Dear Fellow Shareholder,
Value Investing & Cyclicality
In October, we hosted the 18th Annual Third Avenue Value Conference. This year, attendees heard a very timely presentation from keynote speaker Bobby Tudor, Chairman and CEO of Tudor, Pickering, Holt & Co., an investment firm and merchant bank focused exclusively on the Energy industry. In order to avoid consuming paragraphs regurgitating Bobby’s credentials, I will assert that he is among the most experienced financiers and investors active in oil and gas markets today. Bobby began an outstanding presentation by sharing one peculiar element of his eponymous firm’s ethos—anyone who says “this time is different” is fired. While he did go on to present a very plausible scenario for a future balancing of the global oil markets, neither Bobby nor oil are the topic of this letter per se. Rather, we wish to more broadly discuss the topic of cyclicality as it relates to value investing and the importance of the human tendency to believe that “this time is different”.
Before moving on to specific adventures in cyclicality, we offer a few thoughts on the makeup of value investors as preface. Value investing, as we define it, demands a generous helping of skepticism. The value investor himself is likely to describe the trait as a sense of realism. A willingness to take a view contrary to the perceived wisdom of the day, and do so with conviction, by definition requires that the investor be skeptical of the veracity of received wisdom and instead favor conclusions drawn from independent research and analysis. As a result, value investors tend to be less prone to bouts of euphoria and doomsday hysteria. Emotional highs and lows drive valuations to extremes and create opportunities for more even-keeled value investors.
A second value investing necessity is the ability to fixate on long-term value as opposed to short-term outcomes and momentum. It is easier said than done in the context of securities markets dominated by participants who operate with a very short time horizon and with a set of considerations entirely distinct from those weighed heavily in value investing. In truth, analyzing and estimating the long-term value of a security is in most cases a far easier proposition than predicting its near-term trading price. Analytically the two exercises share almost nothing in common and require completely distinct sets of skills. Anyone expecting undervalued securities to reliably converge to their long-term values over the short run is setting himself up for a very frustrating experience. To quote Jim Grant (of Grant’s Interest Rate Observer), “Successful investing is about having people agree with you…later.” Alas, in spite of the outsized success of a number of value investors over long periods of time, value investors remain an extreme minority in the equity investing world.
In the creation of severely mispriced cyclical securities, the assertion that “this time is different” is often of great importance and its infiltration into communal thinking, whether conscious or subconscious, is so frequent that Tudor, Pickering, Holt & Co. felt compelled to make a rule abolishing its use. For business cycles and macroeconomic cycles, the notion that “this time is different”—i.e., that, for some reason specific to the particular upheaval under consideration, a return to conditions resembling historical norms is unlikely this time around—is critical to creating overvaluation and undervaluation.
To the extent that securities are conventionally valued as some form of present value of their estimated future returns, the prices of securities issued by cyclical businesses should intuitively be less volatile than the operating performance of the businesses themselves. In other words, if a return to normalcy from a cyclical low or high was widely anticipated, the security price would reflect that anticipated future normalization. Instead, the opposite seems to be the norm. Securities prices tend to exhibit far more volatility than the operating performance of the underlying businesses and prices frequently overshoot in both directions, wildly so sometimes. While we have much experience in this phenomenon over almost 30 years of investing through industrial and macroeconomic cycles, I was surprised that academics have also made similar observations offering a strong argument for contrarian value investing. David Swensen (Trades, Portfolio), the highly regarded Chief Investment Officer of Yale University, offers the following paragraph in Pioneering Portfolio Management:
As it relates to contrarian value investing, the considerable mispricing which at times accompanies macroeconomic and industrial cyclical depressions can provide exceptional opportunities for investors who approach situations with skepticism, a long-term investment horizon and a diligent evaluation of fundamental risk. The timing of a recovery from a deep cyclical depression is extremely difficult if not impossible to predict but frequently takes longer than the short-term investment horizons employed by most investors. Further, it is understandable that for many investors the emotion and controversy often encircling businesses in severe cyclical downturns have a way of relegating long-term fundamental considerations to the back seat while fear, emotion and an acceptance of security price volatility as a valid measure of risk move forward to drive the bus. We have a compulsion to fixate on the long-term and conduct a thoughtful analysis as to whether prices have overshot a reasonable mark and, whether the company and specific security under analysis will survive and benefit from an eventual recovery. In the following few paragraphs we will discuss real world examples of our investment activity in the depths of macro and industrial cycles, and draw connections to areas of our current investment activity which has been robust over the quarter with five additions to the Third Avenue International Value Fund (Fund).
