Dear Investors,
The first quarter of 2023 has been a positive period for Bestinver’s funds. With an average return of over 9%(1), I am pleased to note how our managers have been able to successfully navigate a volatile quarter which has been marked by the collapse of Silicon Valley Bank and the take-over of Credit Suisse.
In my view, we have witnessed a loss of confidence in two highly particular institutions which in no way reflects a wider credit problem in the industry. What this episode has allowed us to confirm is that the bank crisis resolution framework is well defined and efficient. The losers in these troubled institutions are therefore their shareholders and bondholders (not taxpayers) and the authorities’ reaction has been swift and decisive. This is not a repeat of the banking crises of more than a decade ago. I therefore believe that the fundamentals are sufficiently sound for the bullish environment in which the markets have started the year to continue.
The collapse of Silicon Valley Bank and Credit Suisse must be understood within the context of the interest rate hikes initiated by central banks in 2022. As I have observed over my lengthy career, when the cost of capital rises, weaker companies face three possible scenarios: restructuring their operations, being taken over by a stronger competitor, or going out of business. In the short term, this process often leads to high market volatility and uncertainty. In the medium and long term, it leads to a business regeneration with extremely positive consequences for companies and investors. In recent months, I have had the opportunity to verify that Bestinver’s portfolios comprise leading companies with strong balance sheets that will benefit from this highly productive environment in the future.
As I have already mentioned, our funds’ strong performance in these early months of the year is a source of considerable satisfaction. We can mention, for example, the cases of Bestinfond (Trades, Portfolio) and Bestinver Internacional, with a cumulative return of 10.5% in the quarter. The excellent profit generation achieved by the companies in their portfolio, which have been capable of growing their profits by an impressive 25% in such a complex environment as 2022, has not gone unnoticed by the market. In addition, the extremely attractive valuation at which they are listed, with an average cash-adjusted PER of 9.5x versus 13x for European and 18x for US equities, further increases my confidence in the excellent performance we can expect from our flagship funds in the coming years.
A similar case is Bestinver Grandes CompañĂas, which has grown by 13.6% over these three months. Its strategy focuses on companies with major competitive advantages, capable of generating value in any economic environment and which, following the 2022 adjustments, are listed at prices that have not been seen in years.
It is also important to note the success we are achieving with Bestinver Infra. I am very pleased to announce that we have closed our first fund, after having reached the EUR 300 million asset target, just two years after its launch. Around 70% of its capital is already committed in a portfolio encompassing thirteen countries and diversified into sectors such as renewable energy, social infrastructure and transport infrastructure. Finally, I wish to confirm that we are making progress in the development of investment products for the real estate sector, on which I will provide you with more detailed information in the coming months.
The first quarter of 2023 has been a profitable but complex period, in which media noise has continued to outweigh companies’ essential performance in the markets. We must recall, however, that it is this performance which determines the long-term profitability of investments. In this respect, I am convinced that the outlook for our funds is highly positive and I would invite you to read the interesting management commentaries prepared by their managers. These explain the funds’ future prospects, the investment cases of some of their companies and the main movements occurring in recent months.
Farewell until the next quarter, and thank you once again for your trust in Bestinver.
Yours sincerely,
Mark Giacopazzi
Bestinfond (Trades, Portfolio) commentary
Dear Investors,
Bestinfond (Trades, Portfolio) ended the quarter with a return of 10.5%.
Every three months, Bestinver’s investment team contributes to this newsletter with a clear purpose: to inform unitholders on how the portfolio has performed in the recent past. That performance does not usually have much to do with the results achieved by our companies, but rather with the incessant trickle of events impacting their share price in the short term. The quarter just ended was no exception.
Before discussing recent developments - or perhaps we should call them incidents - we should take a moment to focus on what is really important: the results of the businesses owned by Bestinfond (Trades, Portfolio). In this respect, we should highlight that sales of our portfolio companies increased by 29% during the tumultuous year of 2022. This growth was reflected in the cash they generated - whatever they had left after making the investments they needed to maintain and grow their businesses - which also increased by an impressive 25%. These extraordinary results have enabled them to further strengthen their solvency and to continue increasing their shareholders’ remuneration via dividends and buybacks of treasury shares. We believe that buybacks are one of the best investments that our companies’ directors can make to increase their businesses’ profitability and, in turn, our fund’s potential, as we explained a few months ago in this post on the Investment Team Blog.
As a result, last year saw significant value creation by Bestinfond (Trades, Portfolio) companies but this was not reflected in their share prices due to the ongoing sense of panic in the financial markets. Fortunately, in the most recent quarters the situation has changed. This is just the beginning of a lengthy path of hidden profitability that we will journey along with a balanced portfolio of well-managed, sector-leading companies whose earnings will grow significantly in the next few years. This profitability will be driven not only by the strong operating performance we project for our businesses but also by the attractive valuations at which they are quoted in the markets.
