Ori Eyal – Emerging Value Capital Management letter to investors for the third quarter ended September 30, 2015.
Dear Partners and Shareholders,
For the third quarter of 2015, EVCM fund declined an estimated -6.8% net to investors. Stock markets worldwide were also down in the quarter with the All Country World Index (ACWI) and the HFRI Equity Hedge Index down -9.5% and -5.9% respectively.
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Since inception (10/15/2008), EVCM Fund returned an estimated +101.5% (net to investors). During this same time period the MSCI All Country World Index (ACWI) and the HFRI Equity Hedge Index returned approximately +74.2% and +41.1% respectively.
Emerging Value Capital Management – Q3 Performance Overview:
During the third quarter EVCM Fund declined with the markets. While we are well ahead of our benchmarks on a year to date basis, 2015 has proven to be a difficult year for value stocks and value funds. We take comfort in the knowledge that we own a collection of excellent businesses trading well below their intrinsic economic values.
Given the various geo-political and macro-economic problems around the world, and given that we are six years into a bull market, we have been working to shift our portfolio into higher quality stocks and less risky regions. Our feeling is that in terms of business quality and economic moats, our current portfolio is the best it has ever been. Please see below for a more detailed analysis of some of our investments.
Emerging Value Capital Management – Finding Value Around the World:
As a global fund with a fairly wide investment mandate, we are able to invest in almost any country in the world. This large menu of potential investment destinations provides us with a competitive advantage (compared to geographically constrained investors), as long as we carefully pick and choose where we ultimately do invest.
One of our guiding rules of investing at Emerging Value is: “Research both the country and the company”. Investing in a good business in a deteriorating country is a classic value investing mistake that we work diligently to avoid. This rule is particularly important today, with multiple geo-political and economic trouble spots around the world.
China’s economic slowdown combined with the fall in commodity prices and particularly the sharp decline of oil prices (due to shale fracking technologies) have placed economic pressure on Brazil, Canada, and Australia as well as the entire commodities industry. We do not think a bottom is close and are mostly avoiding the affected countries and sectors.
The multiple wars in the Middle East continue to escalate. Russia’s military has entered the war in Syria and has been aggressively bombing rebel forces, including the “moderate rebels” supported by the US. Iran is receiving a financial windfall from its nuclear deal and will use the funds to further its proxy wars in Syria, Iraq, Lebanon, Gaza and Yemen. We see no end to these wars in the foreseeable future. Our analysis shows that Turkey (NATO member), Lebanon, Jordan, Afghanistan, Saudi-Arabia and Egypt are all facing extreme difficulties from within and without and we would not be surprised if one or more of these countries gets sucked into the all-out war in the Middle East. We are not even slightly tempted in invest in any of these countries.
Europe is struggling to cope with three severe problems simultaneously. Their continued economic stagnation, a resurgent and belligerent Russia, and a massive influx of refugees from the Middle-East. We expect Europe will eventually muddle through these issues, but any resolutions remain years in the future. We have no current investments in Europe but are actively searching for bargains.
Given the issues highlighted above, where are the investment opportunities today? Our careful analysis suggests that the US, South Korea, and Israel are currently among the most attractive investment destinations. These three countries are free capitalist democracies with a clear rule of law, strong investor protections, and enforceable property rights. All three countries are enjoying a strong economy with good GDP growth, positive demographics, low inflation rates, and improving business landscapes.
These three countries are also world leaders in technological innovation which is the key driving force behind economic growth. In our view, the age of energy has ended and the age of technological innovation has begun. The US, Korea, and Israel are very well positioned to prosper in this new era. Not surprisingly, the majority of our capital is invested in these three countries.
Emerging Value Capital Management – Fund Exposure Levels:
Fund Exposure by Geography
We would go a step further, borrowing a phrase from the RE industry and argue that we have invested in the “best houses located in the best neighborhoods”.
Below is a quick snapshot of our top ten long and short positions
Top 10 longs and shorts
In the next section, we will go into greater detail on many of these positions. For now, however, we think it is interesting to point out that our top 10 longs make up over half of our long exposure. As of month end, we were 96% long and 8% short. Our overall net exposure level of 88% reflects the large number of compelling bargains we are finding in global stock markets.
Our main contributors in Q3-2015:
Despite our overall bullishness on our current portfolio, it stumbled along with the markets in the third quarter. Our only significant contributors to performance in the third quarter were from our short book, specifically TNA and United States Oil Fund (USO). Both are poorly designed ETF’s which in our view are almost certain to lose value over time and eventually be worth zero.
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 it 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.
We have been short USO in the past and it served us well, especially towards the end of 2014 as the price of oil fell sharply. We closed out most of the position at a nice profit in the first quarter of 2015. Fortunately, the price of oil spiked temporarily in April of 2015 and we re-established our short position once again. This re-established short position has already proven profitable in Q3-2015 where we trimmed it again. We are patiently waiting for future spikes in the price of USO so that we can re-establish a large short position yet again. Shorting USO has proven to be the gift that keeps on giving
Emerging Value Capital Management – Our main detractors in Q3-2015:
Main detractors from performance in the third quarter include: Samsung Electronics, General Motors, Qualcomm, Horsehead Holdings, Basket of US Financials and Golf & Co. 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 declined as investors were concerned about slower than expected GDP growth and interest rates remaining low for longer than expected. While we share these concerns in the short term, our long term thesis has not changed. The specific details for each bank and insurance company 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.
Moreover, 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.
After a strong Q2, General Motors just reported strong Q3 results with high profits in the US and record sales in China. The stock is up 20% in October yet still trades for just 7 times next year’s earnings of $5 per share. 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 4X EV/ EBITDA and 7X 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 $35.90). We are excited about the market finally seeing a profitable, cash generating GM with the burden of its past mistakes in the rear-view mirror.
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