Emerging Value Capital Management letter to investors for the first quarter ended March 31, 2016.
Dear Partners and Shareholders,
For the first quarter of 2016, Emerging Value Capital Management fund declined an estimated -3.5% net to investors. Stock markets worldwide were mixed in the quarter with the All Country World Index (ACWI) and the HFRI Equity Hedge Index up +0.2% and down -1.7% respectively.
Since inception (10/15/2008), Emerging Value Capital ManagementFund returned an estimated +97.9% (net to investors). During this same time period the MSCI All Country World Index (ACWI) and the HFRI Equity Hedge Index returned approximately +83.4% and +40.5% respectively.
Emerging Value Capital Management - Q1 Market & Portfolio Overview:
Stock markets were volatile during Q1. Major market indexes declined around 10% by February and then recovered sharply in March. Investors were concerned about a slowdown in China, the impact of falling oil prices beyond the energy sector and the risk of a recession in the U.S. These concerns abated to some extent in March as oil prices recovered to around $40/barrel and U.S. economic data indicated a recession was not imminent.
As we have previously written, lower oil prices are a blessing to the world and serve as a powerful economic stimulus. The prospect of steadily rising U.S. interest rates, which seemed all but certain a few months ago, now looks unlikely. Continued low interest rates, cheap money and a lack of attractive investment alternatives should keep investor capital flowing into stock markets. We therefore expect the bull market in U.S. stocks to continue in 2016, although with increased volatility.
While market indexes are little changed in Q1, there is a large disparity in the year-to-date returns (or losses) among individual stocks. As value investors this works in our favor since it allows us to deploy more capital into the stocks we like and that are relative laggards.
More specifically, we used the market volatility in the quarter to accomplish five key objectives:
1) Buy more of many of our positions that we know and like including: Berkshire Hathaway, Interactive Brokers, Amerco, Howard Hughes Corp, Basket of large cap US Financials and GSE Securities.
2) Sell lesser quality positions where we no longer have conviction including: General Motors1, Horsehead Holdings and Qualcomm.
3) Continue shifting our portfolio into higher quality stocks and less risky regions and industries. In terms of business quality and economic moats, our current portfolio is the best it has ever been.
4) Increase the level of concentration in our portfolio – our top 10 positions now comprise 70.7% of our capital compared to 58.4% of our capital at the beginning of 2016. 5) Increase our cash position to about 14% (18% as of end of April) from about 9% at the beginning of 2016 so we have the flexibility to quickly invest in opportunities created by the increased market volatility.
We are very excited about the prospects for our current portfolio. We own a concentrated collection of quality businesses trading well below their intrinsic economic values.
In the next section, 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 70% of our long exposure as we have increased the position sizes of our highest conviction ideas. As of quarter end, we were 86% long and 5% short. Our overall net exposure level of 81% reflects the compelling bargains we are finding in global stock markets.
Emerging Value Capital Management - Main contributors in Q1-2016:
Despite our overall bullishness on our current portfolio, it stumbled along with the markets in the first quarter. Our only significant contributors to performance in the first quarter were Isras Investments and Samsung Electronics.
Isras, a leading real-estate development company in Israel, reported excellent results for 2015. The company generated record NOI (net operating income) from its owned real estate properties and also recorded upwards revaluations on its portfolio. In addition to strong results, the recent addition of Isras into the Tel-Aviv100 stock index helped push up the stock price as investors became aware of the company and its cheapness (both absolute and relative to peers). We invested in Isras right after management announced a new dividend policy where they would pay out an annual dividend equal to 35% of FFO (about 3% dividend yield). Our thesis was that the company is shifting its focus from extensive real-estate asset development to real-estate asset management.
We continue to hold the stock today as its book value of 1.75B ILS understates the Company’s 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. The company trades for 85% of reported book value and about 70% of our estimate of adjusted book value. In comparison, peers trade for about 120% of book value implying significant additional upside for Isras.
Samsung Electronics, the world’s largest integrated consumer electronics manufacturer, recovered somewhat in Q1 thanks to better than expected results in both its smartphone and NAND product lines. Investors were pleased with good Galaxy S7 smart phone sales and with the company executing the second tranche of its share buyback program. The stock price increased somewhat following these results.
