Greenwood Investors updates for the second quarter ended June 30, 2016.
Greenwood Investors 2Q16 Commentary
Dear GreenWood Investor:
If we were to tell the story of the human condition to an alien, the current environment would only elicit laughter or perhaps confusion. Events that have transpired in the world of political economy are the epitome of irrationality, which makes our robotized and volatility-obsessed markets behaving like an unsupervised junior high school. As investors, we have the ability not to get bogged down into the dramatic fray, but use this laughable behavior to our benefit. Taking the analogy one step further, there are always adolescent kids that are highly intelligent, genuine, creative, with high ethics that get abused by their peers. In fact, this seems to almost be a rule for seventh-graders. The flashiest ones in the class tend to use a lot of smoke and mirrors, and there is little substance behind many of these “cool kids,” that everyone else adores.
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The cool kids in the market today either claim to be part of a “new economy,”and hope to have the investment prowess of Jeff Bezos (doubtful) or they likely sell very boring products to consumers (many of which are harmful to them) and buyback stock at twice the valuation of the market in an effort to maximize shareholder value. Much to your authors’ chagrin as a 14-year-old, he was not a cool kid, nor will ever be. We’ll always lean towards the calculator crew, and that’s what we’ve done with our portfolio.
Under shorter-durations of measurement, as in the last six months, managers like Sergio Marchionne have very often underperformed his peers as he doesn’t care what the “cool kids,” urge him to do. “Shut down Alfa Romeo and Italy, do a massive capital raise, buy a stake in Uber, and invest in electric vehicles that have negative returns on capital.” All of these have been suggested to him, and while they are no doubt great for investing banking revenue, they are terrible endeavors for stakeholders in FCA. Not surprisingly, while many analysts and investors have found it difficult to withstand the volatility of FCA shares, Marchionne has still outperformed any of his peers by a minimum of a double. Excluding Alan Mullally, a favorite of ours that exited his role at the top of the auto valuation cycle, Marchionne’s outperformance at FCA rises to over three times better than his nearest competitor. And that’s using today’s share price, which is trading at 2.5x trailing normalized earnings (half that of consensus-long and undermanaged GM). We’re excited about Marchionne’s ability to use this to his advantage and continue generating shareholder performance in line with his career, where he has trounced the US stock market by over 25x.
Similarly, John Elkann at EXOR has recently started transforming his holding company by also going against the herd and buying a reinsurance company. Most analysts take the recent warnings of Warren Buffett on the fundamentals of reinsurance at face value and therefore think the acquisition ill-timed. Yet by making the contrarian move, Elkann is securing low cost capital, which may not be as novel in today’s negative interest rate world, yet will prove very valuable over time. Many European family-controlled businesses ignore the “cool” consultants and hot trends and make high-quality investments in assets that have significant long-term potential, but are temporarily being shunned by investors for various reasons. This is the key to outperforming one’s peers – going to places where most are unwilling, likely because of their own emotional limitations.
Another great European manager, Vincent Bolloré, has spent the last year acquiring a controlling position in Telecom Italia, replacing the management, doubling its cost-cutting efforts, raising the price of legacy plans, and will be augmenting the competitive offering of the company with a bundled quad-play service later this year. He has also accelerated its fiber rollout in a country with broadband penetration under 3%. We’ve been meeting with Telecom Italia for over two years, and the timing was exactly right during the Brexit aftermath to start building our position in the savings shares at half the price Bolloré paid for the common stock. We’re buying the cheapest telecom in the world, with a near-investment grade but leveraged balance sheet such that high single-digit or low double-digit growth in profitability will mean the value of Telecom Italia’s equity (savings shares are at a ~20% discount and even pay a dividend) will grow by 27-35% a year for the next few years.
Volatility-obsessed investors that have driven the prices of US consumer staples up to atmospheric levels would do well to look at Telecom Italia. Our report on the company will be up in the Grove in the coming week. Your author had a chance to discuss both Telecom Italia and the current Wonderland environment in which investors are currently navigating at one of the oldest Value Investing conferences in the world, curiously in Southern Italy. Slides are being made available to investors and friends concurrently with this letter, but please don’t hesitate to reach out if you haven’t received them and would like a copy. We suggest readers take 5-10 minutes to review how curious today’s investing climate has become. Our current real world looks more like Alice’s Wonderland, and therefore we have suggested that investors walk Through the Looking Glass and purchase more-volatile stocks that offer very significant upside, even in the event of another recession.
