Emerging Value Capital Management commentary for the third quarter ended September 30, 2016.
Dear Partners and Shareholders,
For the third quarter of 2016, Emerging Value Capital Management fund returned an estimated +2.1% net to investors. Stock markets worldwide were up in the quarter with the All Country World Index (ACWI) and the HFRI Equity Hedge Index up +5.3% and up +4.6% respectively.
Since inception (10/15/2008), Emerging Value Capital Management Fund returned an estimated +102.3% (net to investors). During this same time period the MSCI All Country World Index (ACWI) and the HFRI Equity Hedge Index returned approximately +95.1% and +49.0% respectively.
Emerging Value Capital Management – Q3 Market & Portfolio Overview:
The third quarter of 2016 was mostly uneventful with no major macro-economic and few company specific events. It was nice to get a breather after the Brexit turmoil of Q2 and ahead of the “excitement” of the US elections. The majority of the stocks that we own did little in Q3 while the underlying businesses continued to grow their intrinsic values by increasing revenues, widening their moats, generating cash flows and buying back their own shares. Therefore, the average discount to intrinsic value in our portfolio, along with our expected return, increased.
We made few changes to our portfolio in Q3 because we like what we own and did not find anything better to buy. We continue to think that we have the highest quality portfolio in our history, that our companies trade at large (and growing) discounts to their intrinsic business values, and that we are invested in the best economies in the world (the US, South Korea, and Israel). Therefore, we remain optimistic about future performance.
Top 10 Longs and Shorts
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 74% of our long exposure as we have increased the position sizes of our highest conviction ideas. As of quarter end, we were 84% long and 8% short. Our overall net exposure level of 76% reflects the compelling bargains we are finding in global stock markets combined with a reasonably sized cash position (16%) that we will utilize to take advantage of any downside volatility.
Our main contributors in Q3-2016:
Our main contributors to performance in the third quarter were Samsung Electronics, Basket of US Financials and Isras Investments.
Samsung Electronics, the world’s largest integrated consumer electronics manufacturer continued benefiting from improved sales & margins in both consumer electronics and memory circuits as these recovered from cyclical low points. Samsung even briefly surpassed Apple in US smart phone market share, a strong indication that consumers like its smart phones.
Unfortunately in September Samsung had to implement a massive recall of its popular Note 7 smartphones due to multiple cases of the phones catching fire after their batteries overheated. We commend Samsung for acting quickly and responsibly to address this problem and protect both consumers and its reputation. We think this incident, which will cost Samsung about $7B in direct and indirect costs, will prove to be immaterial in the long run as most Note 7 owners have already switched to other Samsung smart phones. Despite this recall, Samsung was one of our top contributors in Q3 – an indication of how excessively cheap it was when we purchased it.
Samsung is cheap by any valuation metric. It trades for 10x earnings and 3.3x EV to EBITDA based on our expected 2017 results. 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. In addition, activist investment fund Elliot Management has proposed several value enhancing measures for Samsung, some of which management has agreed to evaluate. We believe there is significant value in Samsung waiting to be unlocked and are encouraged by this recent development.
Basket of large cap US financials including TARP warrants
We were surprised when Wells Fargo, one of the large banks in our basket, was discovered to have created fake customer accounts. Further investigations revealed more misconduct by a surprisingly large number of Wells Fargo employees. The bank was fined and the CEO was forced to resign. This embarrassing scandal was particularly surprising since Wells Fargo was widely regarded as the best managed among the large banks and is a large investment of Warren Buffett. The lesson is that financials are inherently opaque companies where it is very difficult for investors to know and understand everything that is going on. We view this as further support for our decision to take a basket approach to investing in cheap financials.
Barring any further damaging discoveries, we think this episode is mostly behind Wells Fargo and that it will not cause significant lasting damage. If, in a few years, interest rates are 2% – 3% higher than today then Wells Fargo could generate an 17% return on tangible book value which could justify a 2.0 price to tangible book value multiple. Including expected growth in book value, this leads us to a $70 price target (currently stock price is around $45). We receive a 3.3% dividend yield while we wait.
Isras is a leading real-estate development company with a valuable portfolio of retail, residential and office properties owned and under development all across Israel. Last year’s addition of Isras into the Tel-Aviv100 stock index continues to help push up the stock price as more investors became aware of the company and its cheapness (both absolute and relative to peers). Real estate prices in Israel continue to increase thanks to multiple favorable economic factors. The Israeli economy is strong and growing, the population growth rate in Israel is the highest among all developed countries, and supply of real estate is constrained by both regulatory bureaucracy and limited land area. We therefore expect Isra’s high quality real estate assets to continue appreciating in value at a good pace.
Our main detractors in Q3-2016:
The main detractor from performance in the third quarter was our basket of Korean Preference Shares.
Basket of Korean Preference Shares
After several years of strong gains, our basket of Korean Preference Shares declined in Q3 and is flat year-to-date. We do not see any fundamental change to our investment thesis as the underlying value of the companies in our basket continues, on average, to increase. Recall that when we purchased our basket, many of them were trading at 60% – 70% price discounts to their respective common stocks. The current price discount in our basket has narrowed to about 52% which has provided a boost to the strong returns of the stocks that we selected. Overall our basket is up about 100% since we started investing in Korea and we think there is another 100% upside remaining.
Last year, the management of Samsung Electronics, confirmed our investment thesis in their Q3 comments to investors. They said: “…many shareholders have expressed a view that buying back and cancelling preferred shares, which are traded at a discount to common shares is a more efficient use of capital as we can buy and cancel more number of shares with the same amount of money, thus increasing the effectiveness of any future capital return to the remaining shareholders. The company shares the same view. Therefore, we plan to increase the portion of preferred shares for repurchase and cancellation under this buyback program, as long as the price discount to common share is greater than 10%”. Please note that they view any price discount above 10% to be a buying opportunity. For reference, our basket trades at an average price discount greater than 52%, confirming that huge upside remains.
While 2016 has been disappointing so far, we remain optimistic going forward. The expected return for our portfolio companies (difference between market prices and our estimate of intrinsic business values) is very high, with the majority of our investments having the potential to double in price. In addition, we have transitioned our portfolio into mostly high quality companies located in mostly high quality economies (US, Israel, South Korea) which should help protect our capital if markets decline.
Hedge-funds as an asset class have had difficulty keeping up with strongly rising markets over the last few years. This is not surprising since most Hedge-Funds, including Emerging Value Fund, have significantly less than full market exposure. Conservative investing (cash, shorts, high quality companies, no leverage) is like insurance. It seems like a waste of money when everything is going well, but we will be glad to have it in more turbulent times.
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.