Business

Moerus – Long Atlas Mara Limited And BR Properties S.A. ; Getting What You Don’t Pay For

Moerus Worldwide Value Fund  annual letter to investors for the year ended December 31, 2017. Partial excerpt full piece on HiddenValueStocks

Dear Fellow Investors:

It is our pleasure to update you on recent developments regarding the Moerus Worldwide Value Fund (“the Fund”). In this, our second Annual Shareholder Letter, we will touch on Fund performance, how we are currently looking at the world, new investments made since we last wrote to you, and why and how we try to avoid excessive levels of price risk that are sometimes underestimated by those reaching for growth.

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Fund Performance (as of November 30, 2017)*

Moerus Worldwide Value Fund

* Performance data quoted is historical, and is net of fees and expenses.

**Inception date is May 31, 2016.

*** The MSCI AC World Index Net (USD) captures large and mid cap representation across 23 Developed Market and 24 Emerging Market countries. With 2,499 constituents, the index covers approximately 85% of the global investable equity opportunity set.

Past performance does not guarantee future results. The performance data quoted represents past performance and current returns may be lower or higher. Returns are shown net of fees and expenses and assume reinvestment of dividends and other income. The investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than the original cost. Please call 1 (844) MOERUS1 or visit www.moerusfunds.com for most recent month end performance.

Investment performance reflects expense limitations in effect. In the absence of such expense limitations, total return would be reduced. The Fund’s adviser has contractually agreed to reduce its fees and/or absorb expenses of the Fund, until at least March 31, 2018, to ensure that total annual fund operating expenses after fee waiver and/or reimbursement (exclusive of any taxes, brokerage fees and commissions, borrowing costs, acquired fund fees and expenses, fees and expenses associated with investments in other collective investment vehicles or derivative instruments, or extraordinary expenses such as litigation) will not exceed 1.65% and 1.40% for Class N and Institutional Class Shares, respectively.

With regard to the table above, we’d like to reiterate the same point that we make in every Shareholder Letter, but which bears repeating: the Fund’s performance data is noted simply for informational purposes for our fellow investors. The Fund seeks to invest with a long-term time horizon, of five years or more, and it is not managed with any short-term performance objectives or benchmark considerations in mind. The investment objective of the Fund is long- term capital appreciation, and we manage the Fund with the goal of achieving attractive risk- adjusted performance over the long term.

In our last Shareholder Letter (for the six months ended May 31, 2017), we noted that although Fund performance had compared quite favorably to the benchmark up to that point, our short-term results are essentially incidental to our goal of achieving attractive risk-adjusted performance and outperforming relevant benchmarks over the long term, and that our investment approach can and will endure periods of relative under-performance at times. If our history is any guide, given our focus on risk mitigation and management, we believe that such periods of relative underperformance will often coincide with strong bull markets during which general market sentiment is optimistic and risk is more readily tolerated (or underestimated)

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Atlas Mara Limited is a London-listed banking group which focuses on financial services businesses in Sub-Saharan Africa. Founded in 2013 by former Barclays CEO Bob Diamond, Atlas Mara raised capital by going public at $10 per share in December 2013 and conducting a follow- on offering in 2014 at $11 per share. The company’s vision was to create an African banking group consisting of a network of high-quality commercial banks across Sub-Saharan Africa, a region with ample long-term growth potential and an underpenetrated, fragmented banking market. To execute on this vision, management used most of the $625 million in proceeds from the two equity offerings to make five major acquisitions, entering seven African markets: Nigeria, Botswana, Zambia, Rwanda, Mozambique, Tanzania and Zimbabwe.

Unfortunately, even the best-laid plans sometimes go awry. After raising capital in 2013-2014, Atlas Mara found itself confronted by extremely challenging conditions facing much of Sub- Saharan Africa’s economy, including lower oil and other commodity prices, a drought in southern Africa, and meaningful depreciation in the value of many African currencies relative to the U.S. dollar. Atlas Mara stock, which had originally been offered at $10-11, was laid low against this dire backdrop, plunging to around $2 per share by the end of 2016.

Naturally, such a share price decline caught our attention as it often does, and upon further review we concluded that given the circumstances, the company’s underlying business actually performed much better than its stock. Impressively, despite extreme adversity on the economic front, Atlas Mara’s underlying business actually produced profits in 2015 and 2016.

