GreenWood Investors letter to investors for the first quarter ended March 31, 2020, discussing their long position in CTT Correios de Portugal SA (ELI:CTT).
Dear GreenWood Investor:
Reporting our performance this quarter feels quite a bit like the same experience I had preparing for my first confession as a young Catholic. Our performance, which has not been great in recent years, was truly terrible - a record new low for me since starting to manage the portfolio. I do not take this continued underperformance lightly, and if you would permit me, I’d like to confess in a rather longer quarterly letter than normal, some of what went into this historically undesirable result for us. And I’d also like to explain why in some ways, it’s the best thing that could have happened to us.
Psychologists over the past century have largely identified two separate voices in our own heads. Daniel Kahneman calls these two minds System 1 and System 2. System 1 is what ancient Greeks and Buddha called the ego, it is the rapid-firing and emotional part of our brains, which is largely housed in the amygdala and the limbic system. System 2 is the slow, deliberate part of our minds that can handle complexity, and is inherently very creative. It is housed in the pre-frontal cortex, a segment of the brain that is unusually developed in humans over other mammals. In talking about the two separate parts of our minds, brilliant psychologist Carl Jung explained the great benefit that confession has brought to people throughout the ages. Confession admits and embraces the behavior patterns of System 1, which often leave us red-cheeked and embarrassed. As Jung wrote in Modern Man in Search of a Soul, "There appears to be a conscience in mankind which severely punishes the man who does not somehow and at some time, at whatever cost to his pride, cease to defend and assert himself and instead confess himself fallible and human.”
While investing requires a humble approach, our recent results are indeed humbling, and reflect the decidedly fallible parts of our nature. They also reflect my previous cavalier disregard for System 1 thinking, which actually proved to be harmful to us, rather than helpful.
System 1 is the passionate, angry, greedy, and fearful parts of our minds. The amygdala, which is largely our survival mechanism, serves to keep us alive. It got mankind from 400,000 BC to 4,000 BC. But after civilizations arose in the ancient middle east, System 2 thinking was the value driver. It is the cooperative, collaborative, generous part of our mind. It enables teamwork, complex and structured thinking, and infinite creative possibility. It is the source of value creation throughout these last millennia. This is why, as Carl Jung asserted, self-restraint was one of the earliest celebrated virtues of society. It wasn’t the System 2 self that needed restraint, it was the System 1 ego. But Mr. Market is only capable of System 1 thinking. My constant attempt to quiet System 1 through meditation, has built up this disregard for Mr. Market, the very counter-party that determines our fate on a short-term basis. As Jung asserted, claiming ownership of this part of our minds is key to the process of healing. So in that vein, I have a few more confessions.
For the past few years, I’ve been using runs, chores and office commutes as opportunities to listen to research for a book I’m working on, The Builders. It’s a historical and psychological look at some of the most impactful value creators of all time. While macro-economists like to look at centuries of data to inform their thinking on where we are in the arc of history, this project is a micro-economic and psychological analysis of the biggest builders over the past three millennia.
Perhaps the most interesting outcome of that research was the realization that while the originator of value creation has been a highly developed pre-frontal cortex, or the home of System 2, all major commercial value creators also had a very strong System 1, or at least keen understanding of its methods, tricks and behaviors. Many of them understand System 1 so well that the products or services they create catch the world by fire, or rather by involuntary reactions of System 1. System 1, or the ego, doesn’t think before it acts. It wants immediate gratification. While many of these products or services either are a hook, line, and sinker to consumers’ limbic systems, in many other cases, they invite their customers into System 2 stimulation. One of the brilliant, possibly accidental, virtues of Private Equity and Venture Capital, is that these funds can mark their funds to model as opposed to the whims of System 1. While this lack of volatility is a complete illusion, it saves its limited partners the pain of constantly being subjected to the amygdala. System 1 is not a fun place to hang out, as the evergreen scowl on President Trump’s face bears witness.
So in my cavalier disregard for Mr. Market’s or System 1’s views, I was actually ignoring a theory which my own research has been able to unearth. The most impactful value creators are masters of both Systems 1 & 2. To be fair, the insight only came in early January, but this entire social dialogue that the “ego is the enemy” that has taken hold has not served us well. Quite frankly, I’d rather be empathetic to the needs of Mr. Market, and not keep “pushing rocks uphill.”
Accelerating Our Framework Evolution
As Chris and I were chatting about portfolio construction in the context of our ranking framework in early February, he articulated that too much of our portfolio had tough stock market narratives. Too many companies, it seemed, had managers swimming upstream. I’m not sure what I looked like to him, but internally, it was as if I had seen a ghost. He was exactly right. My penchant to puzzle-solve complex situations, and my contrarian nature had naturally attracted me to deeply out of favor transformations where we had a very different view of the world than Mr. Market’s. This is the “hedgehog” approach that psychologist Phil Tetlock talks about. But while hedgehogs hit home-runs, they are less reliable in hitting steady singles every time they bat.