Macroeconomic Cycles - Japan vs. Brazil
After three years as one of the world’s best performing equity markets (even in US Dollar terms), one could be excused for forgetting that only three years ago, a commonly voiced and accepted view was that Japan’s demographic issues and multi-decade battle with deflation rendered it wholly unattractive as an investment destination. We could easily add to the list of woes with perceptions of Japanese corporate culture colored by poor capital management decisions, poor returns on capital and a general lack of consideration for shareholders. Japan had entered the global financial crisis (“Lehman Shock” in Japanese parlance) on its heels, already suffering longterm deflation and anemic growth. The Japanese economy took the crisis very hard and never experienced the magnitude of economic and securities markets resurgence that many other developed markets enjoyed in 2009 and 2010. In March 2011 an earthquake and subsequent tsunami led to a meltdown at the Fukushima Daiichi Nuclear Power Plant. Japan experienced a population decline as foreigners fled. Less well remembered were historic floods in Thailand later in 2011 that inundated an important industrial region upon which the supply chains of Toyota, Honda, Nissan and a slew of auto-related and tech companies were dependent. 2011 was a year to forget in Japan, as were several years prior to that during which China surpassed it as the world’s second largest economy. Human memory has a way of softening recollections of such events but at the time the near-term outlook was so bleak that much of the investing world had forsaken Japan.
During those bleak Japanese days of late 2011 and early 2012, the Fund purchased two new Japanese positions—Daiwa Securities and Otsuka Corp, respectively—adding to Japanese positions already held by the Fund. In the case of Otsuka Corp, which provides IT consulting, office equipment sales and distribution of office supplies - we paid roughly five times EBITDA for a business that was growing decently as a result of its growing market share in the distribution of office supplies. Small businesses were not investing at the time and growth was very weak within its IT consulting and office equipment businesses. The summary investment thesis was that if we see no future improvement from the very poor macroeconomic environment, we are likely to earn a fair, albeit unexciting return. If however, Abe and the Bank of Japan responded to enormous and growing political pressure by crafting a credible and aggressive plan to encourage inflation, GDP growth and business investment, then we would really be in great shape.
In the three years that followed, the excitement surrounding Abenomics grew considerably, far beyond the actual economic progress made. Several initiatives, including massive equities purchases by the Bank of Japan through ETFs and REITs in coincidence with similar purchases by large Japanese pensions and insurance companies helped propel the Japanese equity market’s strong performance. Otsuka has continued to grow its business at a reasonable pace, with EBITDA increasing by more or less 8% per year over the last three years. However, the market multiple assigned to that EBITDA expanded from roughly five times to more than eleven times today. The current multiple of earnings is a very optimistic twenty-three times. In other words, valuations have increased (exploded) in Japan far more than the fundamentals have improved. Stopping well short of making a Japanese market call, we will say the numerous Japanese equities with which we have experience have come to reflect a considerable amount of confidence that policy initiatives will be resoundingly successful.
We think it healthy to maintain some measure of skepticism and consider whether we really want to pay prices reflective of near-certain policy success. In the case of Otsuka, we opted to close out of a very profitable investment during this past quarter. We had earlier closed out our position in Daiwa having had a very similar investment experience. The escalation of Japanese valuations is fascinating in the context of a macroeconomic environment, demography and corporate culture in which improvement has barely been discernable. It is true that a declining Japanese Yen has been very helpful for a number of export oriented Japanese firms, though signs that those gains are flowing into the domestic economy are few and far between. We certainly don’t know how the Abe experiment will end but the policies are not without considerable risk, particularly given the exceptional level of government indebtedness. Many valuations appear contingent upon a smooth walk across the tightrope.
