Ori Eyal’s Emerging Value Capital Management letter to investors for the year ended December 31, 2016.
Dear Partners and Shareholders,
For 2016, Emerging Value Capital Management fund returned an estimated +6.5% net to investors. Stock markets worldwide were up with the All Country World Index (ACWI) and the HFRI Equity Hedge Index up +7.9% and +5.4% respectively.
Since inception (10/15/2008), EVCM Fund returned an estimated +118.6% (net to investors). During this same time period the MSCI All Country World Index (ACWI) and the HFRI Equity Hedge Index returned approximately +97.4% and +50.8% respectively.
2016 was marked by political turmoil. First the United Kingdom voted to leave the European Union (Brexit) and then Mr. Trump was unexpectedly elected to be president of the United States. Emerging Value Capital Management fund performed reasonably well in this environment and kept up with global markets as the majority of the stocks that we own did well in 2016. Many of our portfolio companies, particularly financials, rose significantly following Trumps election and the stock market rally that ensued. We discuss this Trump rally in more detail below.
We made few changes to our portfolio in 2016 because we like what we own and did not find much that is better to buy. We did purchase new positions in Berkshire Hathaway, Goldman Sachs, Fortress Investment Group, Bank Leumi and Blackstone. All five new positions are good business that were trading at unjustifiably cheap valuations and are up nicely since we purchased them.
Below, we will go into greater detail on some of these positions. For now, however, we think it is important to point out that our top 10 longs make up over 79% of our long exposure as we have increased the position sizes of our highest conviction ideas. As of year-end, we were 91% long and 10% short. Our overall net exposure level of 81% reflects the compelling bargains we are finding in global stock markets combined with a fairly small sized cash position (9%) that we will utilize to take advantage of any downside volatility.
The Trump rally:
We have always been careful to avoid personal politics in these letters. Investing decisions should be objective, fact-based and as dispassionate as possible. Mixing in our personal political opinions is unlikely to add value to our portfolio or to improve our decision making process. Therefore, the following discussion will be as factual as possible.
Stock market investors clearly think president Trump is good for US stocks. They expect him to lower taxes, reduce burdensome regulations, increase infrastructure & military spending, unleash free market capitalism, create more jobs, foster a more pro-business environment and generally “make America great again”. Some commentators have even drawn an analogy to former president Reagan and the market rally that followed his election. We think this analogy is a stretch, particularly since when Reagan was elected, interest rates were high and stocks were cheap – the opposite of where they are today.
We do agree that a republican government is probably good news for financial companies, particularly since its inflationary policies are already leading to higher interest rates which help increase the net interest margins for banks and the return on float for insurance companies. Our financial stocks have rallied significantly since the election and we have begun trimming some of these positions. We also think a Trump presidency is good news for Israel, one of our favorite places to invest, which we discuss in more detail below.
Investing in times of global turmoil:
Since we started investing professionally in 1999, global investing has become much more popular. From a niche strategy for adventurous investors, global investing is now mainstream. This makes perfect sense when globalization, free trade, open borders and world peacefulness are all increasing. Yet in the last few years we are witnessing a partial reversal of these trends. Therefore, we think it is now more important than ever for global investors to carefully pick and choose which countries they wish to invest in.
At Emerging Value Fund we have always adhered to the idea of “researching the country, not just the company”. Our analysis has shown that many countries that, in the past, were viewed as attractive investment destination are now headed in the wrong direction. Despite offering cheap stocks, we are not currently investing in Russia, Turkey, Egypt, South Africa, Saudi Arabia, Venezuela, Brazil or China. We think that the macroeconomic and geopolitical risks for these countries are too extreme.
In contrast, we are certain that, despite occasional setbacks, the US, Israel, and South Korea are headed in the right direction and currently are among the best countries in which to invest our capital. These three countries are true capitalist democracies, enjoy favorable demographic trends, and are the world leaders in technological innovation – the driving force behind today’s economic growth. In our view, the age of energy has ended and the age of technological innovation has begun. With technology comprising an ever growing portion of the global economy and with more and more “old economy” sectors getting technologically disrupted, economic success in the future will be based on the ability to innovate and stay ahead of the advancing technological curve. Israel, South Korea, and the US are the best positioned countries to do so.
- Emerging Value Capital Management Interview [Part One]
- Emerging Value Capital Management Talks Korean Preferreds [Part Two]
- Emerging Value Capital Management On USO, TNA And US Financials [Part Three]
The following table shows how our capital is allocated among these countries.
Emerging Value Capital Management’s main contributors in 2016:
Main contributors to our returns in 2016 include: Samsung Electronics, Israel Discount Bank, Isras Investments, and our basket of large cap US Financials. Below is short discussion of these positions.
Basket of large cap US financials including TARP warrants
The large cap US financial companies in our basket increased significantly in 2016 following the presidential election results. The new Republican administration is expected to reduce corporate income taxes, roll back financial regulations and lead to higher interest rates. All three actions should increase the profitability of financial firms. As stock prices continue to increase, we have been trimming our basket and, on the margin, shifting capital from banks into asset managers. For example, if in a few years interest rates are 2% – 3% higher than today and corporate taxes are 20% lower, then Citibank could earn a 12% – 14% ROE which could justify a 1.5 price to tangible book value multiple (currently under 1.0). Combined with 8% annual book value growth over the next 5 years, this scenario could result in Citibank’s stock price more than doubling.
Isras is a leading real-estate development company with a valuable portfolio of retail, residential and office properties owned and under development all across Israel. Real estate prices in Israel continue to increase thanks to multiple favorable economic factors. The Israeli economy is strong and growing, the population growth rate in Israel