I immediately agreed with Chris and we evolved our framework that very afternoon. As a result, we are no longer allowing an extreme outlier in one area of our framework, which ranks companies on three continuums: value - quality - behavioral, to over-ride a terrible ranking in the other two criteria. The second evolution to the framework has been abandoning the 3, 6, 12-month roadmap of the market’s vs. the fundamental views. Instead, we now select three major concerns of Mr. Market’s, assess the fundamental reality of such drivers and make probability-adjusted estimates of the likely progression of those drivers. We also have added three probability-adjusted narrative inflection points, or developments which can cause a sudden and forceful shift in the market narrative.
System 1 is inherently unpredictable. It’s sort of like a child that falls. If there’s no blood, and you maintain a smile, maybe you can avoid the tantrum. Maybe they’ll be laughing 60 seconds after crying. The evolution of that is unpredictable, but we can at least understand what System 1 cares about, and where those inflection points may be.
We were getting there with our entire portfolio, and then the Covid-19 (C-19) market turmoil hit prior to us selling down some companies that had a low likelihood of reaching an inflection beyond the narrative of “pushing the rock up the hill.” It didn’t mean we were paralyzed by the turmoil. Rather, it was almost refreshing for us. While it was both a frustration and a great opportunity, fundamentals didn’t matter during the C-19 selloff. That meant these “rocks uphill” companies sold off with equal vigor to companies that are managed by Builders with better narratives. The funny thing about the selloff is that while Mr. Market did a great job differentiating between industry and market sectors, it did a very poor job distinguishing between good managers and administrators, or companies with a debt or a cash position. Frankly, in a world where the MBA “optimization” processes are no longer relevant, I trust managers who actually embody their business more than I trust the MBAs. I trust cash over debt. I trust organic growth over financial engineering. Mr. Market still hasn’t differentiated between these dichotomies, and owner-operators and familycontrolled businesses have still managed to underperform the market by over 10-points so far this year.
These are the people we feel most comfortable with, and who have generated the most significant long-term outperformance. The recent market drawdown and underperformance of this class of ~2k companies (with a market capitalization over $1 billion) has been historic. These managers have a large amount of skin in the game. They don’t give quarterly guidance. They use less cash for acquisitions, buybacks and dividends. They have lower profit margins, but significantly faster revenue, employee and fixed asset growth despite carrying lower debt levels. In the white paper I’m working on with my friend Ehren Stanhope, we will publish our findings on their behaviors, which unsurprisingly run counter to so many of their peers who are largely compensated in stock options by a board with no share ownership (after all, they need “independence”).
When Mr. Market failed to differentiate, and in fact, penalized this class of companies, we moved quickly. We added five new long positions, three of which are founder-led, and the other two of which have very good management teams with significant skin in the game. Four of these five businesses are net beneficiaries of the current pandemic environment, despite them selling off more than global markets in the beginning of the panic.
I confess we went into the crisis with a larger-than-normal gross long positioning in our fund, which is clearly reflected in the performance. It was because we were so enthusiastic about the year ahead at our coinvestment, or CTT Correios de Portugal (CTT). With deep gratitude to an anchor investor, we started investing in this company in early 2018, and have managed to buy over 8.5% of shares today. We had a playbook of drivers that we believed would deliver very substantial value to the company, and in early 2019, we sought a board seat to help secure execution over these initiatives. We wanted to wait to publicly talk about CTT until we were more advanced in executing these strategic priorities for the company. But, as our very large weighting in the fund suggested, and our funds’ overall heavier gross long exposure show, we think the year ahead, the company’s 500th year in operation, will be one of the most transformational in its long history. It’s a good time to discuss what we’ve been working on in Portugal.
CTT - Committed to Deliver
As a constructivist investor, we took an opposite approach to a traditional activist in the American markets, which typically argue for a leveraged recapitalization of the company. The traditional activist re-arranges the capital structure to favor shareholders in the short-term, and often leaves a long-term bill that will be brutally painful to pay one day down the road (most likely by the creditors). In hindsight though, it would have made sense for our playbook to include a few “quick wins” that would have led to more immediate performance for our investors, who have patiently waited for our more transformational efforts to bear fruit. We could have planned a better roadmap for both System 1 and System 2, but we don’t think we’ll have to wait much longer.
After we took a large position in CTT Correios de Portugal (CTT), the postal carrier of the country, we were welcomed on the board last year. The very meeting we were voted in, we abstained from the vote on the company’s dividend payment. Rather than payout all the cash from the company, which is basically admitting defeat, we saw a lot of potential for growth in the core business, as well as many peripheral areas where the brand could be extended.
Over the prior year, I had developed a relationship with many other large shareholders of the company, during which I got to know João Bento. Through too many conversations to count, we shared ideas for the company and its diverse business activities. When CTT's former CEO decided to retire, João serendipitously had his 100-point plan ready to go. He hit the ground running in late May 2019. He has refreshed some of the executives at the company, and more importantly, created a bench of ~40 direct reports, nearly all of whom I’ve met and impress me with their work ethic. Since last summer, João and these able executives have been laying the groundwork for a return to growth at our company, and a robust return at that. Rather than a centralized structure reminiscent of a government-controlled entity, this team and its collaborative approach has already completely redefined the purpose of the company and its relationship with customers.
