RV Capital commentary for the first half ended June 30, 2016.

Dear Co-Investor,

The NAV of Business Owner was EUR 408.64 as of 30 June 2016. The NAV fell 7.0% since the start of the year and rose 308.6% since inception on 30 September 2008. The Dax was down 9.9% and up 66.0% respectively.

RV Capital

RV Capital – How did our companies get on in 2015?

The main purpose of my half yearly letter is to reflect on the operational performance of our companies in the previous year. This is based on the belief that in the long run the value of our fund is driven by the operational development of our companies as opposed to the gyrations of the stock market.

Given the near 50% increase in the price of the fund in 2015, you are probably thinking some pretty special things happened at our companies last year. You are right.

Grenke continues to expand both at home and overseas

Grenkeleasing grew its net income by 24% in 2015. This was well ahead of its growth in interest income (a proxy for revenue) of 13%. In particular, it benefitted from a decline in interest expenses (despite an increased loan book) as well as a decline in loan losses.

Grenke continues to invest in opening subsidiaries in new countries and further branches within existing countries. It began offering leasing in Singapore as a first bridgehead into Southeast Asia as well as starting a factoring business in Ireland. Furthermore, it opened 5 new branches in existing markets.

Grenke is really just getting started. None of its other countries are even close to the penetration of Germany (its first and largest market), which itself grew new business at 18% in 2015. On top of this, it has promising new businesses such as factoring and startup financing. It is a privilege to accompany it on its journey as a co-owner.

Google gets a new name

The big news at Google in 2015 was its reorganization. It renamed itself Alphabet and separated itself into two segments, the largest of which by far is Google. The Google segment comprises many of its legacy businesses such as Search, YouTube and Cloud computing. The remaining businesses are collectively known as “Other Bets” and comprise Alphabet’s moon shot projects, such as self-driving cars.

As part of its reorganization, Alphabet provided segment reporting for Google and “Other Bets”. In total, “Other Bets” reported operating losses of US$ 3’567 m. As I expect “Other Bets” to be (hugely) profitable in aggregate, it does not make sense in my view to penalize Alphabet for their losses. Excluding them, the Company’s earnings power increased by 23% from US$23’425 m from US$19’011 m. This is an incredible rate for a large, liquid, fairly non-cyclical business and sets a huge hurdle rate for a new idea to make it into Business Owner.

It is not just in the “Other Bets segment” that Alphabet undertakes moon shot like R&D. The Google segment also undertakes considerable R&D in particular in the field of artificial intelligence. As such, even the US$23’425 m mentioned above probably understates the businesses underlying earnings power.

Overall, I am incredibly positive about Alphabet’s new structure and think it will be very value creative in the long-term. The idea behind it is to allow the company to continue to scale as it moves increasingly into fields that are far removed from Search. It is modelled on the structure at another one of our holdings, Berkshire Hathaway. It has worked spectacularly for Berkshire. Expect more of the same at Alphabet.

Novo Nordisk celebrates a string of successes with its pipeline

Novo Nordisk had a typically solid year in 2015. Revenue grew by 8% and operating profit by 21%, both in local currencies. Net income even grew by 32%, driven by a DKK 2’376 m tax-free gain from the IPO of NNIT, its IT subsidiary. On a recurring basis, net income grew 22%.

The big news at Novo over the last year or so is the tremendous progress it made with its pipeline of innovative new drugs.

  • Most importantly, Novo finally received approval for Tresiba, its new long-acting insulin, and launched in the US in January 2016. This gives Novo the gold standard in the most important insulin category.
  • It filed for approval for Xultophy in the US. Xultophy is a combination product of Tresiba (a long-acting insulin) and Victoza (a GLP1) for type 2 diabetes. In my view, it has the potential to revolutionise the treatment of diabetes as it lowers blood sugar with a significantly lower risk of hypos.
  • Novo filed for regulatory approval of faster-acting insulin aspart in both the EU and the US for the management of blood glucose around meals for both type 1 and 2 diabetes patients.
  • Most significantly in the longer run, a once-daily oral formulation of semaglutide (a GLP1) showed very encouraging results in a proof-of-concept phase 2 trial, and has since entered phase 3 development.

It is an incredible series of successes, and I only picked out the highlights. Despite this, 2016 will not be without challenges. In particular, it will be interesting to see what impact Lilly’s forthcoming launch of a generic long-acting insulin will have on the market.

However, as Novo has, or will shortly have, the gold standard for many diabetes treatments, I remain confident in the future.

