Dear co-investor,
We need to start this letter by reviewing the impact of COVID-19 on our portfolios. Without going into the level of detail of our previous letters from this year, we confirm that the impact on our companies' operations has been small, while the cut in valuations (13/14%) that we explained in those letters has been maintained. Fortu-nately, in this quarter there have been no additional neg-ative surprises in our companies.
Despite this, share prices have not recovered at the pace we expected, with situations as paradoxical as the fact that Teekay LNG is going to have all-time record earnings in 2020, as was envisaged, while its share price fell by 30% in the first nine months of the year, standing at a P/E ratio of 4x.
These case and similar ones force us to review some investment philosophy issues that may continue to help unitholders on this desert crossing.
PHILOSOPHY
The first thing is to remember that we are Value Investors because we understand that it is the only way to protect our savings in the long term and, even more so, in the face of crisis scenarios like those we are currently expe-riencing.
But what does it mean to be a Value Investor? Do we only invest in boring or non-growing sectors?
Value Investment is basically investing in companies that are worth more than the market says. It's that simple.
This may seem very basic, but some confuse the con-cepts and think that Value Investment is something it is not. Remember that Value Investors do not only look for cheap companies based on low multiples ("classic value"). Their main objective is to look for market ineffi-ciencies. As we already know, the market always tends to efficiency, but on that path there are times when certain assets are incorrectly valued. We are trying to make the most of those times. And in order to take advantage of these inefficiencies, we need to be able to have a long-term vision for the investment to mature.
These inefficiencies can also be found in growth companies and in fashionable sectors in the markets, but our goal is not to take advantage of growth or fashion per se, as they tend to be listed at a premium, but to take advantage of the fact that the asset is not being valued well.
If we review our current portfolio, we notice that only 25% can be considered "classic value": automobiles, oil, fertilisers and oil tankers, essentially. In these investments some may argue whether there will be a mean reversion of profits with the consequent appreciation of securities, and to minimise this risk, we prefer companies that have little debt or are backed by assets or have a barrier to entry or competitive advantage.
In the remaining 75% there is good growth and a promising future, with the essential feature being the existence of companies in similar businesses that are very well valued by the market. That is the key: not to look for com-panies or dark businesses, but brilliant businesses in interesting sectors at attractive prices.
We are looking for companies that, for some reason, are not well valued by the market in their respective niches (whether because of their size, liquidity, or because the company is going through a temporary problem and the market extrapolates it forever, etc.) We try to make sure that these problems and that poor valuation is temporary, and that cash generation always prevails. This premise remains absolutely in force, as the ability to generate profits is the only determinant of the long-term share price. In this process, we have found natural gas infrastructure companies, care homes for the elderly, defence compa-nies, leading companies in multichannel commerce, engineering companies with technological leadership to name but a few. The list goes on, it's long, and you don't see declining businesses in it. Some segment of a com-pany may be, but it will be the exception.
It should also be remembered that it is hard to be a Value Investor (many hours must be spent on it), but relatively simple. Only by doing this work can we be contrarian and take advantage of market inefficiencies in the short term, with patience being the main requirement to succeed.
Therefore, it should be noted that for Value Investors the last three and a half years have been the worst in the last 60 years, value has never been so cheap relative to growth companies, see "Reports of value's death may be greatly exaggerated", by Robert Arnott and his colleagues at Research Affiliates. We think this will change.
Dixons Carphone (LSE:DC., Financial) ~5% of the International Portfolio
We are not looking for dark businesses, we are looking for businesses that the market incorrectly values:
We have just commented that some people think that being a value investor involves investing in companies in dying sectors, or at the very least in sectors with little growth. Nothing further from the truth, investing in value involves investing in good assets forgotten by the market, and if they are in growth, so much the better. Let's take Dixons as an example, which is the leader in electronics and home appliance retail in six European countries, and among the top five positions in our international portfolio.
The company results from the combination of Dixons itself with Carphone Warehouse, which is the leader in mobile phone retail in the UK. This merger proved disastrous for shareholders of Dixons, as CW has contrac-tual obligations to sell mobiles with British telecommuni-cations companies. These obligations have resulted in annual losses of £100mn in the last two years, impacting the company's share price. The contracts have already been renegotiated and from the next tax year, 2021/22, they will have a neutral result and hope to have a profita-ble business thereafter.
Meanwhile, the main business, the sale of electronics, goes from strength to strength, being a leader in both online and physical stores, with market shares of 25/30% in all countries. These shares have been increasing year after year.
