Emerging Value Capital Management letter to investors for the second quarter ended June 30, 2015.
Dear Partners and Shareholders,
For the second quarter of 2015, Emerging Value Capital Management fund returned an estimated +2.5% net to investors. Stock markets were up with the All Country World Index (ACWI) up +0.4% and the HFRI Equity Hedge Index up +2.0%.
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Since inception (10/15/2008), EVCM Fund returned an estimated +116.2% (net to investors). During this same time period, the HFRI Equity Hedge Index returned approximately +50.2%, and the MSCI All Country World Index Net (ACWI) returned approximately +92.4%.
Emerging Value Capital Management - Q2 Overview:
EVCM Fund performed well in Q2, outpacing its two main benchmarks. Our results were mostly driven by strong returns from our investments in US financials and Israeli stocks.
During the quarter Greece came close to financial default. It was once again given a financial rescue package in return for agreeing to severe austerity measures. Beyond Greece, we think Europe is facing severe macro-economic and geo-political problems including structural economic issues, a cold war with Russia and an influx of refugees. Given these issues, we are somewhat surprised by the lack of compelling bargains in European stocks. We currently have no investments in Europe but continue searching for the right opportunity to invest.
Emerging Value Capital Management - Fund Exposure Levels:
Our high level of net exposures (91%) reflects the large number of compelling bargains we are finding in global stock markets – particularly in the US, South Korea and Israel. A more detailed breakdown of our exposure by geography illustrates how we are globally diversified with our largest geographic exposures in the US, Asia and Israel.
Emerging Value Capital Management - Fund exposure by Geography:
Our portfolio is also diversified by market cap. Almost half of our net exposure (47%) is to large cap stocks since, in general, we think large cap companies are currently both cheaper than small cap companies and are better positioned to compete in global markets.
Emerging Value Capital Management - Fund exposure by market cap:
Our stock selection process is bottoms-up, without any pre-determined allocations to specific geographies, countries, industries, or market-caps. It is therefore gratifying to see that our bottom up stock selection process results in a well-diversified portfolio across multiple investment dimensions (geography, market cap, industry and investment thesis).
Emerging Value Capital Management - Our top contributors in Q2-2015:
Main contributors to performance in the second quarter include: Basket of US Financials and Isras Investments.
Basket of large cap US financials including TARP warrants
The large cap US banks and insurance companies in our basket continued to perform well due to their slow recovery from the 2008 finical crisis and the growth in the US economy. The specific details for each bank and insurance company that we own are different, yet the underlying thesis is mostly the same. The large cap financials in the US were all severely hurt in the financial crisis of 2008. Since then they have been working to repair their businesses, reduce risks, simplify operations, and restructure bad loans.
The banks in our basket will benefit greatly when interest rates finally increase since they will be able to earn higher returns on assets with only a minor corresponding increase in the cost of their deposit base.
For example, if in a few years interest rates are 2% - 3% higher than today then Bank of America and Citibank could earn a 12% - 14% ROE which could justify a 1.6 price to tangible book value multiple (currently about 1.2). Combined with 8% annual book value growth over the next 5 years, this scenario could result in their stock price doubling in 5 years.
Isras is a leading real-estate company in Israel. It develops and owns quality residential, commercial, industrial and office real-estate assets. The company assets and development projects are spread throughout Israel with most enjoying high demand and low vacancy rates. Isras is reasonably leveraged and has been taking advantage of the very low interest rate environment to refinance, thus reducing interest costs and extending debt maturities.
Until recently Isras was focused on extensive asset development and therefore re-invested all cash flows and did not pay dividends to shareholders. This resulted in the company being underfollowed and mostly neglected by investors. Recently Isras management announced a new dividend policy where they will pay out an annual dividend equal to 35% of FFO (about 4% dividend yield).
Isras’s book value is about 1.4B ILS. Book value understated true economic value for several reasons. First, Isras values its yielding assets at 8%-9% cap rates which are above market rates. Second, Isras owns land assets recorded at low historical purchase costs which have not yet been marked up on its books. Third, Isras has tax loss assets that are not on its books.
Due to liquidity and free float issues, Isras is currently not a member of any major stock market index in Israel. We think that these issues will be resolved soon and that the company should enter the Tel-Aviv 100 index in 2016. This will serve as a strong catalyst since it will immediately put the company on investor’s radar screens and will further highlight its cheapness in comparison to other real-estate companies in the Tel-Aviv 100 index.
Emerging Value Capital Management - Our top detractors in Q2-2015:
Main detractors from performance in the second quarter include: Samsung Electronics, General Motors and Qualcomm.
General Motors reported strong Q2 results with margins and profits beating analyst expectations yet investors did not seem to care. Recently, Morgan Stanley published a research report on GM titled: “Is Anybody Out There? Phones Have Gone Seriously Cold on GM”. The lack of investor interest in GM is surprising given the positive developments in the business.
Profitability in China and Brazil remains strong although the market is concerned about a possible slowdown in China. GM recently increased its dividend, announced a $5B share repurchase and promised to return additional capital to shareholders in the next few years. GM is unreasonably cheap, trading for 3X EV/ EBITDA and 6X P/E. The company could earn over $5 per share next year (excluding any additional restructuring costs) which could warrant a $50 stock price (vs. current price of $31.35). We are excited about the market finally seeing a profitable, cash generating GM with the burden of its past mistakes in the rearview mirror.
