Mittleman Investment Management, LLC’s composite declined by 5.8% net of fees in the second quarter of 2017, versus gains of 3.1% in the S&P 500 Total Return Index and 2.5% in the Russell 2000 Total Return Index. Longer-term results for our composite through 6/30/17 are presented below:
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The top three contributors to our Q2 2017 performance were KB Financial Group (KB): $43.97 to $50.49 (+17% with dividend), Greatview Aseptic Packaging (468 HK): $0.50 to $0.62 (+24%), and Rallye SA (RAL FP): $20.30 to $20.56 (+9% with dividend). KB had a greater effect on performance than the larger percentage gain from GaPack due to KB’s larger position weighting in the portfolio.
The three most impactful detractors from our Q2 2017 performance were Revlon Inc. (REV): $27.85 to $23.70 (-15%), International Game Technology (IGT): $23.70 to $18.30 (-22% with dividend), and AMC Entertainment Holdings (AMC): $31.45 to $22.75 (-27% with dividend). Larger portfolio weightings in Revlon and IGT made their losses more impactful than the larger percentage decline from AMC.
After two years spent in the red, with a -0.81% slide in 2014 and a -21.96% tumble in 2015 for a cumulative loss of -22.6% over those two years combined, our composite enjoyed a +19.76% rebound in 2016 followed by a 5.39% gain in Q1 2017 for a cumulative gain of +26.2% over that year and a quarter time-frame, almost completely recouping what we had lost in the prior couple of years. But that healing process abruptly reversed in Q2 2017 as the share prices of our three largest positions, all U.S.-listed companies in unrelated businesses (cosmetics, lotteries/slot machines, and movie theaters), almost simultaneously, tanked. And while the prices of these stocks did drop sharply during the quarter, the actual intrinsic value of their underlying businesses almost certainly did not change that much, if at all, as we will attempt to explain in this letter.
And while we often invoke the “investing is two steps forward, followed by one step back” mantra, it is particularly frustrating to experience this step back while the market is racing upwards to new highs almost daily. In that way, this period is remarkably reminiscent of 1999 for me, when I owned (for clients who later became the foundation of Mittleman Brothers) hated value stocks like Philip Morris (MO) initially at about $40 as it went to $19, on its way to $65+ a few years later.
Another core holding in 1999 that went the wrong way that year was American Real Estate Partners (ACP) which is now known as Icahn Enterprises (IEP), Carl Icahn’s investment vehicle. The stock dropped from $9.60 to $7.04 by year-end 1999, despite having a high-$20s NAV per share. We had been in the stock for three years already at that point, with roughly a $9.00 per share cost basis. The fact that we were down on that position after three years while a raging bull market was seemingly lifting everything else to the moon was immensely frustrating and embarrassing at the time. Yet, we sold that stock about seven years later in late 2006/early 2007 for about $54 per share on average and as high as $88 as the stock ran to $130 in 2007. The point of this walk down memory lane is to highlight how similar the dichotomy was in 1999 versus today, with the hot stocks like AOL, Cisco, and JDS Uniphase getting unimaginable valuations while those boring old free cash flow generators we owned back then were seen as cheap for good reason. Our portfolio underperformed in 1999, hopelessly out of sync with the popular stocks in the market indices, but made significant gains over the ensuing three year bear market that saw the S&P 500 drop nearly 40% and the NASDAQ Composite drop nearly 67%. So with valuations in the U.S. today at levels not seen since 1999 (although not as extreme as then), our current positioning amongst the unloved but discernibly cheap free cash flow generators that we own today should be a source of comfort rather than concern, despite the recently disappointing results. Some color on our three best and worst performers in Q2:
KB Financial Group (KB) owns the largest retail bank in South Korea, Kookmin Bank, and was first profiled in our Q3 2011 Investment Review as a new position initiated in September 2011 at average cost of $34.16. Encouraged by significant insider buying by the then-Chairman and CEO at about $45 per ADR, I argued for a $60 fair value based on a 10x P/E ratio on what we assumed would be $6.00 per ADR in net earnings for 2011 and 2012, and 1.25x book value multiple on net tangible book value of $48. And while earnings for 2011 came in at $5.82, KB produced unusually depressed earnings for the next five years: 2012: $3.96 per ADR , 2013: $2.97, 2014: $3.43, 2015: $3.87, and $4.80 in 2016. Needless to say, we were way off on the earnings progression. And we can’t even blame it on currency because the South Korean Won actually strengthened slightly during the first three years of our ownership. Regardless, we felt the issues that plagued the business were either transitory or in the process of being fixed, and that this highly overcapitalized bank (11% CET1 in Q3 2011, 15% in Q2 2017) would eventually put that excess capital to good use by executing on their plan to expand in higher ROE businesses like asset management and insurance, evolving into a Citigroup-style financial supermarket. With earnings up dramatically year-to-date, they finally appear to be reaping the benefits of having done so.
KB’s book value was $48 per ADR when we started buying it nearly six years ago, now it’s $67, a paltry 6% CAGR. But ROE looks closer to 10% prospectively in 2017 and 2018, with EPS running about $6.70 per ADR. So a $70 stock price (+39% upside) at a 10.5x P/E multiple shouldn’t be too much to ask. Book value should be $74 by the end of 2018. Investing in South Korea entails special risks, with North Korea, run by a nutcase who executes his underlings with anti-aircraft guns for falling asleep during his speeches, seemingly the most urgent threat. But, given that China and the U.S. both have very significant interests in not seeing a war break out on the Korean peninsula, and China has immense leverage on North Korea, the nightmare scenario should likely be avoided. South Korea is in decent shape financially with low government debt to GDP of 36% (versus 75% for Germany, and 103% for the USA), a chronic current account surplus, and $371B in currency reserves. On the negative side, household sector debt is high in South Korea at 90% of GDP, vs. 79% for the U.S, and South Korea’s biggest trading partner is China, a country with debt issues that may keep a lid on its growth rate for some time.