Furthermore, unlike in most developed markets, where banks are plagued by low or even negative interest rates and tiny net interest margins3, the banking sector in Africa currently possesses some attractive fundamentals, with mid-to-high single-digit net interest margins and healthy demand for loans, suggesting meaningful potential for profitable loan growth going forward. Last but certainly not least, Atlas Mara, to date, seems to have done a reasonable job at the all-important task of managing credit risk in a difficult environment.

Despite the attractive combination of solid business fundamentals and a heavily discounted stock price, we initially passed on a potential investment in Atlas Mara, primarily because the company’s Nigerian investment, which consisted of a 31% stake in publicly traded Union Bank of Nigeria (“UBN”), needed additional capital. At that point, it was unclear to us how Atlas Mara would be able to participate in any capital raise at UBN and avoid having its stake diluted, seeing as the company had minimal liquidity at the parent company level.

But then in June 2017, the company announced that Fairfax Africa – an investment fund set up by the Canadian insurance holding company Fairfax Financial – planned on making an investment in Atlas Mara and backstopping a rights issue. This capital infusion from a well- respected, long-term investor enabled Atlas Mara to not only maintain but also increase its stake in UBN at a depressed valuation, accelerating its strategy to build its banking business in Nigeria on attractive terms. Having resolved our chief concern, we purchased shares of Atlas Mara in the Fund and then subscribed and, in fact, successfully over-subscribed to its rights issue, establishing our position at about 10 times earnings and a 35% discount to pro-forma tangible book value, which in turn reflects meaningfully depressed local currency values. As of November 30, 2017, Atlas Mara was a 3.1% position in the Fund.

BR Properties S.A. is a leading Brazilian owner of commercial real estate. The company’s portfolio currently consists of 46 properties making up over 7.3 million square feet of GLA (Gross Leasable Area), the large majority of which are office buildings in Brazil’s two largest cities, São Paulo and Rio de Janeiro. The company’s focus is on high quality, Triple-A office buildings in prime, strategic locations in each city.

Not very long ago, Brazil was a darling of the emerging market and broader investing world, the “B” in the (formerly) trendy “BRICs” markets alongside Russia, India and China, and even the subject of its own laudatory cover story in The Economist4. But over the past three to four years, in part due to the commodity downturn as well as many mistakes of its own making, Brazil has suffered a rapid reversal in fortunes. Its economy endured its worst recession in decades, perhaps dating as far back as the 1930s, with Gross Domestic Product (GDP) falling by nearly 7% since the start of 2014. Unemployment soared from below 5% back in 2014 to a recent peak of over 13%. Its currency, the Brazilian Real, declined by about 33% against the U.S. dollar in 2015 alone, which sparked rising inflation and the need to raise interest rates, depressing the economy even further. As if economic conditions weren’t bad enough, Brazil also saw the impeachment of President Dilma Rousseff, an ongoing corruption scandal involving the state- run oil company that has ensnared officials at the highest levels of government, and the Zika outbreak. It has, in all, been a perfect storm that has punished the Brazilian economy and put its promising longer-term fundamentals and growth prospects on hold.

Given all the lowlights noted above, the demand for office space in Brazil has obviously been depressed considerably. But to make matters worse, the supply of office space in São Paulo and Rio de Janeiro has surged in recent years. Investment decisions made during better days led to significant amounts of capital being deployed in office projects, resulting in overbuilding and excess supply just as demand started to come under pressure. The result? Vacancy rates reached all-time highs, and office rents in many parts of Brazil’s two largest cities have fallen anywhere from 25-40% in real terms over the past four to five years.

Needless to say, the past few years have been very challenging for Brazil and for its commercial property market in particular. BR Properties’ stock has not been immune – it declined from nearly BRL 28 per share in October 2012 to below BRL 8 per share in late 2016/early 2017. But such bleak conditions could sometimes prove, in retrospect, to have been interesting buying opportunities. One example that comes to mind (with the benefit of hindsight, of course!) is New York City commercial real estate in the 1970s. To that point, BR Properties has a strong record of acquiring properties at attractive yields, and has indeed recently acquired a number of properties at what seem to be modest prices, using conservative rental rate assumptions that reflect the depressed environment. The company seems well positioned to continue to opportunistically source attractive deals in what is a fragmented commercial property market. Meanwhile, its existing, high quality portfolio stands to benefit if and when Brazil’s recovery takes shape and historically poor occupancy and rental rates begin to normalize.