As expected, Samsung reported weak Q2 results, mostly due to declines in smart-phone margins as both Apple and Chinese phone manufacturers ramp up their competitive offerings. The semi-conductor division continues to shine but was not enough to overcome weakness in other divisions.
Samsung is a complex conglomerate with many moving parts and is difficult to fully analyze and follow. Most investors seem focused on Samsung’s smartphone business while paying little attention to its many other highly valuable business segments (DRAM, NAND, chipsets, displays, digital cameras, television sets, tablets, laptops, networking equipment and home appliances).
At the current cheap stock price we are paying a fair price for the non-smart phone businesses and essentially getting the smart-phones business for free. Samsung is the world’s largest integrated electronics manufacturer. It has created tremendous shareholder value over the years and will continue to do so in the future.
Qualcomm designs, manufactures, and markets advanced integrated circuits and chipsets used mostly in networking and wireless products. The company owns an extensive technology patent portfolio which it licenses to other manufacturers. QCOM’s chipset business has experienced recent difficulties as key customer Samsung Electronics has shifted to an in-house solution. The technology licensing division, which generates over 60% of profits continues to perform well and is set to grow as intellectual property rights get better enforcement in China.
Jana partners, a highly regarded activist investment firm, is actively involved with Qualcomm. Jana now has two members on QCOM’s board and has been pressuring QCOM to take shareholder friendly actions. These include large share buy-backs, cost cuts, reductions in management option grants, and a possible split-up of the company.
At current prices we are paying for just the licensing business and essentially getting the chipset business for free. With Jana partners acting as a catalyst for unlocking value, we find the risk reward balance in QCOM to be compelling.
Select Emerging Value Capital Management Fund Investment:
United States Oil Fund (Ticker: USO) is an ETF that is supposed to track the price of a barrel of oil (WTI - west Texas intermediate oil). In theory, it is an interesting financial product that allows investors to easily invest in (or bet against) the future price of oil. It is mostly owned by retail investors that view it as a proxy for directly owning barrels of oil.
Like many Wall-Street “products”, USO is a wolf in sheep’s clothing. USO does not own any oil directly. Instead, it uses futures contracts to gain exposure to the price of oil. Because these futures contracts are usually in contango (front months cheaper than later months), USO suffers from “roll decay” which makes it lose value over time. Every month, USO needs to sell the front month futures contracts that is owns and replace them with futures contracts that are one month further out, and therefore more expensive. As the month goes by, the newly purchased futures contracts become the front month futures contracts and the process repeats again, every month, forever. This can be summarized as “buy high, sell low, repeat every month forever”. Simply put, USO does not accurately track the price of oil and is likely to cause large losses over time to its investors. Given enough time, USO will probably go to zero.
Our past short position in USO worked out very well towards the end of 2014 as the price of oil fell sharply. We closed out most of the position at a nice profit. Fortunately, the price of oil spiked temporarily in April of 2015 and we reestablished our short position in USO once again.
Fannie Mae / Freddie Mac Preferred Shares
During the financial crisis of 2008 the US government chose not to fully privatize the GSE's and instead allowed them to remain public companies with common and preferred stocks freely traded. In 2011 the US government arbitrarily amended the terms of preferred shares and began requiring Fannie and Freddie to pay it all of their profits (instead of a 10% dividend). Several investor groups are suing the government and are arguing that for the government to confiscate these companies from shareholders after it has been more than fully paid back on its crisis-era financing is unconstitutional.
Beyond the legal issues, allowing the GSE preferred shares to resume their dividend payments is a win-win situation for all involved. Many of the preferred shareholders are community banks, which were encouraged (some would say tricked) by the US treasury to purchase them. Allowing the preferred shares to resume their dividends would effectively recapitalize these community banks.
There is presently no viable alternative for Fannie Mae and Freddie Mac. Winding them down would effectively eliminate the fixed rate 30-year mortgage which would disrupt the housing market recovery and make it significantly more difficult for Americans to become homeowners. We believe that is precisely the reason that the government has kept the GSE’s in legal limbo. Winding them down would be terrible for housing and fully nationalizing them would add trillions (yes, trillions) to the national debt. The state of limbo, however, cannot last forever and recapitalizing the GSE’s is likely the best course of action for all involved. There is a reasonable chance that, after discarding all other options, the US government will realize that recapitalizing the GSE’s is in everyone’s best interest.
Betting on legal outcomes, even when one believes he is legally and morally correct, is far from a sure thing. Ultimately, our investment in the GSE preferred shares is a question of risk-reward. The upside for the GSE preferred shares (10x our money) is about 10 times the downside (going to zero). So even if we thought the odds of winning in court were only 20% (we think they are much higher), it is still a statistically good bet to make as long as we size it correctly.
After six years of rising stock prices, markets on average are clearly not cheap. Yet, our global investing scope combined with our meticulous exploration of every nook and cranny continues to uncover compelling investment opportunities. We are carefully choosing where we wish to invest since many countries around the world suffer from severe geo-political problems.
As bottom-up stock pickers, we do not target any particular level of market exposure. Rather, we invest our capital if, and only if, we find compelling opportunities. Emerging Value Capital Management Fund is close to fully invested which is a strong indicator of the excellent opportunities we are finding. Our portfolio contains multiple unique and compelling value investments that should provide high returns over the next few years.
Thank you, our investors and shareholders, for your trust and support of Emerging Value Capital Management fund. Please don’t hesitate to call with any questions, thoughts or comments.