Trapeze Asset Management: Risk And Reward Q3 Letter
There is always risk in investing in public markets, whether in equities or fixed income, or even cash. As value investors we seek to minimize the risk and maximize the reward by buying significantly undervalued securities with solid businesses and the potential for above average upside. And, indeed, our equity-based portfolios attempt to exemplify that philosophy, buying large cap companies at least 20% undervalued, and, in our All Cap mandates, small caps at least 40% undervalued to compensate for the greater illiquidity and volatility of smaller cap companies.
Recently the risks however have come not from the micro aspects of our holdings (that is, not from their balance sheets or business prospects for example, most of which are good and progressing) but from the volatile macro factors: the dramatic decline of prices for oil, precious metals and commodities generally; the strength of the U.S. dollar from the ending of quantitative easing by the U.S. Fed; and, recently, the massive quantitative easing by the Bank of Japan (which dropped the relative value of the yen). These factors also include Japan having just fallen back into recession, the slowing of China’s growth and Europe’s continued malaise, and most disconcerting, the threat of deflation throughout the developed economies. Inflation in China, for example, is below 2% compared to its 4% target; it just cut its interest rates to stimulate growth and lower its currency, especially versus the yen. Manufacturing and inflation data from the Eurozone, the world’s largest economy, is worrisome, and the ECB is actively looking to take remedial steps. Reflation and stimulus are the orders of the day.
This has created an environment of continuing ultra-low interest rates almost everywhere throughout the developed world, with some obvious exceptions such as Russia (9.5% to support the declining ruble) and 11.25% in Brazil where inflation is excessive. The CPI in the U.S. is currently 1.7%, below the Fed’s target. The 10-year U.S. Treasury bond yields a miniscule 2.3%. One-third of S&P 500 stocks yield more than bonds.
To be sure, the economic news isn’t all bad. U.S. Q3 GDP improved to 3.9% and U.S. retail sales rebounded during October. Leading economic indicators were up 0.9% in October and existing home sales were better than expected. U.S. unemployment at 5.8% is the lowest since mid ’08 although wage growth is still lagging. Canada’s jobless rate fell more than expected to 6.5%, a 6-year low, although, as in the U.S., the labour participation rate was very low.
We took advantage of the early October sell-off and purchased shares in holding companyLeucadia National. The company is a conglomerate with most of the assets in investment dealer Jeffries, though it has a wide range of other businesses. Trading at an almost 30% discount to our sum-of-parts estimate, we were attracted to Leucadia’s margin of safety but we also see upside to our $30 FMV estimate. Founders Ian Cumming and Joseph Steinberg have taken backseats while the entrepreneurial executives from Jeffries will look to continue their legacy by deploying capital opportunistically.
We also purchased shares of specialty chemical company Eastman Chemical after its stock drifted lower subsequent to a disappointing Q2 earnings report. The primary concern for investors was a decline in the company’s organic growth profile. Eastman’s organic growthrun-rate has declined over the last few years. However, while others were focused on the delta of the growth rate, we calculated that the implied growth rate of the stock at our purchase price was close to only 1%. We believe that Eastman’s earnings growth will be much higher than 1% in the coming years. Our near-term FMV target is $95.
Private equity firm KKR has nearly $100 billion of assets under management and a proven track record of success dating back to 1976. We bought shares after its stock price declined more than 15% since the beginning of the year. A number of positive elements at KKR are being ignored by investors. Its recent acquisition of KKR Financial Holdings, a specialty finance company, decreases its dependence on private equity deals and provides a big boost to the percentage of distributable income derived from recurring income. The improved liquidity from higher public investments and the transparency and consistency that a recurring income stream provides should lead to a higher earnings multiple. Another catalyst will be the launch of second generation funds that currently have over $10 billion in AUM. Our sum-of-the-partsvaluation is over $30 per share.
We continue to hold shares of Honda Motor. We purchased Honda earlier in the year after its shares declined by over 20% due in part to costs incurred from vehicle recalls. Now Honda finds itself front and centre in the Takata air-bag debacle that has impacted several auto companies. We see these issues as temporary and downside limited with shares trading near book value, a valuation level seen only a handful of times over the last twenty years. Our fair value estimate for Honda is approximately ¥4,500 which equates to 1.3x book value and 11x our estimate of 2015 earnings.
Trapeze Asset Management full letter here TAMI – Q3 2014 (1)