Credit Acceptance accelerates growth in new loans

Credit Acceptance grew its net income by 8% in 2015 to US$300m. Adjusted for various accounting effects, growth was 14%. As it bought back a substantial number of shares in 2014 and to a lesser extent in 2015, adjusted EPS outpaced net income growth at 21%.

Credit Acceptance experienced a substantial increase in new business volumes in 2015 with the number of loans up 33%. It is difficult to pinpoint precisely where this growth came from as competitive intensity remains high for auto loans. CAC did however greatly expand its sales force a few years back. After overcoming some initial teething problems, it now seems to be firing on all cylinders. Importantly, the growth did not come from a loosening of credit standards. Credit Acceptance has not changed its pricing since 2012. I remain very positive on the long term future for CAC. If it can replicate the market share it has in its strongest regions elsewhere in the US, the business can become many times bigger than it is today.

In the shorter term, there are signs of an overheating in the auto loans market. Some thoughtful investors draw parallels between auto loans today and residential mortgages in the financial crisis. It is important to remember though that the root cause of the financial crisis was not lending to people with lower credit ratings per se, but, amongst other things, a deterioration in lending standards and a misalignment of interests between those sourcing the loans and those underwriting them.

I cannot comment on the market as a whole, but CAC is unlikely to fall into either of these traps. It remains disciplined in its underwriting as evidenced by the continuity in pricing. Furthermore, there is alignment throughout the value chain. The borrower, the dealer, and CAC all have a financial interest in the loan being repaid. In my view, CAC will be a major beneficiary if a crisis causes capital to exit the industry. How this plays out on the share price in the short term is, of course, impossible to predict.

Berkshire Hathaway with modest gains

Berkshire grew its book value at 6% in 2015. I believe book value is a better indicator than net income of the change in its intrinsic value as net income tends to be distorted by gains and losses from its marketable securities portfolio and, more importantly, excludes the retained earnings from its non-controlled businesses.

I expect Berkshire to grow by a high single digit percentage amount over time. This is lower than my expectation for the other companies in our fund. Despite this I see Berkshire as a valuable addition to the portfolio.

Berkshire is by far the lowest risk investment in the portfolio, a characteristic that is ignored by the market most of the time, but will be top of mind when the next major crisis hits. This, in combination with its high liquidity, means it will likely be a reliable source of funds in a crisis. It offsets to a certain extent the fact that Business Owner generally does not carry excess cash.

Furthermore, the fact that Berkshire only trades at a modest premium to book value suggests that the market undervalues its safety and growth potential in comparison to, for example, a long dated government bond. As such, we may at some point benefit from a revaluation.

Bergbahnen Engelberg-Titlis-Trübsee (BETT) defies the strong Swiss Franc

BETT, our Swiss cable car operator, had an incredible year in 2015. After 20 months construction period, BETT opened the Titlis Express, its new cable railway, in December 2015 on time and on budget. This is an incredible achievement by Norbert Patt and his team. As the video of the construction shows, the project was far from trivial: https://www.youtube.com/watch?v=Gy6CYei5GZo.

The Titlis Express shortens the journey time from the valley to Stand to 16 minutes and increases capacity from 1’600 to 2’400 guests per hour. The increase in capacity will allow BETT to host a higher number of visitors on its busiest days in both the summer and the winter. The shorter journey time will improve the overall guest experience. Revenue from the cable railway segment grew by 18% in 2015, driven mainly by a surge in visitors. The number of Chinese and Indian guests grew by an astonishing 40% and 30% respectively. This is all the more impressive when you consider that in January 2015 the Swiss national bank removed its currency floor, causing the Swiss Franc to appreciate over 20% in a single day.

BETT’s net income grew by 27% to SFr. 30 m. It benefitted from two positive effects in 2015: a CHF 9.5 m gain from the sale of apartments and a CHF 2.0 m gain from the liquidation of a pension fund. The gain from the sale of apartments was approximately the same in the previous year (CHF 9.8 m) and so it does not affect the comparison. Excluding the gain in the pension fund, net income growth was a still impressive 19%.

In 2016, there is likely to be a decline in guests as the introduction of biometric passports in the EU and the terror attacks in Paris dampen demand from Asia. However, Asian outbound tourism will grow over time. I saw this first-hand during my visits to online travel agents CTrip and Qunar in China last September. Better still, as Asian tourists make up an ever increasing part of BETT’s revenue pie, its growth will accelerate. How many other 100 year old businesses can look forward to accelerating growth?

