Click here to read our brief quarterly letter reviewing the decisions we’ve made throughout the last year, the results and our outlook for what will surely be an eventful year!
•We’re avoiding over-valued US sectors like the plague
•As a result, we’ve missed the momentum of US securities, of which the leadings ones have zero equity risk premium baked into them (the 20 best performing stocks in the S&P 500 are trading at 41.4x earnings)
•Our investments have largely outperformed their industries and sectors – particularly Europe, energy and small caps
•Our portfolio’s risk-adjusted return is 13.8x, more than double where it was in early 2014
•The preconditions are fertile, but timing unknown, and the odds are stacked in our favor
“Bait the hook well; this fish will bite.” Shakespeare’s Much Ado About Nothing
Monday, December 12, 2015
Dear GreenWood Investor:
While 2014 started off with a bang for us, as small cap equities rallied and Fiat agreed to buyout the UAW’s stake in Chrysler, the year ended up being much ado about nothing. As US equity markets, particularly healthcare and technology equities, have rocketed higher, we have been monetizing and selling down the few investments we have left in such over- valued sectors. Over the last couple of quarters, as optimism has waned over a European recovery, our portfolio has become inadvertently more Italian and French. We’ve always focused on owning the cheapest,highest-quality companies we can ?nd on the planet, and global investors have mistakenly bifurcated valuations based upon which side of the Atlantic the stock trades. This has happened despite the fact that cheaper European companies often compete and win against the same US ?rms with valuations that are often double to triple their peers across the pond. As we will demonstrate in an upcoming video, chasing good performance to try and eek out further gains often ends in disappointment. We’re statistically more likely to do well with exposure to industries and sectors which have undergone a period of pronounced underperformance recently. We think the S&P 500 will be a very easy benchmark to trounce in the coming years. So 2014 can more aptly be remembered as one with much ado about Europe.
As we reviewed in the third quarter letter, the US market has reached valuation levels which guarantee longer-terminvestor dissatisfaction. Yet investors who are trying to squeeze a bit more momentum out of the US equity bull market are picking up dimes in front of steam rollers. The twenty best performing stocks in the S&P 500 for 2014 are euphorically priced
for parabolic growth. As the group is valued at 18.7x cash-?ow (EBITDA) and 41.4x earnings, there is zero equity risk premium built into these momentum stocks. As the US market continues to be led by a scarce group of equities whose valuations are disconnected from reality, we’ve found literally the opposite environment for many southern European companies. If we have erred in 2014, it has been transitioning away from such an unattractive US opportunity set a bit too soon. Yet we believe such transitions are necessary to produce attractive medium and long-term results. Thus, this
year’s results are best understood in the context of these decisions we’ve made. Our European investments have handily outperformed the MSCI European index’s return of -8.6% and our global micro strategy has outperformed the MSCI all- world, all-capitalization index despite having a signi?cantly lower exposure to US equities. The Russell 2000 index, which contains more small capitalization companies (to which we have a heavier exposure), returned 3.5% in the year.
Our energy holdings in Contango and Cairn are handily outperforming the sector that’s been obliterated, in fact Cairn is trading at roughly the same levels where we bought it when oil was trading for $110 a barrel. That’s the power of buying stocks on the cheap. While companies like Approach Resources (AREX, of which we sold most of our position north of $25 vs. today’s $5) are incredibly cheap and oil under $60 is unsustainable for longer than a year, we’re not convinced oil and energy stocks have found their bottom. Thus, we’ve remained patient throughout the current energy rout.
Exhibit 2: GreenWood Model Portfolio Composition2 as of 12/31/14
Fiat is the best performing automaker in the world, both in its operations and in the stock price. Every mass market competitor’s stock has returned between -28% and 5% since the beginning of 2014, while Fiat Chrysler has returned over 40% in the last year in un-hedged US dollars. Since most of us have been able to hedge the euro, this return has been
a 67% gain over the last twelve months. So have we sold any Fiat? Absolutely not, in fact it’s a more compelling bargain today than when we bought it. During an unanticipated very eventful fourth quarter, the company paid down debt and decided to spinout Ferrari to us stockholders during 2015 (likely this summer). We believe the value of Ferrari’s stock we will soon receive will be worth at least €3.50 per share, which means the stand-alone Fiat-Chryslertrades at 1.6-1.7x our estimated cash-?ow for this year. Thus, although we’ve enjoyed healthy returns in Fiat, it is even cheaper than when we ?rst bought it, and it has a very robust geographic and product expansion in the quarters and years ahead. We think Fiat will continue to be the best-performing automaker. As such, it remains our largest position at nearly 15% our portfolio, with Exor adding an additional 6.5%.
The fact that no one, including those closest to the company, saw this Ferrari spin-out coming, just proves that investors should be skeptical when they hear someone touting “near-term catalysts.” Timing is unpredictable in stock returns, we just need to make sure preconditions are in place for outsized returns. As always, we’ve been trying concentrate our efforts on planting a few exceptional seeds in fertile ground to ensure we have multiple prize-winningfruits when it comes time to harvest. The preconditions for great returns exist in our portfolio as we’ve monetized most of our US holdings that
have reached fair value and transitioned to a portfolio made up of very cheap, very high-quality and verywell-managed businesses- mostly in markets that have stacked the odds heavily in our favor. The European Central Bank is about to embark on a large Quantitative Easing program, and the Italian government has an ambitious agenda for reform and economic stimulus in the coming weeks and months. The decline in the euro alone will make our companies’ products even more compelling values over competing American offerings.
In that vein, we were very thankful to begin purchasing a stake in Finmeccanica (FNC IM) on Thanksgiving morning. While it’s not trading for 1.65x cash-?ow, there are numerous similarities between Fiat and Finmeccanica. Both are run by excellent CEOs with fantastic track records, are trading at the cheapest valuations in their respective industries, have aggressive growth and restructuring plans, and represent the very best of Italian industry. In the next couple of weeks, Finmeccanica will host an investor day outlining these restructuring plans and it will likely ?nalize the sale of itsloss-making train manufacturing unit for an attractive price to Chinese or Japanese bidders. Also similar to Fiat, we think the near- term upside for the stock, which trades for under €8.00 today, is in the mid €20 per share range. Longer-term,should both CEOs execute as well as they have historically, shares could be worth north of €40 per share. We believe we’ve created our most entertaining and informative video yet, and have outlined the opportunity in Finmeccanica in this ?ve- minute youtube video. Of course we’ve detailed our analysis in a more thorough report, which is available upon request and is being mailed to GreenWood Investors concurrently with this letter. Opportunities like these, in the two largest industrial companies in their country, don’t exist in the United States. These bargains are akin to therisk-adjusted returns that were available to US investors in 2009.
As such, we are very excited about our forward-looking performance possibilities. Our portfolio’s risk-adjusted return pro?le stands at 13.8x, which means for every unit of estimated fundamental risk we take, we have 13.8x the return potential, more than double where it was in early 2014. Our weighted average return on invested capital stands at 60%. We’ve never entered a year with the odds stacked this high in our favor. As we stated at the end of our video on Finmeccanica, we’ve got our carry-ons stowed, our seat belts fastened, and we anticipate take-off any day now.
Steven Wood, CFA
Full Greenwood Investors letter here