is that it can bear a lot more that can reasonably be expected. Even in a scenario involving a one-year stoppage, the revaluation potential would be quite more than doble.
Perhaps the most important thing about Meliá aside from the value of its assets, is that it does not have debt or liquidity problems. The current situation differs from that lived during the 2008-09 crisis mainly in this aspect. Only a tenth of its real estate assets have mortgage debt, that is, in a scenario in which this situation is prolonged a lot more, Meliá could mortgage or sell property.
It is also important to indicate that most of Meliá’s assets are very well situated, with investments in the reconditioning and improvement from 3-4 stars to 4-5 stars already made. The hotel sector will obviously suffer over these months, but the smaller ones will suffer more and there will be some family hotels that will end up closing, partly offsetting reduced demand with reduced supply.
As a result of all of this, we consider that with a long-term vision, our investment in Meliá will also be highly profitable.
A final message
During limited periods of time, difficult to anticipate a priori, investment in value behaves worse than other investment styles. Benjamin Graham, “the father of value investing” or as he was known then “the Dean of Wall Street”, used a verse from Horace in the dedication of his book Security Analysis (1934): “many that have now perished will return and many that are now honest will perish”. It was a warning for all those that go out on a limb in this passionate world. He lived many ups and downs, also like many other extraordinary investors such as Buffett, who saw Berkshire Hathaway's shares fall by 50% three times, as his partner Charlie Munger (Trades, Portfolio) commented. Logically, the strategy of buying cheaply, with a considerable discount with respect to the business value, regardless of how shares fluctuate temporarily, has always ended up having good results. We also prefer good volatile profitability to poor non-volatile profitability.
With this philosophy we build our portfolios.
The higher permanent loss of Cobas AM
In May, Mayte Juárez left us. For decades, she was the person ultimately responsible for purchasing shares for our portfolios. All her colleagues remember with affection all the contributions she has made to Cobas, and to other inititiatives, since it was founded, and to the development of the people that train them. Her intellectual curiosity, her combative and non-conformist spirit, her tenacity and professionalism, her humanity and optimism and her friendship have been, and will remain an example for all of us.
