Logos LP Q2 letters to investors
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“Patience is bitter, but its fruit is sweet.” -Jean-Jacques Rousseau
The current price per unit is $22.91 and although this is well above our initial offer of $12.52, we caution that generating above-average returns moving forward will likely be more challenging. The bull market is now over 3,000 days old, up over 260%, and is now the second longest and second strongest since WWII. Return expectations should be adjusted accordingly.
The following table represents Logos LP’s total unlevered net return as of the second quarter compared a basket of relevant indexes:
Although the stock market's P/E has proven to be a poor predictor of the market’s future direction (for example, a bear market began in 1980 when the P/E ratio on the S&P 500 was 9.5) we see the current environment falling outside the standard deviation of expected norms (virtually zero risk premium on the VIX and many valuations appear strained based on future earnings growth) and thus we have decided to increase our cash position by trimming certain peripherals, part of one core position and raising new investor capital.
We see some pockets of value in North America and those that remain depressed are beginning to pick up steam as investors of late have been rotating out of winners and focusing on the laggards. This rotation is healthy. It has in fact been a big factor stabilizing the markets. There have been periods when tech has notably underperformed, and periods when retail and even some energy stocks have outperformed. This week, the market outperformers were among the year's biggest losers: retail, oil service and banks.
Nevertheless, we maintain that this is a market which continues to cause immense anxiety. Are investors complacent? We think not. Instead most are over-analyzing and over trading with a keen eye on political developments, a flattening yield curve, lower oil prices and Fed policy.
As suggested previously, we maintain that this lengthy secular bull market still has legs. Earnings are looking good: First-quarter earnings are up 15.3 percent, and second-quarter earnings estimates are also up a healthy 7.9 percent, according to Thomson Reuters. Third-quarter estimates are up 8.7 percent, and while the forward estimates usually come down, early second-quarter earnings reports have been solid. Inflation remains low and both consumer and corporate balance sheets remain strong.
But could the tide be turning? The spate of volatility which we experienced last week spooked the market and reminded us of an old parable about Chinese bamboo.
After the seed for this unique grass is planted, you see nothing, absolutely nothing, for four years except for a tiny shoot coming out of a bulb. During those four years, all the growth is underground in an incredibly intricate and strong root structure.
Then, in the fifth year the Chinese bamboo grows often grows beyond 8 feet.
Putting capital to work successfully for the long-term whether in this market or any other requires patience. This week we were reminded of the importance of sober reflection, emotional diligence and humble expectations. Investors in this environment can be lulled by the high returns the market has offered.
As Odysseus was curious as to what the Sirens sang to him, investors can let their expectations of return be warped, setting themselves up for disappointment. Or as many sailors discovered: disaster.
Like the parable of the Chinese bamboo teaches us, growth must be nurtured. Good things happen to those who plant the “right seeds” and wait. With patience, nurturing and the proper expectations, that “fifth year” will come.
As such, we continue to hold our largest core positions or “right seeds” for the long-term as we believe the fundamentals are still intact and those companies are making key investments in areas that will fuel shareholder value for decades.
A Random Walk
In 1973, the first edition of A Random Walk Down Wall Street written by Burton Malkiel was published which explored the randomness of stock prices and the underpinnings of equity valuation.
We believe the book is a must read for all investors both sophisticated and novice alike, but there is a specific paper cited by Malkiel in the book (written by Morgenstern and Granger in 1970) titled the Predictability of Stock Market Prices which we found quite fascinating from an academic perspective.
Essentially, both Granger and Morgenstern argued, to quote Malkiel, that the “intrinsic value of stocks is a search for the will-o’-the-wisp”, or in adage to the old Latin maxim, “a thing is worth only what someone else will pay for it”. For many investors, this is quite an interesting statement as it relies less on the true quantitative value of the asset (i.e. calculating the estimated cash flows from that asset discounted to the present or placing a premium based on the characteristics of that company’s operating earnings before interest and taxes in the most basic mathematical sense) and more on the subjectivity of that prospective buyer’s perspective at that moment in time.
Generally, there is some truth to this notion, but perhaps we are entering a new phase in the current business cycle where this axiom is most relevant. For example, one may not be willing to pay 11x book value for Amazon shares in 2004 despite facing tremendous tailwinds (i.e. the impending ubiquity of Internet commerce), but would be more than happy pay for 22x book at ~$500bn market cap notwithstanding a lofty valuation and arguably a much smaller runway than 2004 Amazon.