Baidu sees its O2O strategy vindicated

Baidu reported a near tripling of its net income in 2015. This was due to the sale of its stake in Qunar for a 25% voting interest in CTrip (China’s leading travel booking portal).

The transaction was hugely value creative. By bringing together the number 1 and number 2 travel players, Baidu created a near monopoly position for air and hotel bookings in China. Furthermore, the deal secures privileged access to travel data for Baidu’s search platform. The transaction should put to bed any concerns over the rationale behind Baidu’s investments in local services (often referred to as “O2O”). On an operating basis, i.e. without the one-off gain from the sale of Qunar, Baidu saw a 9% contraction in its operating income. This was solely driven by a ramp-up in investments in O2O, in particular at Nuomi.

In its core Search segment (i.e. excluding Nuomi and iQiyi) Baidu was able to increase its revenues by 27% and operating income by an impressive 37%. I believe these figures best show its change in earnings power in 2015.

2016 is shaping up to be a much tougher year for Baidu. In May, a young man died from cancer after receiving an ineffective and controversial treatment having followed a Baidu search ad. Subsequently, Baidu was forced to curtail advertising for medical treatments and change the way it presents sponsored search results. More recently, the Chinese authorities announced that sponsored search results will be treated as advertising and as such be subject to a higher tax rate. Both are likely to be a significant headwind to the financial results in 2016, but unlikely to impact its overall growth trajectory.

It is of greater concern that in the case of the medical ads Baidu put short term financial gain above the wellbeing of its customers. Apart from being unethical, it is bad for the long term health of the business. Robin Li made a firm commitment to correct this going forward. I will be following closely whether his words are backed up with firm actions.

TFF Group struggles with whisky

TFF had a tougher year in the fiscal year ending April 2016. Whilst the market for wine barrels showed modest growth of 2%, there was a 25% contraction in revenues for whisky barrels. Whisky has been booming for many years now, so a breather was inevitable at some point. Overall Group revenues declined 5% to €195m and net income fell 15% to €29m.

The hiatus in earnings growth does not mean though that our company did not increase its long term earnings power last year. Most importantly, TFF entered the Bourbon market by building a new cooperage in Ohio (Yes, you read correctly: “Ohio” – wages are cheaper there than Tennessee and Jerome Francois was able to buy a former furniture manufacturing facility out of bankruptcy).

The cooperage was completed in May 2016 and is likely to produce US$20m revenues as early as fiscal 2017. Over time, revenues should grow to US$60m. The bourbon market is booming. Furthermore, growth in craft ales is driving demand for barrels in the US. I confidently expect TFF to be back on its growth path this year.

I hope that by then I will be able to report first-hand on its Bourbon business. It is a tough job, but somebody has to do it…

Bringing it all together

I estimate that the companies in Business Owner increased their earnings power in aggregate by a range of 20% – 30% in 2015.

A range is more appropriate than a precise figure as several factors are subject to judgment, such as how to deal with changes in weighting of the individual companies in the course of the year.

At the low-end Berkshire and TFF had modestly disappointing developments, but collectively only account for about 13% of the portfolio. The results from the others ranged from 19% (BETT) to 37% (Baidu) on a recurring basis. On top of this, there were one-off gains at Novo, Baidu and BETT. Dividends were not a major factor.

In addition to gains in underlying earnings power, we also benefitted from the strength of the Dollar in 2015. I estimate that this added around 5% to the Euro based returns. The mid-range 25% increase in earnings power and 5% gains in currency implies an increase in intrinsic value of 30%. This is a great performance, but is nevertheless short of the 47% change in the fund’s price in 2015. The difference can be put down to our companies simply becoming more expensive. In financial parlance, the market accorded them a higher multiple of earnings.

It is difficult for me to judge to what extent, the market was correcting a previous undervaluation or creating an overvaluation. Either way though, the long term gains from holding businesses that compound at a decent clip swamp the modest and uncertain gains from trading around a potential overvaluation.

As such, I will continue to focus on identifying great businesses run by honest and talented managers rather than trading on the stock market. Success at the former will be a far more important determinant of our returns than any activity (or lack thereof) at the latter.

Is it possible to be long-term and contrarian?

With the exception of TFF Group, all our companies were firing on all cylinders last year. As satisfying as this is, a legitimate question is whether the portfolio is sufficiently contrarian.

Most thoughtful investors would agree that two prerequisites of being a successful investor are being both long-term and contrarian. But is it possible to be both? It strikes me as a legitimate question as one could plausibly argue that the two are mutually incompatible.

