Reading Capital letter to investors for the year ended December 31, 2016.
2016 Hedge Fund Letters
Q3 2016 Hedge Fund Letters
We have completed four full years of Reading Capital, and I must point out that I have not enjoyed my work so much, since I was an ice-cream salesman (and an avid taster) at the Penguin legendary creamery when I was sixteen. I thank you all for your partnership and trust. For 2016 Reading Capital produced an annual return of 22.5% (net of fees), against a decline of -2.5% in the Tel Aviv 100 index.
This return was achieved, without the use of leverage or options, in fact the opposite is true; we opened 2016 with 31% cash, and closed the year with 42%, so that the return on invested capital was much higher. After payment of end of year taxes, and injection of new funds, 2017 has opened with an even higher share of cash.
At the present moment, we hold 12 shares in our portfolio. Nine are traded in Israel alone, one is dual listed, one is traded in London, and one only in U.S.A. Yet, our most significant holding is our cash mountain. And it is from the peak of this mountain that we launch a plea to Mr. Trump: “Announce an embargo on France!” (Or some other insensible idea).
Please feel free to contact me with any question,
Comments on 2016
Manic depression characterized the Tel Aviv 100 index throughout the past year. Teva, usually a dominant share, recorded a bad year, after very positive results in 2014 and 2015, and together with its colleagues in the pharma industry, pushed the Tel Aviv 25 index downwards at a rate of -4%, against increases (+17%) in the Tel Aviv 75 index, and the Tel Aviv MidCap 50 index (+18%).
These indices will change in 2017, and next year we shall compare ourselves to the Tel Aviv 125 index or to any other creative index our lovely Stock Exchange will produce as the central index. The change in the pricing of many small shares, have directed us, unlike past years to investment in larger companies.
In response to a number of questions: the standard deviation of the fund stood at 2.3% against 3.0% in the TA 100. We place little importance in this figure.
2016 has continued the trend of market consolidation between the larger players (Altschuler is buying Menorah’s funds, Phoenix and Excellence are merging). and the domination of index investing intensify with 27% of the trade in shares. These are two significant elements on the local stock market, with a negative influence on the volume of trade, but they play to our advantage, as a small player who chooses its shares meticulously.
It is worth spending a moment on Teva, with Mylan & Perigo, because they have been infected by the most worrying disease on the American stock market, the non-GAAP flu. For those of you who are not familiar with the term, Non-GAAP, these are reports filed, not according to accepted accounting practice, in which companies neutralize items with a one-off impact on their reports.
As always, in this cases, non GAAP originated , to neutralize non-cash deductions , in companies that had heavy M&A activities. But from there it rolled on to management & employees options (which dilutes the other shareholders), to long-term legal expenses (Good Morning, Teva!) which are a regular part of the business model, to fines, organizational restructuring, to dismissals, to bonuses, and more, and more, and more. If you look for the words “non-GAAP” and “adjusted” in companies such as Mylan and Perrigo you will become dizzy from the number of times that they appear. I suggest that you open the nearest report to your internet browser, and look at the huge gaps that appear in these companies, between the free cash flow, and the non-GAAP profit report.
I believe that the U.S. Securities and Exchange Commission (SEC) should prohibit the neutralization of expenses that have already appeared in the past five years in the financial reports, but until we see that wonderful, new world emerging, we should remember that the non-GAAP numbers that we see in these companies, are an illusion in one direction, only. That does not mean that we shall not purchase the shares of companies that adopt this method, but the retail investors, and even most of the professional investors tend to see in the P/E (based on Non-GAAP numbers) as the main factor in their decision to buy, and so reports of this nature constitute a risk to over-pricing.
Sales in 2016
Our most prominent sale this year happened in the third quarter when we parted ways with Tadiran shares. Mr. Moshe Mamrod, the owner, has made in less than two years, achievements that I thought would take five years to reach. We sold our holding, after the company shares doubled itself again during 2016, and reached a fair price.
The second prominent change was within the bank sector. We exchanged our holding in Bank Leumi (with bad timing) to Bank HaPoalim, followed by exposure to FIBI ( great timing).
A look to the future – 2017
For a full report on the company, see the letter sent to investors in mid-2016. With current P/E of 11.6 for 2016, we see the parent company in mild growth,as the PVC plants in London and Israel have stabilized and the “gem” Palram Applications (100% subsidiary) can maintain double digit growth for many years with an operative leverage.
See the impression made by the products of Palram Applications, the world largest greenhouses for individuals that sells also through Amazon & Home Deopt, in the web site: http://www.palramapplications.com/ and note that they have not yet started to be sold in many geographys, including the home country – Israel.
Palram’s main problem is a faulty allocation of capital. With a surplus of cash in the balance sheet, but I do hope to see a dividend policy (50% of earning?) during 2017.
FIBI – First International Bank of Israel
As part of our journey in the banking sector in 2016 we have transferred our holding from Bank Leumi to Bank HaPoalim, and thereafter to FIBI bank, as part of our desire to have exposure to the banking sector. We believe that after a long period of depression, including part of the last year, the direction of the Israeli banking sector is changing rapidly as the prices are attractive, “softer” regulation and, as mentioned in past letters, banking is one of the few sectors for which, exposure to rising interest is a driving force.