The noise has become a real din
Returning to the quarterly newsletters, writing them involves an effort that is amply rewarded by what we learn in the process. They allow a moment of reflection in which to sort out ideas and try to distil what is important from what seems urgent but really is not. What is our objective? To take investment decisions based on a fundamental analysis of the businesses and seek to take advantage of daily market noise to benefit the portfolio’s long-term performance.
The problem is that in a number of recent quarters this noise has become a real din. This has been justifiable in some cases but in many others the hysteria provoked by each new piece of news has been extraordinary. This management team believes that the way we consume information nowadays, being permanently connected to the global situation via mobile devices, is largely to blame. In economic terms, we could say that we have a significant surplus of information. In addition, thanks to social networks, this surplus has a very particular characteristic: its immediate obsolescence. We are suffering from a veritable smorgasbord of reality, which, however, we digest quickly and lightly. We are therefore shaken by each new event, which we rapidly forget so that we can be shocked again by the next media assault.
We know that to generalise is to distort reality to some extent, but without wishing to show any prejudice we consider it necessary to mention certain episodes that highlight this peculiar capacity we have acquired to transform horror into oblivion almost instantaneously. Who can remember now the potential Covid-19 explosion caused by Chinese tourists who were going to visit us after three years of being locked up in their country? Is anyone talking now about the terrible earthquake in Turkey that happened a few weeks ago? What happened to the inevitable energy rationing we faced this winter? There are numerous examples and they highlight the continuous succession of panic situations (decorated by memes) we are living through without any clear view of an ending.
Banks are not normal companies
The quarter ended with a looming financial crisis and the feeling that, once again, the apocalypse was just around the corner. A return to the “hard landing” of global economies that contrasts not with the “soft landing” scenario that markets had embraced at the beginning of the year, but with the “no landing” expectation that unassailably reliable macro data had injected into the consensus weeks before the collapse of Silicon Valley Bank (SVB).
Financial crises should not be taken lightly. They are usually tough and slow to digest, as we learned in the previous cycle. In our view, however, we are not being faced by another lost decade. The banking contagion that began with the collapse of SVB and the fall of Credit Suisse is, in our view, more a confidence shock than a symptom of a wider credit issue. The problem is the social alarm that has been created. This panic could sweep away a few more banks and that, indeed, would cause a bigger problem. This is not our main scenario, but we cannot be too sure as banks are not normal companies.
Banks are highly leveraged businesses. They operate with very little capital, i.e. with a lot of debt. This debt mainly takes the form of deposits. Indeed, without being aware of it, we are all lenders to the banks in which we keep our savings. What do the banks do with these resources we give them? They extend loans but also, to a lesser extent, they buy financial assets (bonds). It could be said that banks are - in essence - intermediaries. And what do they mediate? Interest rates. Depositors lend their money to a bank in return for interest payments and banks lend that money, again, in return for an interest charge. When the return they earn on loans is higher than the return they pay on deposits, banks make money. What is the key for all this to work? Time. Depositors receive a lower interest rate in exchange for being able to withdraw their money at any time, while loans earn higher interest because they take years to repay.
Generally speaking, banks face two types of problem that could be defined as far-reaching. One arises on the asset side, when a significant part of the loans (or investments) they have extended turn out badly. The other arises on the liabilities side, when a large number of depositors suddenly withdraw their money from the bank. The former are usually slow-motion accidents, the latter occur at the speed of light. The two are often interrelated. Only if a bank suffers continuous management errors and a flawed risk strategy will its depositors begin to question, understandably, whether they should seek a better home for their savings.
Finally, reference should be made to banks’ capital. In general terms, we could say that a bank’s capital is nothing more than the value of the loans it has granted (and the bonds it has bought), less the debt that finances them (mainly deposits). For practical purposes, they are publicly traded shares and their task is simply to absorb problems that may arise from banking practice. When we say that banks are not normal enterprises, we mean that they operate with very little capital. Their capital represents a very small part (10%-20%) of the companies’ assets and debt, which explains their enormous vulnerability to any kind of business turbulence.
SVB, a very special bank
The above is a very general description of what a bank is, but it helps us to frame the events of recent times. Starting with SVB, it has to be said that we are referring here to a very peculiar bank that was hit by a rather exceptional economic environment. We should note that only 6% of its deposits were below USD 250,000, the limit set by the US deposit guarantee fund (FDIC). On the other hand, 55% of its assets did not consist of loans but of long-term fixed income instruments. This is an extraordinarily high figure as these instruments, on average, represent less than 10% of the US banking system’s assets.
