Interview: The Long-Term Vision of Horos Asset Management

Worldwide investment universe with a focus in downside protection

Jul 05, 2019

Horos Asset management was founded in May 2018. It currently manages 50 million euros. It tries to invest in companies that ideally comply with five investing principles: businesses that it can understand, with competitive advantages and strong financial profile, managed by good capital allocators and with an attractive margin of safety.

Javier Ruiz, Alejandro Martàn and Miguel Rodràguez are the managers of Horos Value International fund. They have worked together for the last seven years and in that period they have produced an outperforming record (12.4% per year vs 11.8% for the benchmark).

Javier Ruiz was very kind to share their long-term vision, in a worldwide investment universe but with a focus in downside protection.

Roque: Value investing is in a crisis. Since the great financial crisis, it has been an underperformer in relation to growth and to the general markets' performance. What factors do you think will most contribute to an outperforming strategy over the long term?

Ruiz: First, I would like to make it clear that we are not keen on tagging investment styles in terms of growth, value or any other classical academic definitions. If you look at our current portfolio, you will find companies with a clear growth profile (such as Naspers or Alphabet), but also other names with a market valuation multiple times lower than their liquidation value (Keck Seng Investments or Asia Standard International). We like to define value investing as

Charlie Munger (Trades, Portfolio) once put it: “All intelligent investing is value investing – acquiring more than you are paying for.”

Having said that, it is true that we are seeing a never-ending amount of money flowing into the quality names (i.e. consumer brands) and flying away from cyclical and less liquid stocks. Negative yields and macro uncertainty could be reasons that explain these movements. We don’t try to time the market, so I’m afraid we have no idea of what may contribute to the change in the current environment, but we are increasing our positions in companies that have been over-penalized by it.

Roque: You have mentioned your investments in high-growth big-cap internet companies, like Google, Naspers (indirect investment in Tencent), Booking Holdings or Baidu. In fact, they are not trading at low multiples, so why do you think their growth will be sustained in the foreseeable future? Shouldn’t we expect the free market to function and competition to come in and reduce their abnormal returns?

Ruiz: We actually think that they are trading at low multiples if you normalize their free cash flow, adjusting for expansion opex and capex, under-monetized assets, under-scaled business lines and others, and also take into account their cash in the balance sheet. For example, in the case of Tencent, in which we invest through Naspers, we believe that their advertising and payment businesses have a wide margin for increasing ad displays and prices from current levels, so current free cash flow does not reflect Tencent’s true ability to generate cash. Regarding Alphabet, if you subtract their cash and normalize operating margins (i.e., YouTube and Cloud) and capex (infrastructure expansion), it would trade at very attractive multiples for such a quality name, even without giving any value to Waymo and other moonshots.

We should expect some reversion to the mean in terms of returns in a free market, but this reversion may take some time (even decades) to materialize if the business benefits from a sustainable competitive advantage. In all the cases you mention we believe that we are investing in businesses which own ecosystems that combine network effects with huge economies of scale and that is something very difficult to replicate or attack.

Roque: Recently, you presented your investment idea in Aercap, at the Value Spain Conference. How do you consider the risks of this business?

Ruiz: Aercap is a financial company that buys aircraft from OEMs and leases it to airlines (they also can do sale-and-lease back operations). The company is well managed by Aengus Kelly, who have created an outstanding value for the shareholders during his tenure, specially by buying-back shares when they trade at discount to book value (about 40% of outstanding shares since 2015) and acquiring ILFC at very attractive valuation multiples.

Aercap’s main risks are related to competition, residual value and financial markets. Competition has increased with new players entering the market over the years, and they have concentrated on the sale-and-leaseback market (negatively impacting the yields). Aercap is taking advantage of the situation by selling mid-life aircraft at premium to book value. Residual value arises as they are the owners of assets with an estimated life of 25 years. To cover against that risk, Aercap focuses in the most in-demand aircraft (narrow bodies and most-efficient new technology aircraft) and maintains a very conservative depreciation policy. Lastly, financial markets could become more restrictive in the future and that may impact the aviation industry, but we should have in mind that airlines and lessors are in their best shape ever; lessors immunize their interest risks and, in the case of Aercap and few others, have an investment-grade rating which give them higher flexibility in comparison to former cycles in which they only had access to bank lending. In the end, we believe that all these risks are quite manageable by the company and its current share price (Aercap trades below book value) provides us a with (very) high margin of safety.

Roque: You have a significant exposure to Asia. What advantages and disadvantages do you see from the investment there?

Ruiz: Asia currently resembles the time when [Warren] Buffett managed his Partnerships. It is a market with tremendous investment opportunities for those who dare to have a look at it. We often like to say that to successfully invest in Asia (or any other distant place) we need to find companies which we are at least as comfortable with as local ones. This translates into investing in family-controlled companies with a historical track record of value creation that operate businesses within our circle of competence. Usually, these companies are illiquid and lack analysts’ coverage, which permits a patient investor to buy their shares at 80%, or even more, discount to a conservative NAV. The main disadvantage is that their managers are overly focused in managing their business at the expense of ignoring their absurd share discount. So, we may have to wait years to see their valuation gap closed.

Roque: Your largest holding is Keck Seng Investments. Can you explain your investment thesis?