With the annulment of past deductions for Bank Otzar HaHayal (subsidiary) in the fourth quarter, and the closure of the Swiss branch that was making losses, it can be presumed that FIBI will be able to produce 8% ROE at the current level, against a pricing of 0.75 P/B (and 10.5 P/E). We can expect a reasonable return in the future, from the most conservative bank, which now complies with all the capital demands made by the banking inspectorate, and can be expected to distribute a dividend yield of 4.5% in 2017.
Our expectations were, and remain, high from the Israeli IT company. However, in light of mixed results, it only increased by 6% in 2016, despite the industry uplift. The disappointment, from the angle of the share, leaves room for compensation in 2017. We shall not add to what we have already written in the past, and we have two principal claims:
With a free cash flow of 40M shekels per annum, that is expected to rise gradually, Teldor is traded at a value of only 280M shekels.
Teldor is a great acquisition target as the largest three Israeli IT players wish to go to the next level and to create significant size advantages.
Africa, a real estates developer, have major assets mainly in Romania (one of Europe’s positive growth surprises in 2016) and in Israel. The company is traded at a P/B of 0.71, and after a successful year in 2016, we estimate 2017 to repeat the success for the company and the shares.
Here are the major Price triggers that are expected during 2017:
The 2016 dividend that was postponed until January 2017; 120M shekels – a return of 6.4%.
The 2017 dividend in December, at a sum of 120M shekels; an additional 6.4% (which will constitute an annual revenue of 12.8%).
The sale of half of the company’s central asset, AFI Palace Cotroceni, a shopping mall, whose price we expect to be finalized higher than the equity in the books. The central bucharest Mall continues to show a long-term improvement in net operating income (NOI) on a regular basis.
We are getting a “free option” to the possibility of a company taken private, a scenario that has not been priced, but seems very likely to me for a possible purchaser of the parent company (Africa Investments).
This is the first time that I have purchased a significant holding in one of the shares that I was covering closely as a sell-side analyst in the past. So I feel like walking on especially familiar territory. During the fourth quarter we bought shares of the Israeli telecommunications giant, following a drop in the price of the share during the year.
Despite the current delays of the start of the new year, the main arguments against Bezeq are comparatively weaker than in the past, and the ratio of risk to return works in our favor:
The brand has proven itself despite major changes in the local telecom market and allows significant profits at the consumer market as Bezeq fixed line telephony considered to be of the highest quality, despite the possibilities. One can argue whether this is a rational preference or not, but it basic preference by the majority of the market.
We are getting a free option on the cellular segment. Shares of Partner and Cellcom (the cellulars competitors) rise as the market hope to see the end of cellular pricing war that eroded, to almost zero, the profits of all players, including Bezeq’s subsidiary, Pelephone. We prefer Bezeq to cellular, as we are not paying for that possible improvement.
Changes in regulations are expected this year that will allow Bezeq to finally leverage it’s size advantage with the subsidiary companies Bezeq Beinleumi (ISP) and Yes (Satellite TV). Cancellation of the organizational separation, will allow Bezeq to reduce costs, by a joint cutting of costs in the head office, through elements such as back office, insurance, finance and get major losses of its subsidiary recognized for tax.
As in the case of the banks, we shall not become rich from this investment, but with a dividend that returns 7% per annum, that is in alignment with the interests of the controlling shareholder, and with a FCF that is stronger than the net profit (2B vs 1.4B), Bezeq is a solid investment despite the cloud of regulation that does not cease to drizzle.
One morning, last December, I checked the weather application, which told me, with surprisingly impressive decisiveness for that time of year, “Chance of rain: 0%”. At the end of the day, while I was returning home, water from the heavens started to drip onto me. Aha! I quickly whipped out the application with a look of rebuke, but the application was adamant: “Chance of rain: 0%”. And so there was nothing I could do, except add the screenshot. It seems that even the machines, that are designed to replace us, find it difficult to admit that they were wrong.
And now for something completely different: looking forward, one main question is, why should we hold so much money that is not being put to use? That is a difficult question, to which there is no precise, mathematical solution. On the one hand, money that is “sitting idle” with zero interest, and not earning anything, is “wasted”, but one must remember, that, just like in life, trust is built very slowly but fear rush suddenly into the room. Major fluctuation, which did not happen, and the introduction of volatility into the markets, would have allowed us to make much better use of cash.
Our concentrated style of investment, which might be characterized by significant fluctuation in the portfolio itself, when we find a new idea for investment, necessitates behavior different from the administration of standard portfolios. Our portfolio might look completely different, when certain opportunities, for which we are waiting, reach “our” price. In addition to a certain rate of holding cash, that will be with us most of the time, the current rate came about because the margin of safety we seek before we enter an investment is relatively high, or, in other words, many companies are currently priced for a world in which “Chance of rain: 0%”.
But what is close to zero, is not the chance of a negative event, but the rate of interest which always was, and probably always will be, the major influence on the markets. I believe that there will be sufficient opportunities in the future, to take advantage of our high liquidity, whether through special events, or at the time of sharp changes in the market itself.
All the best. January 2016
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