How can a postal company, a melting ice cube, return to growth? Well, while mail is reported as a large portion of the company’s revenue, only a quarter of the overall revenue last year was tied to ordinary transactional mail (the secularly declining kind being eaten by the internet), and it will clearly be lower this year. Surely that will be going away over the medium term. Two major parts of that reported segment, registered mail and international mail don’t face the same underlying digitalization headwinds. In fact, the company’s international mail is largely being driven by soft parcels coming in from China, as Chinese e-commerce companies were the first to arrive in Portugal.
The company’s ubiquitous network that touches nearly every house and business almost every day is a fantastic delivery mechanism for the clear bull market in parcels, particularly e-commerce-driven parcels. Express networks are not properly set up for the last mile outside of highly urban areas. That’s why postal companies largely win the last mile of e-commerce. It’s a business that’s somewhat similar to a cement company, local market share matters heavily. As we all learned in geometry, when a truck’s delivery radius shrinks by half, as its market share doubles, the total area driven is reduced by ~75%. That means market share conveys a very significant cost advantage. And while CTT is not a sexy business, it’s almost as boring as it gets, it is highly durable. It’s one reason why challenger mail delivery companies in the past always failed. But now that mail is disappearing, it’s not guaranteed the postal carriers win ecommerce. There are two separate networks anddelivery methods. Mail routes have been traditionally fixed, while express & parcels routes are typically more dynamic. We have a great challenge, but also a great opportunity, to try and converge these two networks into one. Already, around 70% of the company’s parcels are being delivered by postmen, and frankly, the word postman should really be parcel-man today. The bag or van has mostly parcels in it.
As already mentioned, this year is the company’s 500th anniversary, and as a new board member told me when I met her last year, “you need to know something, everyone in Portugal has a piece of CTT in their hearts. We all have ownership over it.” It was a symphony to my ears, as she mentioned the key skin in the game trigger that drives highly favorable outcomes no matter what business or industry we’re in. It’s no surprise that the largest telecom in the country was once a segment of the company. Just a few years ago the company launched its own bank, which we estimate has taken almost half of all new accounts in the country since being opened. It has the highest customer satisfaction, and with a labor and physical footprint around one tenth of its competitors, it will have a permanent cost advantage versus peers.
Investors have given this bank, with a balance sheet of €212 million in equity, a zero or negative valuation in the market. We don’t share their pessimism, and originally wanted to help underwrite an IPO to allow a spin off of the bank. Unfortunately, investor appetite for European banks over the past 18 months has collapsed to a state of revulsion. Still, the bank is accelerating growth plans to become more like a fin-tech than a bank, and we’re encouraged by the strong growth in profitability and significant revenue coming from non-interest income. That’s not because the bank charges aggressive commissions to its customers, in fact it’s the opposite. But the bank handles a very considerable portion of the payments in the country, which is no surprise that when fin-tech Revolut wanted to partner with a local bank, as an experiment with cash top-up of payment cards, it chose us. We believe there will be many more partnerships in the payments arena. We are excited about an acceleration in the non-interest income, no matter what happens to the pervasive negative rates in Europe. The value of the bank is not very concerning to us, though it has been to the market. We’re in the very early stages of working on something to help alleviate investor stress there. But it’s certainly not worthless, despite Mr. Market giving it such an appraisal.
We are much further along in optimizing another under-appreciated asset within the company, the significant real estate portfolio throughout the country. Because the company is centralizing its distribution centers, in order to more fully automate tasks, a very large number of logistics centers will be left vacant over the course of the next year or two. While the portfolio is quite diverse, some of these are fairly well-located assets, and can be repurposed to a highervalue mission. As CEO João Bento disclosed on the last quarter’s call, the value of this portfolio today is over €200 million, and we believe there will be incremental value-add as we work with a real estate manager to unlock the considerable value in this portfolio. Thus, combined with the bank, and even if we take a major haircut to the bank’s value, the stock with just over a €300 million market cap today and a €32 million net cash position, means the company’s current enterprise value is deeply negative. So investors today are getting paid to take a core business which before the coronavirus, was on track to hit over €90 million in EBITDA in 2020, even after the new lease expenses and banking income are removed.
Mr. Market is also worried about the company’s deteriorated regulatory relationship, which last year accelerated the loss-making status of the regulated universal mail service. GreenWood estimates that this contract is loss-making at the EBITDA line, and including depreciation, which is roughly equal to maintenance capital expenditures, lost nearly €20 million. That is the definition of unsustainable. In early March, I had the chance to meet with Portuguese Economy Minister Pedro Siza Vieira and confirmed that at least this large shareholder is committed to keeping the universal service, as the government wishes, but only under a sustainable contract. The current contract, which was abruptly changed in January of 2018, carries with it a deep negative net present value