Therefore, when its depositors - venture capital managers and technology startups - began to withdraw their deposits en masse, the bank was forced to sell the bonds in its portfolio in order to meet these liquidity demands. What was the result? The emergence of a very significant loss since, following the meteoric rise in interest rates in recent months, the market value of these instruments had plummeted. As you may imagine, SVB’s capital was clearly insufficient to absorb a disaster on this scale. The outcome was a well-deserved, lightning-fast bankruptcy.
In our opinion, we are describing a very peculiar bank. This is an institution with the most volatile depositor base imaginable and extremely poor asset management (SVB’s directors could easily have hedged its bonds against interest rate risk). Faced by this situation, the US authorities’ response to the risk of the problem spreading was equally swift. The FDIC insured all SVB deposits and the Federal Reserve introduced a mechanism to meet the liquidity needs of other banks by offering loans for up to one year in exchange for assets (fixed-income instruments such as those that SVB had to sell) that would be valued at par, not at market value. Unfortunately, the firewall did not work immediately and there were some very nervous moments in the sector. You can guess why. Fear is a much more inflammable material today than it was a few years ago and it only takes one click to transfer a deposit to another institution or to a money-market fund.
Bank runs can become self-fulfilling prophecies: if depositors fear that their bank is in trouble, the rational response is to quickly withdraw their funds, thereby jeopardising the bank’s very survival. Moreover, they can be contagious: if depositors learn of a run in another bank, they may start to question the safety of their deposits and thereby trigger a spiral that can lead to their own bank’s destruction. This has been the first run on deposits with mobile devices in our hands. We will probably go from panic to memes in a matter of weeks, but at Bestinfond (Trades, Portfolio), which has no US regional banks in its portfolio, we will continue to monitor the situation very closely.
Credit Suisse, the weakest business model in the European financial sector
This bank has been in trouble for more than a decade and various management teams have tried unsuccessfully to make its investment banking business profitable. In recent times it has been impacted by the Archegos family office and Greenshill funds scandals. It attempted to resolve this reputational deterioration a few months ago via a capital increase. This operation was needed to finance its umpteenth restructuring, in which it forecast significant losses for this year and a negligible profitability for the business in the coming years. What was the result? A plummeting share price and the exit of a substantial volume (15%) of the assets managed by its private banking division.
That was when the sneeze from the American banks arrived which, as we may imagine, infected the weakest business model in the European financial sector. The result is history. Only a week after SVB’s bankruptcy, the Swiss bank was taken over by its rival UBS. This was also an emphatic operation, overseen by the Swiss authorities who sought to nip in the bud the systemic risk posed for the country by the complete loss of customer and investor confidence in Credit Suisse.
A balanced portfolio with little exposure to the banking sector
At Bestinfond (Trades, Portfolio) we had a reasonably modest position in European banks at the end of the quarter (5.7% of the portfolio), involving institutions that do not have any of the problems described above. The collapse of an American regional bank, with the most unstable deposit base imaginable and an absolutely atypical asset base, says very little about the health of banks with entirely conventional depositors and assets. The same is true of an investment bank that has been incapable of making a profit over the last decade and which has waded into every possible puddle in the industry.
These two disasters are sure to lead to a further tightening of banking sector regulations (in the case of the United States) and may potentially put a stop to interest rate increases by central banks. It is also quite likely that the sector’s profitability will decline due to the expected improvement in the remuneration of deposits in the coming months. We might add that none of this is positive for banks, but the valuations of the names in our portfolio have discounted a future scenario which is much bleaker, in our opinion, than the one we expect to materialise.
In our view, the most important conclusion of this episode is that we have been able to confirm that the framework for resolving banking crises is well defined. The losers in these troubled institutions are their shareholders and bondholders (not taxpayers) and the authorities’ reaction has been swift and decisive. This is not a repeat of the banking crises that began in 2008 and lasted for almost a decade. Beyond the effectiveness of the resolution mechanisms, the main difference is that today the European financial sector is much better capitalised (with a capital ratio of 13% compared to 6% at that time), liquidity ratios are very high and credit risk is moderate, thanks to the debt reduction processes undertaken by companies and individuals in the last decade.
In any event, as Bestinfond (Trades, Portfolio) unitholders you should keep one central idea in mind: our fund’s strategy is to beat global markets over a full economic cycle and to do so, moreover, in a reasonably balanced manner. There are times when a portfolio that is highly concentrated on a particular area or type of business can deliver spectacular results in the short term. That is not our plan. We will never have a very relevant position in any one sector. You may ask, therefore, whether the situation that has arisen in the last few weeks has been keeping us busy. We have certainly been looking to catch opportunities in these troubled waters, but by no means are we worried.
Portfolio movements
In this quarter we have again had the chance to continue enhancing the fund’s potential, while improving its balance.