It has been shown that the customer needs to touch the product, and 80% visit the website and the store. It is con-firmed that the multichannel model is suitable for these products, and that the leader of this model in each coun-try has a competitive advantage that is difficult to sur-pass. Such is how the American leader, Best Buy (BBY, Financial), of which we were shareholders a few years ago in our pre-vious stage, is close to historical highs, having multiplied its price by 10 in the last 8 years. It is trading at 15x market consensus estimated profits for 2021.
Dixons meanwhile languishes by trading at approximately 5x its estimated profits for 2021/22, with exactly the same business model as Best Buy.
Brexit and the fiasco of its merger with CW probably weigh on the investment mood.
We do not avoid growth businesses
Dixons is the leader in online sales in the six countries in which it operates. In the last seven weeks up to August 29, online sales account for 42% of total sales (albeit infla-ted by the closure of stores in the UK for a few weeks).
We estimate that in a standardised environment these online sales can already account for 30% of total sales, which would mean £3 billion. AO World, the largest pure online competitor in the UK expects to have sales of £1.5bn in the UK and Germany this year. Interestingly AO World capitalises today at £1.7bn versus £1.25bn for Dixons, and clarifying that, in addition to an online busi-ness twice the size and higher profitability, Dixons is the leader in stores in six countries. Market efficiency? Obviously not, if we compare Dixons with Best Buy and AO World.
In conclusion, we are not looking for dark businesses, we don't avoid businesses that grow; we are trying to search the market to pay as little as possible for a business that is difficult to replicate and with future growth. And we are patiently waiting for good things to happen.
In the case of Dixons, it will soon be clear that the telephony business will cease to be a liability, with the company surpassing £200mn in net profit; however, we are also starting to see the executives make decisions to bring out value. They recently announced the possible IPO of their Scandinavian business, which has extraordi-nary quality and is overlooked by the market. These and other decisions will cause our valuation of the company to be endorsed soon by its share price.
Dixons is a new example of the type of investment we have in our portfolio today: competitive advantages, depressed listings for easily explainable reasons and temporary market myopia.
VALUE BEGINS TO EMERGE
In the portfolio as a whole, we see how companies are gradually taking steps that make us optimistic about their future behaviour.
This is important, since in the letter of exactly a year ago (you can view it here), we discussed in more detail the ways in which the gap between valuation and price closed and how the market always ended up recognising the value of companies. Today we can say that we started to see some of what we were saying a year ago.
International Portfolio
Danieli (MIL:DAN, Financial) ~4%, a case of corporate simplification..
The market did not have Danieli, on the "radar" because corporate governance "could be improved". That's why we had no further exposure to Danieli despite its extraordinary net cash position. Danieli has 2 types of shares (with and without voting rights) and is controlled by the Benedetti family, which until recently had its back turned to the market.
This situation is expected to change radically, as the Bene-detti family has just proposed shareholding simplification.
Even if the conversion rate is not as expected, we think the net effect of the transaction is positive. This makes Danieli another investment alternative for many more institutio-nal investors, which we think will end up being reflected in the share price.
Remember that Danieli has almost as much cash as it is worth on the stock exchange, and obviously you would have to add the value of its businesses to this cash, mainly that of manufacturing plants to produce steel. This busi-ness has a promising future because the steel manufactu-ring industry is one of the most polluting and Danieli has the technology to reduce its environmental impact.
Golar (GLNG, Financial) ~5%, the possibility of value emerging may be dela-yed, but the value is there.
During the summer Golar and its partner (Stonepeak) announced that their Golar Power division, renamed Hygo, would go public in the US stock market (IPO). Hygo is its plat-form for selling LNG for power plants, industrial processes and even for transport/trucks. The market positively valued the decision and shares of Golar went up. We took advantage of the situation to sell ~20% of our position.
The IPO was 100% covered, valuing Golar's share in the busi-ness at ~$1000mn. On the one hand, this figure was very much in line with our valuation of Hygo and on the other hand, it was very similar to the market capitalisation of all Golar, giving a minimum value to the rest of Golar assets.
Unpredictably, the day before the final IPO price closed, there was news that the CEO of Hygo was being investigated for a possible case of corruption in his previous job.
This situation has made Golar delay the IPO of Hygo and change the CEO. In addition, to try to streamline the process, it ordered an external audit of all contracts. This audit that has not found any evidence of incorrect conduct by Hygo. This audit has been in addition to that which Hygo was already subject to by both the SEC (the US supervisor) and the investment banks responsible for placing the shares druing the IPO process.
We believe that when the situation is clarified and the IPO of Hygo, can finally be done, this will help crystallise value for Golar.