As was the case with Atlas Mara, we had already been intrigued by BR Properties’ depressed valuation and interesting long-term prospects, but two transformational events further strengthened the investment case for us. First, in 2016, backed by Abu Dhabi’s sovereign wealth fund, GP Investments took control of BR Properties (with a 70% stake) when the latter’s previous control group ran into trouble and essentially became a forced seller. GP Investments has a solid, 24-year track record of private equity investing in Brazil. In fact, GP actually co- founded BR Properties back in 2006, built it into the largest commercial property owner in Brazil, took it public, and sold in 2012 (at what turned out to be a good time to sell). We view GP’s involvement as a positive in that we believe they know the market and industry well, and their network could potentially provide access to deal-flow and potential off-market property deals that others might not have. Then in June 2017, BR Properties raised roughly BRL 950 million ($290 million) in an equity offer, thereby strengthening its balance sheet significantly and providing added flexibility to pursue property acquisitions from distressed, motivated sellers if further opportunities arise. We purchased shares of BR Properties in the Fund at a roughly 25% discount to pro-forma tangible book value, which in turn we believe to be cyclically depressed. As of November 30, 2017, BR Properties was a 3.5% position in the Fund.

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Buyer Beware

2017 was the latest in a string of frustrating years for many value investors, particularly in the

  • The S&P 500 and other indices seemed to hit new records Many of the largest tech stocks, most of which make up some of the largest components of equity indices, continued to perform very strongly in 2017, with all but one of the FAANG stocks providing year-to-date total returns of over 50% through November 30 (Alphabet, the exception, returned over 30%5). In general, significant pockets of global stock markets currently seem to be valued quite richly and priced, if not for perfection, for an extremely optimistic future to say the least.

Is risk in general, and price risk in particular, being underestimated in the current environment? While it is impossible to tell for sure, the following are just a few of many data points – both quantitative and qualitative – that in our view warrant heightened wariness:

  • As we’ve noted before, only in 1929 and again during the late 1990s/early 2000s dot- com bubble has the S&P 500 Index traded at a higher Cyclically Adjusted Price- Earnings Ratio than it does today6. While the CAPE Ratio certainly has plenty of limitations and does not tell the whole story (or much of it), the levels at which the broader market is currently trading do not place it in great historical
  • The Market Cap-to-GDP Ratio – an alternative measure of stock market valuation sometimes dubbed the “Buffett indicator” because of the well-known value investor’s stated affinity for it – is also currently higher than it has ever been in over 60 years of available data, with the sole exception of the late 1990s during the dot-com bubble7.
  • Individual investors, in general, do not have much unspent money remaining in their brokerage accounts, having seemingly already deployed much of their “dry powder”: according to one study, cash levels (as a percentage of assets) among Charles Schwab client accounts have fallen to their lowest levels since at least 19958. When were the previous lows over that timeframe? The first quarter of 2000 (at the tail-end of the dot- com bubble) and in 2005-2007 (before the housing bust and Global Financial Crisis).
  • Capitalizing on the recent Bitcoin and cryptocurrency frenzy, microcap company LongFin , which had just started trading on December 13, surged by as much as 2,600% just a few days later after issuing a press release saying that it acquired “a blockchain-empowered global micro-lending solutions provider9.” LongFin, whose market cap reached nearly $5 billion almost literally overnight by simply announcing its participation in the digital currency craze, is only one of many recent examples that have conjured up memories of the microcap ghosts of the dot-com bubble.
  • “Story stocks” continue to roar onward and upward regardless of, and in some cases, in spite of the actual fundamentals and economics of the For example, Tesla, whose stock was up roughly 45% in 2017, has been burning money, by some estimates, at a rate of around $8,000 per minute10. No matter, it seems: it is the future!
  • A portfolio manager of two successful funds, with collectively over $4 billion in assets under management, recently summed up his approach – and perhaps the prevailing sentiment of the market – as follows: “I don’t believe in Warren I care about new things, things that are innovative, that are growing, that are changing the world. Valuation is an immaterial part of the process for me11.”