While investors remain overly focused on smart-phones, we feel that they fail to notice Samsung’s many other highly valuable business segments (DRAM, NAND, chipsets, displays, digital cameras, television sets, tablets, laptops, networking equipment and home appliances) as well as its competitive moat. Thanks to its size, Samsung enjoys low manufacturing costs (economies of scale) and high bargaining power with suppliers. To put its size in perspective, Samsung sells twice as many smartphones as Apple. Samsung gains additional competitive advantages from its vertical integration, with internal production of many of its own chipsets, memory circuits, and displays.
The consumer electronics space continues to expand with new product categories emerging that did not even exist a few years ago such as house cleaning robots, smart watches, virtual reality headsets, personal fitness trackers, personal health monitors, Internet connected home appliances and more. Samsung is already leveraging its size and competitive advantages to become a leading supplier in all of these categories. Needless to say, all these devices will also require chipsets and memory components that Samsung will supply. Over the years Samsung has created tremendous shareholder value and will continue to do so in the future. Samsung is cheap by any valuation metric. It trades for 8x earnings, 90% of book value, and 2.6x EV to EBITDA. At the current stock price, we are paying fair market value for the non-smart phone businesses and essentially getting the smart-phone business for free.
Emerging Value Capital Management - Main detractors in Q1-2016:
Main detractors from performance in the first quarter include Israel Discount Bank and our basket of large cap US Financials. Below is a short discussion of these positions.
Israel Discount Bank
Israel Discount Bank (IDB) declined in Q1 as investors were disappointed that the banks strategic cost reduction program appears to be progressing slower than expected. Reported 2015 ROE was under 6%. However, excluding non-recurring one-time costs, adjusted ROE was almost 7%. We always expected that the cost reduction measures would take a few years and do not share the markets disappointment with their slow and steady pace. We note, for example, that bank salary expense has declined 12% in the past two years, even though the banks loan book continues growing. We were also pleased to see the bank continue to sell non-core assets including its Switzerland subsidiary and its holdings in first international bank.
As a reminder, IDB is the third largest bank in Israel. Operationally, it is the least efficient major bank in Israel. Its employees belong to a fairly militant union and they make cost cutting and operational improvements an always difficult undertaking. As a result IDB suffers from a bloated cost structure and earns sub-par returns on equity. When we invested, sustainable ROE was below 6%. The market is well aware of these issues and therefore values IDB with a low price to book of only 0.5.
Two years ago IDB hired a new CEO, Ms. Lilach Topilsky. Previously, Topilsky led the operational turnaround in Bank Hapoalim (Israel’s largest bank). Ms. Topilsky developed a strategic plan for the bank which mostly consisted of cost cutting and selling off non-core assets. Through natural attrition and early retirement programs, the plan is already cutting costs and IDB’s sustainable ROE has increased to around 7%. We think that in time sustainable ROE will reach 8% (or higher) which would warrant a 0.9 price to book multiple (80% upside from current prices).
IDB also has non-core assets which provide strong valuation support. We value IDB New-York at about 2.8B ILS (less than book value). We value 72% owned Visa Cal at 1B ILS (10x normalized net income). Excluding these two assets, we find “Core-IDB” trading for just 2.6B ILS which is about one third of book value. A price that is clearly too cheap and should increase as assets are sold and/or ROE improves.
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, interest rates remaining low for longer than expected, and credit losses from oil & gas companies suffering due to low oil prices. While we share these concerns we view them all as transitory in nature.
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 1.0). Combined with 8% annual book value growth over the next 5 years, this scenario could result in their stock price more than doubling in 5 years.
While our Q1 results are slightly disappointing, we are optimistic about the remainder of 2016 and beyond. Our portfolio is one of the highest quality portfolios that we have ever had. We have been increasing our portfolio concentration level, adding on price dips to our highest conviction ideas and increasing our cash position to be ready to take advantage of market volatility. Every one of our investment positions has large potential upside and limited downside (with the exception of the GSE securities that could go to zero but could also go up 10x. For more on the GSE securities, please see the attached appendix).
In summary, 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 EVCM fund. Please don’t hesitate to call with any questions, thoughts or comments.