Aryzta (XSWX:ARYN, Financial) ~6%, times of change
In September, a group of investors requested to change the Chairman and some members of the Board of Directors becau-se we thought that no value was being generated for the share-holder. Most shareholders accepted our proposal. The new management team's main mandate is to analyse the alternati-ves it has on the table to maximise the value for shareholders, either accepting an offer for the whole company or for a part of it. We think this change is a turning point in the history of Aryzta.
Iberian Portfolio
In the Iberian Portfolio there have been no measures in com-panies similar to those that there has been in companies of the International Portfolio during the quarter, but some transac-tions in competitors that confirm our valuations of the assets of several companies in portfolio are interesting.
Elecnor (XMAD:ENO) ~10%, the sale of Cobra by ACS may help crysta-llise value.
Elecnor is our main position in the Iberian Portfolio as it is a company that we have known for more than 20 years and because it has excellent businesses: Engineering, Enerfin (wind division) and Celeo (electric transmission networks). Two of them (electrical and renewable infras-tructures), sectors in fashion; however, in this case we can buy them at more than reasonable prices.
Only by applying the multiple at which ACS will sell Cobra, its Engineering division, to the Engineering division of Elecnor (both businesses are very similar), we have a value close to €1bn versus the €800mn of market capitalisation of Elecnor. To this we should add, both the value of its more than 900MW wind farms, and the value of its business of Celeo, which was valued by its partner APG, one of the largest funds in the world, at more than €500mn at the end of last year.
These are easy numbers to do, but the market pays no attention to it, partly because no research company covers Elecnor. The Cobra deal may open investors' eyes.
Vocento (XMAD:VOC) ~8%, a controversial company or a company little followed by the market?
Many investors discard Vocento directly without at least analysing it because they think that it is a newspaper company, "a business in decline". However, Vocento is much more than newspapers. It has real estate, a (fairly stable) audio-visual business, among others, but, mainly, it has an online Classifieds business. A significant part of its market capitalisation is made up of the valuation of its
Classifieds division alone, to which the other businesses must be added as well as the press business, which is better than what the market thinks because the digital transformation is very advanced.
To give us an idea of the potential of Classifieds, you have to remember that: i) at the end of 2018, Vocento merged its business of car classifieds with AutoScout24, remar-kably improving its competitive position, which will allow it to substantially improve its results, ii) Idealista, the main portal of real estate classifieds in Spain, has just been bought by EQT for more than 30x EBITDA, and iii) the sector of online classifieds is a sector with listings with very high multiples, Adevinta (European leader of classified) is listed at 17x EBITDA.
Without the need to use those so high multiples, we can all consider that there is a lot of value in that division that very few are considering.
Sonae Capital (XLIS:SONC) ~2%
The risk of having companies listed at such low prices as the present ones is that they end up being taken over at prices below the real valuations of the companies. It already happened in our previous stage along the 2008 crisis (Ciba, Cortefiel, etc.) and it has now happened with Sonae Capital.
The Azevedo family has not missed the opportunity to try to buy the ~30% that it does not have at a price that they themselves say is below its value. The Azevedo family says that it valued the company at €1.1/share pre-CO-VID-19, but considering the impact of COVID-19, its valua-tion lowered to €0.6/share, which is the reason why they are launching a takeover bid at €0.7. Justifying that price in which they would be paying a premium of ~45% of the price the day prior to launching the takeover bid.
Some days prior to the closing of the period of acceptan-ce of the take-over bid , the Azevedo family ended up raising the price of it by 10% because they don't want to miss this opportunity to buy back the entire company since they know that the company is worth much more than what they are paying. After this improvement in the price of the take-over, we have sold all our positions because at these levels the upside potential of Sonae Capital is less than the portfolio's average.
The positive reading of these takeover bids is that they confirm that current prices do not reflect the value of the assets and are unsustainable in the long term.
Finally, we wanted to reiterate the confidence we have in our portfolios. This confidence is based on the fact that the value of our portfolios is real and is increasingly more evident: either a competitor is listed at higher multiples, or deals are made at multiples that confirm our valuations, or the companies are looking for ways to raise the value of their assets (IPO, corporate simplifica-tion, etc.)
In any case, as we have always insisted, time is in our favour. We believe that the longer the price recovery takes, the starker this upside will be. The profits are stored in the companies.
Finally, we would like to express our appreciation to all unitholders who have invested with us. It is important to emphasise that we have hardly had any redemptions and the retention rate has been 97% throughout the year. Like numerous unitholders, employees continue making contributions to the funds, with it being the second unitholder (excluding mandates) in Cobas funds.
We believe that the patience of unitholders, so necessary for an effective value investment, will be compensated with good yields in the long term.
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