Dear co-investor,
In our second quarter letter, we mentioned that the current situation reminded us of the one during the 1998/2000 period, when there was then a preference for 'growth' companies to the detriment of 'value' companies, as there is now. In this letter, we want to use our experience to answer some questions that some co-investors are asking us and, also, explain why we have such strong conviction in the quality and potential of our portfolios.
As we commented in previous quarterly letters, the companies in our portfolios have very high upside potentials. The question that any investor might ask would be:
What has been happening in recent years? Why are funds not reaching their target prices in 2–3 years? Why are we obtaining worse returns than the stock market indexes?
Over short periods of time, our investments may be affected by a range of circumstances. These may be circumstances specific to the portfolios -like if we make a mistake or ideas taking some more time to 'mature'- or they may be market circumstances -the time in the financial cycle, market trends/preference for a certain type of company (such as growth companies) or due to the increase in passive or momentum investing (buying what is going up), among others-.
It is worth remembering that there are two sides to passive investing: on the one hand, it is cheaper for the investor; but, on the other, it distorts the market, as it increases demand for companies that are in the indexes and leaves aside companies that are not. In other words, securities are not selected based on fundamentals.
The impact of passive investing is very significant today. To get an idea of the size of this type of investment, we should remember that passive investing in the USA is now approximately 50% of the total invested in equity funds, whereas it did not reach 10% 15 years ago. That is why the distortion is greater than usual today and a little more patience is needed.
These phenomena is temporary. The only thing that determines a change in stock pricing in the long term, is the ability of companies to generate profits. This is always the way.
We have made mistakes in the past and we have been affected by certain market trends/preferences (dotcom bubble, real state bubble before the recession, etc.) in which we did not take part, as we don’t participate now. So, it is worth remembering that, like now, we have had periods of 2–3 years in the past with negative returns.
To show this, we have drawn up a study of our returns from 1997 to 2014, which analyses profits obtained in all 1-year, 3-year, 5-year and 10-year periods. Due to the life - time we have been with Cobas (two years and nine months), we will summarise conclusions for 3-year periods here.
This study for 3-year periods involves analysing the return of each of the periods, with the first starting on 20 November 1997 and ending on 20 November 2000, and the second starting on 21 November 1997 and ending on 21 November 2000, and so on.
There were 5056 3-year periods from 1997 to 2014, during which we obtained average return of 41%. Of these 5056 periods, we had negative returns on 1080 (21%), with an average return of -15.8%, losing 49% in the worst cases.
The full result of the study is shown below:
In other words, in spite of obtaining average annual return of 14.6%, there were significant losses in 21% of the 3-year periods.
It is also important to highlight that, in spite of these extensive periods of negative returns, this study shows that we never obtained negative returns for 10-year periods. In the worst case, we obtained +54% return and the average profitability for all 10-year periods was approximately 150%, having obtained returns of 322% in the best cases.
To obtain these returns in the long term, the prices of companies in our portfolios, in general, reached our target values (as shown at our annual conference). So, a very legitimate and interesting question is: How does the gap between our target prices and current prices closes?
It is first worth remembering some basic concepts.
• Companies generate profits over time and, if this does not feed through to the share price, then the company accumulates a sort of hidden value that pushes up its upside potential with each day that passes. For example, if we have a portfolio priced at 10x P/E ratio, the portfolio value goes up 10% with every year that passes.
• The longer and more pronounced the lack of recognition of the value, the stronger the recovery later.
In other words, when investing properly, time plays out to our advantage.
There are different ways in which value is recognised:
• The market is efficient in the long term. It might be swayed by trends in the short term but it ends up recognising the value of assets in the long term. Always. There are no exceptions.
• The greater the upside potential, the more likely it is that somebody might recognise its value and end up buying the company. For example, we have received takeover bids for Parques Reunidos, Greene King and Nevsun. And at valuations mostly similar to our own.
• Low prices mean that company owners buy back shares. For example, Teekay Corp, CIR, Golar LNG, Subsea7, Prosegur, Repsol, Meliá, Vocento, etc. And, in addition to generating value, this attracts the attention of investors and, therefore, the stock price tends to rise.
• The simplification of company structure helps the real value of assets to be recognised. For example, Teekay Corp, Golar LNG, Renault, Porsche, CIR.
• Investment thesis often have to 'mature'. Whether it is because companies are in the middle of a restructuring process or because they have invested in assets, but the asset is not yet generating cash, time is the key factor. • In cyclical companies, during the lower part of the cycle, we have to wait for this to change. When the cycle changes, not only will the profit improve, but the multiple that the market assigns to these companies will too.
So far, we have tried to explain that what happened in the first 2–3 years of Cobas’ life is normal and what we can expect in the long term. But, in the face of doubts about the macroeconomy in the short term, the trade war between China and the USA, Brexit, currency manipulation, etc., we consider it appropriate to answer the following: Is it not better to forget about equity funds and invest when the stock market drops?
As we can never know what is going to happen in the short term, in the face of situations like this, we prefer to be invested in equity funds for 2 reasons:
The first reason is that, in the face of a hypothetical catastrophic scenario, it is best to have investments in real assets and not in fixed income, which is no more than a promise to pay, which may be fulfilled or not. For example, let us look at the well-known case of what happened in Argentina during the 2000–2002 crisis and subsequent years:
This would, at first, seem to be a very basic concept that we are all familiar with and that we have often repeated. However, we want to remember it because of the unprecedented overpricing we have today in fixed income. A clear example is that Greece has just issued negative-yielding bonds.
In addition, our portfolio is reasonably defensive: long-term contracts, defence, stable consumption, or companies that, in spite of being cyclical, have their own supply and demand dynamics that are not necessarily correlated with the general economic cycle. Only about 20% of the portfolio has a certain cyclical risk, a lower percentage than we had as of 30 June, 2019.
The second reason is because we consider market timing, i.e. trying to guess what the market is going to do in the short term, to be very dangerous. To see just how dangerous it is, look at the study that Fidelity International drew up in August 2019 in conjunction with S&P500, covering from 1993 to June 2019, which concluded that simply by missing the 5 best sessions, accumulated return for the period would drop from 1045% to 659%. If we miss the 30 best sessions, profitability drops to 133%.
We would like to finish up by insisting that we have already seen in the past everything that has happened in these almost 3 years at Cobas Asset Management, that we are working as we have always done (going against the tide of trends) and that, when the work is done conscientiously, the value of the assets is recognised in the end.
Lastly, we would like to show our gratitude to all the co-investors that have shown us trust and patience during this time, key attributes that are essential to obtaining good long-term returns.
This document has been carefully prepared by Cobas Asset Management. It is intended to provide the reader with information on Cobas’s specific capabilities but does not constitute a recommendation to buy or sell certain securities or investment products.
Any investment is always subject to risk. Investment decisions should therefore only be based on the relevant prospectus and on thorough financial, fiscal and legal advice. The content of this document is based upon sources of information believed to be reliable, but no warranty or declaration, either explicit or implicit, is given as to their accuracy or completeness.