Awilco (AWDR NO) is one example of a cyclical investment that will outperform in a recession. The company is the very definition of a cigar-butt, in that it owns two rigs (one working, one parked) in the North Sea of the U.K., which is a mature and declining oil basin. Yet the cigar butt is heavily owned by insiders, who are keen to pay out all of the company’s free-cash-flow to investors. Thanks to one rig being contracted until early 2018, this means we will get back >100% of our initial investment through dividends over the next six quarters. After this, we’ll own the rigs for free, of which at least one will have a very long future given the large amount of peripheral resources and asset retirement work operators have in the basin. If oil ever goes back to $60 a barrel, we think rig rates will normalize at higher day rates than today, but lower levels than in the past. In this more normal environment, we think Awilco has a near ten-fold return potential. Our cost basis, much like FCA after the spin of Ferrari, will likely be zero. Clorox, Equinix, Edwards Lifesciences, or any other “steady,” businesses offer the exact opposite risk-adjusted return profile: large multiple depreciation potential and a more limited scope for margin expansion and earnings growth.
As our presentation reviews, the current infatuation with low-volatility stocks has unsurprisingly driven a herd-like crowd into a smaller group of low-beta stocks that are priced near historic peaks of other well-loved assets, like technology stocks in 1999-2000 and the Nifty Fifty stocks in the early 1970s. As the crisis caused by Long-Term Capital Management has shown, even the brightest humans have routinely ignored history and cornered themselves into low-volatility asset classes that unwind with spectacular drawdowns. We will do well to always avoid these areas of extreme enthusiasm and crowding, as we have sought a portfolio of under-loved and under-respected high quality companies trading at incredibly low valuations. These are almost all led by highly adroit managers that are focusing on making the companies more profitable and more competitive. Because of these efforts, even our most cyclical holding Fiat-Chrysler will generate positive returns if we experience a recession. Not just a little positive, but significantly positive, as the stock price is currently giving >90% chance of U.S. unemployment rising beyond 13%. These managers and valuations will give us a much-needed margin of safety in the current Wonderland world of markets and politics.
Speaking of Wonderland, the country that colonized half the world has now voted to be the first respected country (leaving Russia, Venezuela, Iran and North Korea out of this mix) since World War II to pull away from the world, from diversity and from economic vitality. Because of the deep recession the UK has solidified for itself, we are more convinced by the day (but are open to disputes!) that this Brexit will strengthen the EU. The Spanish voters have already swayed back towards the pro-EU party. We see very few scenarios that make the Brexit referendum lead to a breakup of the Eurozone (click here to read our in-depth analysis of the implications). Even if this low-probability scenario plays out in the coming years, the market reaction in London in the wake of the Brexit vote gives us confidence that by being invested in export-driven companies in peripheral countries, whose currencies will decline and earnings and stocks will appreciate, and being net short export-driven companies in Germany (more to come on this front), is the right portfolio to have even in this extremely unlikely scenario.
On a personal note, I am incredibly grateful for your faith and support. My aim is always to highlight each unique manager and opportunity, because these ladies and gentlemen will ultimately determine our results. Having sold a few smaller legacy positions that had more pronounced downside in the event of a recession, we have ensured all of our holdings have skewed potentialities. They all have very limited fundamental downside, with all the preconditions for success maximized. Yet taken as a whole, the portfolio’s average risk-adjusted return, return on invested capital and qualitative factors are all more attractive as a whole than any of the underlying holdings.
Global investor positioning has rarely been so underweight Europe. The last time European markets were this hated was in 2012 during the Grexit crisis. That turned out to be an exceptional time to buy European export-focused companies. I believe our portfolio offers this kind of opportunity today, as the risk-adjusted return has rarely been this stacked in our favor. As the chart below shows, at times when this has peaked, our subsequent returns have been quite favorable. July is already proving this to be the case once again, yet we will remain vigilant and opportunistic as we continue to hunt for better prospects around the world.
Thank you again for your continued support and trust.
Steven Wood, CFA
See full PDF below.
Additionally, our presentation on EXOR was selected by the Ira Sohn foundation as a finalist in the stock-picking contest. I’m convinced the only reason it wasn’t selected to be presented live was that it highlighted some critical aspects of GM, which was pitched directly after by a well known value investor and judge of the contest. I transferred the presentation into a live-youtube format, which you can watch here or below. I am so humbled that the video has already been viewed by people for nearly 15 days of watch time. The presentation also coincided with the discount to EXOR’s NAV narrowing from nearly 40% to mid 20%, so we have perhaps helped add value to our largest position.
Lastly, I’m extremely pleased to tell you that the cornerstone of our “suggestivist” flight plan we shared with both you and the management team of Rolls Royce this time last year has been accomplished in the acquisition of a major supplier by the company last week. Having just attended the Farnborough air show, we came away increasingly positive on both the prospects of Rolls Royce and Leonardo-Finmeccanica. Notes from the airshow are posted in the Grove.