For example, in a typical contrarian situation, the market might take an overly pessimistic view of a company due to clouds on the immediate horizon. Think of Google during the transition from PC to Mobile, Novo Nordisk after the initial rejection of Tresiba, Grenke during the financial crisis, and many other examples. Effectively, the market takes bad news and extrapolates it indefinitely into the future. It says: “These problems are indicative of a deeper malaise. The company is in a death spiral.” The opportunity for the contrarian is to counter: “This is a temporary setback. In a few years, the company will be back on track.”

The conundrum, as you have probably already spotted, is that the investment can only be contrarian for a short period of time. If the contrarian is right, the company will quickly get back on track and the market will realise the error of its ways. If he is wrong, he was not contrarian in the first place. He was just, well, wrong.

So is it possible to be long-term and contrarian? A quick fix would be simply to say that it is possible to invest in a contrarian situation with a long-term perspective, i.e. with a willingness and ability to wait however long it takes for the situation to right itself. Obviously, one would hope the recovery materialises as quickly as possible, but if it takes longer, so be it.

There is nothing wrong with this answer. It is probably the route many thoughtful investors go down. It possibly has one flaw though: the great fortunes and the great investment track records have generally not been built by swapping horses every few years.

Let me make life harder for myself and refine the question as follows: Is it possible to reconcile a long holding period with being contrarian?

I believe it is, but it involves looking for very particular types of contrarian situation that potentially can persist for long periods of time or even indefinitely. These situations are rarer than the temporary kind, but a number of different types spring to mind.

First and foremost, the market typically underestimates the duration of some companies’ superior economics. Competition in functioning capitalist societies is brutal and the standard assumption is that after a certain period of time growth rates, margins and returns on capital normalise. This is a good rule of thumb and certainly preferable to the alternative heuristic – “Trees always grow to the sky.” However like any good heuristic, it sometimes lets you down. Thus, can anyone seriously doubt that in ten years’ time Google will be serving more searches or Novo will be treating more diabetes patients?

When analysts make 3 year earnings estimates for these companies and then assume a fade to GDP growth they persistently undervalue them in an ongoing way.

Second, some companies are able to invest nearly indefinitely, thereby masking the true profitability of the underlying business. Amazon is the poster child for this. To a certain extent, I would place Trupanion in this bucket as well. If all goes to plan, Trupanion will invest almost indefinitely in new customer acquisition. As it can acquire new customers at excellent returns, this makes sense but depresses reported earnings due to the high upfront marketing costs. Investors seeking the gratification of a short-term earnings boost are permanently disappointed, potentially creating a contrarian opportunity for the long-term holder who believes the marketing spend is value creative.

Third, some industries seem to be forever out-of-fashion. Credit Acceptance is a great example of this. Its track record is probably one of the finest I have ever come across, but it was trading at a low multiple when I bought it, is trading at a low multiple today, and, I am fairly sure, will be trading at a low multiple in the future. Many thoughtful people dislike the idea of lending to unfortunate people due to the higher interest rates which are necessary to offset the higher loss expectancy. One can argue, as I would, that the alternative of not having a vehicle (and hence job/money/life) is far worse, but other
people are not going to change their minds any more than I am going to change mine.

Fourth, I suspect markets underestimate the importance of the longevity of a business. Longevity, I understand, was the main reason Buffett bought a railroad. BETT, TFF, and Berkshire Hathaway are all companies which have the potential to live forever. In a world where the pace of change is increasing at a breath-taking pace, this is a valuable feature that is certain to be undervalued. There will always be a mountain in Engelberg, there will never be an alternative to aging fine wines and spirits in barrels, and Berkshire is as close to an indestructible business as ever will be built.

There are probably many more examples of long-term contrarianism I could go into, but you get the gist. One final point though: there is no rule stating you cannot buy a longterm contrarian idea at a point in time when it is going through temporary problems. Thus Buffett bought American Express (a company whose growth potential the market was going to underestimate in the subsequent five decades) at the time of the Salad Oil crisis (a temporary crisis which was largely forgotten within a few years). In buying new businesses, I will continue to aim to “double dip” by buying businesses which are contrarian both in the short and long-term, but my preference is for the latter.

Investor Meeting

On 11 June 2016, we held our 8th Annual Investor Meeting. The subject this year was investing in crises. The point was to show how the very best companies benefit enormously from crises. The subject also served as a gentle reminder after many years of benevolent markets that setbacks are inevitable from time to time.

My thanks go to those of you who made the journey to attend and the InvAG for being such a generous host.

Yours sincerely

Robert Vinall

See full PDF below.