These three months have seen remarkable returns for some of our stocks (many of which were losers in 2022) such as Meta (META), Inditex, Pandora (P, Financial), car manufacturers, Rolls Royce (LSE:RR., Financial) and cement companies, to name a few. Others, however, have not been so well treated by the market during this period. This is the case of IFF (IFF, Financial), Harley-Davidson (HOG, Financial) and Berkshire Hathaway (BRK.B, Financial). You can imagine the steps we have taken during the quarter: buying more shares in some of these latter companies whose value and share price have diverged, financing them with sales in those companies where that differential has narrowed significantly.
Nordea’s (OSTO:NDA SE, Financial) stellar stock-market performance over the past year and the early part of the quarter has allowed us to replace the Nordic bank with HSBC (HSBC, Financial), a global bank with a very attractive exposure to Asia which will undoubtedly benefit from China’s reopening. We have sold the French catering company Sodexo (XPAR:SW, Financial) and Zurich Airport, two companies which we bought at the height of the Covid-19 pandemic and which have generated good returns with very limited risk. These are businesses with an obvious defensive character which had to face a situation that was unimaginable two years ago, but whose share prices have already discounted the unquestionable return to normality now taking place.
We have received a takeover bid for Univar (UNVR, Financial). It is always a reason for satisfaction when this happens since in a certain way it validates our investment process, but less so when the premium offered by the buyer (in this case Apollo Global Management (APO, Financial)) is insufficient. We believe the offer does not reflect the true value of the chemical distributor, even though it is almost 100% higher than the price at which we began investing in the US company in the fourth quarter of 2020.
We have continued to reinforce our positions in companies that enhance the fund’s strength, without sacrificing the fund’s appreciation potential. These are companies that are considered defensive - as their business does not depend on the economic cycle - but which have a clearly offensive role within the portfolio thanks to the discount in their valuations. Heineken (XAMS:HEIA, Financial) is one of them, as are IFF and GSK (LSE:GSK, Financial). In this context, we should mention that we have started to buy shares in a leading company in a sector that is going to benefit from an unstoppable trend: the ageing of the population. We will discuss this very attractive idea in more detail in the coming quarters.
Finally, we would like to make a brief reference to another recent addition to the portfolio. This is Bayer (XTER:BAYN, Financial), an investment case which we detailed in our third quarter 2022 newsletter and which has now become one of the fund’s most important components. A number of things have happened since then, almost all of them good. The most relevant is the appointment of the new CEO, Bill Anderson (56), an American professional who made a name for himself in the industry during his time as CEO of Genentech before moving to Roche, where he was responsible for the Swiss giant’s pharma division. His arrival, probably precipitated by the recent arrival of top global activist investors at Bayer, confirms our feeling that the pharma division’s pipeline is robust enough to cushion the expiry of the Xarelto and Eylea patents. It also confirms the possibility that in the future we may witness a separation of the Crop Science (Monsanto) and Health (Pharma and Consumer) businesses. This scenario is not considered in our assessment, but is one in which one plus one does not add up to two, but rather to four.
As we told you a few months ago, Bayer trades at a PER of 8x and offers a dividend yield of close to 5%. These multiples reflect the stigma attached to a company that has had to face some highly significant difficulties since 2018 but which has very sound assets, is well financed and now has a new management team capable of crystallising its value in the future.
An insurance policy for survival in the tough times and a guarantee of prosperity in the good times
We wish to conclude this letter by reminding you that one of the most important ingredients in obtaining good long-term returns for our savings is temperament. We are leaving behind a global pandemic, a war between two commodity producing countries that has pushed inflation to its highest level in many years; and, in recent weeks, there has been a crisis of confidence in certain US regional banks that has led to the collapse of Credit Suisse.
It may seem that the long term is becoming a succession of short terms that are absolutely exceptional. This is not the case. In some respects the last three years has been an unprecedented period, but we should not forget that instability is a common feature of the economy and markets. There are periods of relative calm followed by periods of heightened tension and volatility. Rare and unexpected events occur more frequently than we think, it is just that we are now more aware of them (every minute).
But uncertainty is not the same as risk. It is usually the other way around. Think of any of the many difficult moments in the markets during Bestinver’s 35-year history. The pattern always repeats itself: share prices fall, valuations become attractive and investments cease to be risky. Now think about the present moment. The market has been getting ready for months for a recession that has not arrived and hedging against an energy hyperinflation that has every appearance of already being behind us. There has been - and continues to be - a disconnection between fundamentals and expectations that has laid the foundation for what should be very good future returns for our fund.
We would prefer the world to be a more peaceful place, without doubt, but we should not be scared by this perception of a continuous threat. Quite the opposite. Remember that being the owners of good businesses managed by intelligent people which, above all, were bought at good prices is an insurance policy for survival in the tough times, just as it is a guarantee of prosperity in the good times.
Thank you once again for your trust in Bestinver.
Yours sincerely,
The Investment Team.