Again, the data points noted above are just a few of many indications that in general, valuations and business fundamentals currently seem to be of little relevance for many investors in the market. In particular, the quote from the portfolio manager on Buffett was somewhat reminiscent, again, of the late 1990s. Tech stocks had been soaring regardless of valuation and the fundamentals of the underlying businesses, and market followers pondered whether or not the world of investing in the new, high-tech age had passed value investors by. In fact, Barron’s published a feature entitled “What’s Wrong, Warren?” in December 1999 – just a couple of months before the peak of the dot-com bubble.

The problem with this line of thinking is that, simply put, we believe that valuation does matter for long-term investors. The current environment is neither unique nor representative of some “new era” of investing. Over history, there have been numerous periods when the market values of certain stocks have been very different from their underlying, intrinsic values. This disparity can exist for several years, but, over time, intrinsic value and market value usually converge.

Eventually, over the long run valuation imbalances get corrected. Remember, valuations ultimately proved quite relevant, to devastating effect, in the wake of the Nifty Fifty growth stock craze of the early 1970s, after Japan’s wild bull market run of the late 1980s, in the aftermath of the dot-com bubble in the late 1990s, and again in the bull market and excessive risk-taking frenzy in the run-up to the Global Financial Crisis beginning in late 2007. We believe that this time is not different, and that valuations will ultimately matter to investors’ long run returns once again. It’s therefore important, in our view, for long-term investors to remain focused on downside protection and on conservative valuations that are backed by actual business fundamentals rather than highly optimistic forecasts of the future.

This is not to say that it’s impossible to make money by paying up for popular growth stocks regardless of valuation and underlying business fundamentals; this has clearly worked for those who have been able to successfully play this game over the past couple of years. But doing so requires eventually finding a willing buyer for your shares at even higher prices than what you had paid for the shares. This might not seem difficult to do today, in a roaring bull market

where the popular stocks remain in fashion. But over time, it becomes akin to a tricky game of musical chairs, where downside potential is significant if you are caught unaware when the music stops, and when the actual economics of the underlying businesses become important again. This is not a game that we are willing to play with your capital or our own.

The many bits of information that we’ve observed, which seem to suggest that people have been “lulled to sleep” by strong recent stock price performance and are taking valuation lightly – given our view that market values and intrinsic values eventually converge – lead us to believe that what we call price risk is elevated in some corners of the market. In our opinion, one particularly dangerous attribute of price risk is that it can leave you extremely vulnerable even if your analysis of the business turns out to be sound. It’s important to keep in mind that stocks are ownership interests in underlying businesses, and if you pay an extraordinarily high price for a stock, you could earn sub-par returns even if the underlying business performs reasonably well, but not extraordinarily well, in the future. Further, if something unforeseen occurs and the business does not even perform reasonably well, you could be exposed to significant downside risk, because paying up for the prospects of future growth provides less of a margin of safety to cushion the blows from adverse developments.

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Getting What You Don’t Pay For

At Moerus, we strive to avoid the excessive price risk that comes with overpaying for growth. Instead, we prefer investments that we view as cheap on an as-is basis, using what we believe are conservative estimates of intrinsic value here and now, not forecasts of the future that are based upon optimistic assumptions of continued prosperity. Again, we like growth a lot; solid long-term growth can often be the major driving force in compounding shareholder value over time. We just don’t like to pay for it. But interestingly, our stinginess and stubbornness have not prevented us from finding opportunities in numerous holdings that we believe offer attractive long-term growth potential, even though they are valued attractively based only on the state of each business here and now. Over the years, we’ve found that buying out-of-favor businesses cheaply enough based on what we know today, in our opinion, not only provides greater downside protection by contributing to a margin of safety, but also, perhaps counterintuitively to some, may offer considerable upside potential. This is because our purchase price is intended to attribute little, if any, value to expectations of significant growth, and therefore if we do truly buy well, any “positive surprises” or even merely a return to normalcy could provide material upside to the market’s valuation of the business.

For some examples, we’ll begin with the Fund’s position that was sold during the second half of Fiscal 2017: Global Logistic Properties (“GLP”). GLP has long boasted readily apparent long- term growth opportunities related, most notably, to how the continued growth of e-commerce seems likely to increase demand for technologically advanced, strategically located logistics facilities. After all, GLP is essentially a logistics facilities and services provider to the Amazons of the world! Yet at the time of our purchase in the Fund, in what was a pleasant surprise for us, GLP shares had become available at a discount to our conservative estimate of intrinsic value, primarily due to concerns surrounding a slowdown in consumer spending growth in China and Brazil. Ultimately the market’s short-term concerns ebbed, and an offer that more appropriately valued the company’s long-term prospects was made, at a significant premium to our cost.