At the other end of the spectrum, Brazil was among the world’s most coveted investment destinations in 2011, so much so that it required capital controls to limit investment inflows and the accompanying strong appreciation of the Brazilian real. Brazil was the mirror image of Japan in several ways – endowed with extraordinary resources, favorable demographics, rising middle class, macroeconomic growth, and other attributes to get top-down investors excited. Of course these observations tell you nothing whatsoever about the attractiveness of potential Brazilian investments, many of which were valued at ludicrous levels expressing confidence that the good times would roll on indefinitely. Those days are long gone. The Brazilian economy has slowed while high inflation has proved extremely stubborn, a duality which makes policy solutions very challenging. The exposure of rampant graft in and around Petrobras, the state-controlled hydrocarbon company, has additionally complicated the landscape as many implicated politicians are jockeying for indemnity rather than fixing major structural economic issues. It sounds like plague, pestilence and so on. Most investors, focused on the next few quarters may be justified in fleeing Brazil, as they did Japan in 2010 and 2011.
Measurements of capital flight from Brazilian markets illustrate that this is exactly what has been happening. As if we needed yet another sign post, Goldman Sachs recently announced the closure of its BRIC fund, which had reportedly lost 88% of its asset base since 2010. The irony will not be lost on those who recall that a Goldman economist invented the term BRIC. Signs of capitulation abound.
Brazil’s path to resurrection will not be a short one and the first steps have not even been taken yet. However, when one starts contemplating life beyond the next few quarters, the set of relevant questions begin to change. One might ask whether this time really is different – meaning, is Brazil likely to survive this mini-crisis just as it has survived major economic crises of the past, military dictatorships and coups? Or is it now headed towards perpetual chaos? Additionally, one must ask possibly the most interesting question, which is whether security valuations reflect, or hopefully more than reflect, all of that gloom which is known to even casual observers? And might there be businesses that are extremely likely survivors with valuations reflecting exceptional long-term value (on a risk-adjusted basis)? As a final point, it is important to understand that the timing of appreciation of undervalued securities is extremely difficult to predict and does not, other than by coincidence, move in rhythm with actual improvements in real world conditions. In other words, just as in Japan where a mere whiff that conditions might improve created an explosion in valuations, in Brazil we may wake up one morning to find a broader acknowledgment that the demographic and natural resource endowments of Brazil are just as intact as they were in 2011 and, although it will be circuitous and sloppily executed, the Brazilian government will find some path forward. Valuations change with changes in sentiment, which changes far more frequently and dramatically than is justified by real world conditions. In addition to Japan, we could also point to the recovery from the European sovereign crisis as a case study. We have seen European equities rise by roughly 15% per year (in euros) over the four years since the heat of the crisis. I would remind readers how shockingly little has actually been accomplished in terms of sovereign debt reduction, budget balancing, successful macroeconomic growth stimulation or financial sector structural reform, in order to facilitate such an asset price recovery.
We have taken advantage of the prevailing sentiment in Brazil to purchase Cosan Ltd, a Brazilian industrial conglomerate with a variety of exceptional and resilient businesses. Cosan operates one of Brazil’s largest fuel distribution businesses in partnership with Shell. The company is also the largest producer of sugar and ethanol in Brazil and, through a separate publicly-listed entity, controls the largest natural gas distribution business in Brazil. The company is controlled and operated by a team of extremely competent and experienced executives who built the company from a very small scale over decades. It is worth noting that those decades of business building spanned the Brazilian military dictatorship and multiple major economic crises referred to above. Today, the valuation of Cosan Ltd has become exceptionally attractive as a result of a poor near-term macroeconomic outlook and, to a lesser extent, the complexity of the conglomerate structure.