Ruiz: Keck Seng Investments is a Hong Kong family-controlled company founded in the early 1940s by the Ho family, owner of 75% of the vehicle, so its interests are aligned with those of its shareholders. The holding company specializes in the ownership and management of hotels in the U.S., China, Japan, Vietnam and Canada. Keck Seng also has an important residential portfolio in Macao that we hope will benefit from the recent opening of the bridge that connects Hong Kong with this city. The poor liquidity of the share or the fact that the assets are valued at acquisition cost on the balance sheet have contributed to a market inefficiency, which in our opinion is unjustified. Just to give you a quick idea of how cheap it is, Keck Seng is trading at an important discount to their U.S. assets (which does not make any sense, since we are talking about the Sofitel in Manhattan and the W in San Francisco) and not giving any value to all the other assets (the hotel in Vietnam or even the residential portfolio in Macao would also cover the current valuation alone). It simply does not make any sense. We believe that a (conservative) valuation should range from 20 to 25 Hong Kong dollars, when shares are currently trading at 5 Hong Kong dollars. That explains why it is our largest holding.

Roque: How do you think about the political risk, namely in China? How do you incorporate it in your valuation?

Ruiz: When we finish an investment analysis, we incorporate a conviction adjustment to our valuation, which usually relates to political risk. China is one of the cases in which we make this kind of adjustment and demand a higher margin of safety to invest there. What recently happened with the video game industry and Tencent is an example of how the rules can change from one day to the other.

Roque: Can you share some of the mistakes that you have made over your investment career and what you have learned from them?

Ruiz: We have identified three sources of mistakes in our investments: overleveraged companies, misalignment of management incentives and technological disruptions. All of them can kill your investment thesis so we try to protect our portfolios from them. That explains why the gross of our portfolio is invested in net cash or low debt companies with a high free cash flow generation profile and also in family-controlled companies, which tend to allocate capital in an efficient way (they have a lot of skin in the game). Technological disruptions are the hardest to hedge as investors and we are afraid that in the future it will be the main source of mistakes (if we anticipate a higher risk of disruption than the level of disruption that actually occurs we suffer a mistake of omission, or of commission if the opposite is true).

One example that combines some of these types of mistakes would be our investment in Viacom (MTV, Nickelodeon, Paramount). We bought shares in 2015 betting that revenues would stabilize. Our mistake was that we did not anticipate the disruption coming from new streaming platforms and the change in TV consumer patterns. This error was magnified by their share buybacks using leverage. Disruption plus leverage is a terrible combination, so we sold all our position less than six months after our initial purchase, assuming losses close to 50%.

Roque: You have cited Nassim Taleb’s ideas several times in your letters to shareholders. Why are his ideas so important to you?

Ruiz: His philosophy is an outstanding complement to our investment style. Concepts such as convexity, optionality, skin in the game or fragility have helped us to improve our analysis of companies and markets. Just to give you a quick example, we are very bullish with uranium prices and a couple of years ago started a position in Cameco. Cameco is one of the most important uranium producers in the world, owner of some of the best assets, and boasts a sound financial profile with the capacity to generate large amount of capital. However, last year we reconsidered this investment, after “discovering” that we could gain exposure to the uranium price without assuming the operating risks inherent in a mining business, if we invested in Uranium Participation and Yellow Cake (which we did), two financial vehicles that buy and store uranium. At the prices we sold Cameco, we were investing in these vehicles with a higher return potential and much less downside. So, we found a compelling convexity situation that improved the risk-return profile of our portfolio.

Roque: What do you need to feel comfortable investing in a cyclical business?

Ruiz: In order to invest in a cyclical business, we need to feel comfortable with the demand-and-supply dynamics. In short, we look for market situations in which the price of a commodity is so low that the producers of a commodity are not incentivized to invest in new capacity and developments. These situations can originate important bottlenecks and price appreciation. This is the case of the uranium market. After years of expansion, especially as a result of Kazakhstan’s entry into the industry, the market entered an “anomalous” situation, in which mining companies did not reduce their production, despite the fact that the price of uranium did not cease to fall due to the slowdown in demand after Fukushima accident and the entry of new supply. What is the reason for this behavior? The long-term contracts that the mining companies signed with the utilities, at prices much higher than the spot price. Once these contracts near their end, mining companies have seen that the situation is not sustainable and have initiated a series of very significant production cuts (such as the suspension of McArthur River, the world’s largest high-grade mine, by Cameco).

But what about demand? On the one hand, the future is more positive than one might expect a priori, given the negative sentiment towards this energy. The emerging economies, led by China and India, need nuclear power to meet future needs, so they have a significant number of nuclear reactors under construction and a larger number of reactors planned for the coming years. In addition, Japan is reactivating nuclear reactors that have managed to adapt to the new regulatory requirements. On the other hand, utilities have not yet felt the urgency of signing long-term contracts again. However, as the excess inventories in the market are consumed, the supply will have to be guaranteed again for the following years, which should significantly push up the price of uranium. Therefore, uranium represents about 8% of our portfolio.

Roque: Can you give us a book or article reference that most value investors don't mention but that you find it to be particularly enlightening?

Ruiz: "Capital Returns" by Edward Chancellor is one I can’t recommend enough. The book explains the capital cycle approach to investing using examples from Marathon Asset Management letters, which makes it a terrific guide to analyze cyclical businesses and the best times to invest in them.

Roque: Why have you named your firm “Horos Asset Management?”

Ruiz: Horos was born with a long-term vision. Without such, it would be impossible to carry out the value investment philosophy that characterizes us, and, as you know, requires a timeline of several years. The word “horos” was used initially by the Greeks to refer to the boundary where heaven and earth seem to blend together. From it, etymologically came the word “horizon,” and for this reason we could not think of a better word that describes the essence of this project.