Let’s turn again to the Fund’s two new positions. Atlas Mara is building a network of banks in Sub-Saharan Africa, a severely underbanked region that boasts a population of over 1 billion people. This population is younger than most, entrepreneurial, and given favorable demographics, seems poised to become the largest labor force in the world within the next couple of decades. The region also has only really just begun scratching the surface in developing regional integration and intra-Africa trade, suggesting significant room for long- term growth and development that could become the envy of growth investors the world over. BR Properties, leveraging the local expertise and the financial firepower of controlling shareholder GP Investments (backed by the deep pockets of Abu Dhabi Investment Authority), seems well positioned to take advantage of a grinding recession and opportunistically acquire prime commercial property at cheap prices in Brazil. Despite having fallen on very hard times in recent years, Brazil – with its 200 million-strong population, 4,500 mile Atlantic coastline, and a rich endowment of various natural resources – is the same country that, not too long ago, was among the most sought-after destinations for growth potential in the world, for good reason.

Yet in each of these two cases, primarily due to what we believe is temporary, surmountable adversity, we were able to invest in the business at what we believe is a material discount to intrinsic value.

Numerous existing Fund holdings likewise possess interesting growth potential that we believe is being undervalued by the market at current prices. Arcos Dorados Holdings, the largest McDonald’s franchisee in the world, is the exclusive McDonald’s franchisee throughout much of Latin America and the Caribbean, a region of roughly 600 million people that offers considerable potential for consumer spending growth and a quick serve restaurant market whose penetration is very low compared to elsewhere in the world, suggesting plenty of room for potential growth. In a market environment in which investors are happily paying steep premiums for brand and franchise value, Arcos Dorados, which benefits from an iconic, globally recognized brand as well its ability to leverage McDonald’s expertise (marketing, menu libraries, best practices, etc.), is trading at what we see as a material, unjustifiable discount to its much larger peers elsewhere in the world (including McDonald’s itself), despite what we believe are Arcos’ favorable growth opportunities.

Aker ASA and Gran Tierra Energy, which own significant oil exploration and production interests in the North Sea and Colombia, respectively, took advantage of the collapse in oil prices to opportunistically acquire assets at what we believe are attractive prices, positioning themselves with significant potential for reserve and production growth for years to come.

Shares of each of these companies became available at significant discounts to our estimates of intrinsic value due primarily to depressed oil prices and investors temporarily fleeing the energy sector, but we think both businesses are well-positioned to benefit from a continued recovery in crude prices. As outlined in our prior Shareholder Letter, Organizacion Terpel S.A., Colombia’s dominant fuel distributor with over 40% market share, should have the winds of favorable trends in demographics, increasing car ownership, and road network construction blowing in its favor for years to come, yet trades at what we believe is an unjustifiably low valuation relative to the operating cash flow that the business generates.

We similarly see attractive growth prospects in many other Fund holdings. As such, we believe that the portfolio is well-positioned to benefit from the contributions that growth makes to long-term compounding of value, without taking on excessive levels of price risk that often come with overpaying for it. We will continue to strive to accomplish this by focusing on businesses that we see as undervalued based on conservative estimates of today’s reality, rather than upon optimistic hopes and dreams of the future. Finding these opportunities is never easy, particularly today when much of the market seems willing to (over)pay for great expectations. But we’ll vigorously pursue them wherever and whenever they exist, with a continued focus on the following areas that have, over time, proven to be fertile grounds on which to bargain-hunt:

  • Where others can’t go (businesses that are not large enough to be deemed “investable” by behemoth funds which can only invest meaningfully in large/mega-large cap stocks);
  • Where others won’t go (countries or regions where many investors don’t have the inclination, mandate, and/or experience to confidently go); and
  • All other places when others won’t go (during times of considerable, though temporary adversity or even unpopularity for an industry, country, or specific business).

As always, many thanks for your continued support, interest, and curiosity. We look forward to writing you again later in the year. Best wishes for a happy, healthy, safe, and prosperous 2018!

Sincerely,

Amit Wadhwaney

Portfolio Manager