Within the seventh edition of the book, Malkiel explores various bubbles throughout history and how they often repeat, which may hold some truth to Granger and Morgenstern’s conclusion:
“The new-issue mania of the early 1960s, the "Nifty Fifty" craze of the 1970s, the biotechnology bubble of the 1980s, the incredible boom in Japanese land and stock prices and the equally spectacular crash of those prices in the early 1990s, as well as the "Internet craze" of the late 1990s … provide continual warnings that we are not immune from the errors of the past.”
Notice how these decades all have a theme attached: the “Internet Craze” of the 90’s; the ‘biotech bubble’ of the 80s; the ‘Nifty Fifty’ in the 70s. Are we in the ‘Bitcoin bonanza’ of the 2010s? What about the FANG decade? Is Bitcoin’s value not wholly dependent upon what others are willing to pay for it?
Despite these thought provoking questions, it has become clear that stocks within the technology sector, coupled with record low employment and inflation, have driven this market higher leaving investors little choice of where to put their capital other than equities.
Yet strangely no one seems to want to sell anything…with bonds and gold also up YTD (S&P 500 up 9% YTD, Long bonds (TLT) up 6% YTD, Gold up 8%). Moreover, strong corporate earnings growth, healthy corporate balance sheets, strong returns on invested capital relative to interest rates and interestingly, strong organic revenue growth, do seem to suggest that corporations across the globe are in a healthier state than they were in the first half of this decade. This has propped up valuations, leaving those who have been invested since 2010 feeling quite intelligent and those with new capital to deploy with the difficult task of finding value.
A difficult task indeed, as the “prudent long-term investor” attempts to side step the significant amount of price correlation amongst all major asset classes…
Activities in the Quarter
Over the past 6 months, we have shifted the portfolio’s peripheral focus towards low multiple (either forward earnings, EBIT or price-to-sales) largely domestic industrials with conservatively estimated double digit FCF growth and high single digit operating income growth for year-end 2018.
Some net new positions which fit that description include: Huntington Ingalls Industries (NYSE: HII), Gentex Inc. (NASDAQ: GNTX).
We also doubled down on a couple of peripheral positions already in the portfolio such as Home Bancorp Inc. (NASDAQ: HBCP). We also trimmed peripherals such as Enghouse Systems Inc. (TSE: ENGH).
On a net basis, we have increased our cash position for the quarter and are patiently waiting to either fortify some of our new larger peripherals, fortify one of our core positions or enter into new peripherals on our watch list within the Canadian equity markets.
The following is a case study for one of our new peripheral positions:
Case Study: Gentex Inc.
Gentex Inc. (NASDAQ: GNTX) is a global manufacturer of signaling devices, dimming windows, electronic devices, cameras and other devices for the automotive, aerospace, municipal and defense sector.
The company has been on the decline this year (-14.15% since March and -3.86% YTD) due to fears of peak auto sales (which GM has confirmed this June), questions around U.S. federal budgets, uncertainty around autonomous vehicles and fears of slowing growth due to competition from large players like Magna. However, we believe this created an opportunity – the company is now trading at less than 13x next year’s PE (currently trading at 15x PE) all the while growing in the near double digits (last quarter revenue and operating income grew over 11%), donning a return on invested capital over 18% (with a ten-year average over 15%), debt/equity ratio of 0.02, current ratio of 4.35 and a lofty 18.71% FCF/sales ratio. Clearly, the company is not only liquid but incredibly profitable and growing in addition to being a top operating performer in its peer group. For example, the company sports a very strong 29.88% return on tangible equity as of 2016, which puts it over 87% of its competitors.
Our projections indicate FCF growth of over 10% next year with earnings growth at 9% (3-year average net income growth rate is over 15%), which are conservative considering the company continues to push gross margin (gross margin last quarter hit 40.3% trending up from 34.8% in 2007 and up from 39.4% last year), grew EPS by over 17.5% last quarter and has stated that 2018 revenue guidance will be 6-10% above 2017 levels (which are estimated at $1.78bn – $1.85bn).
This gives us an estimated price target well above $25/share in the medium term, which represents a near 40% discount. Although this company has been positioned as a peripheral within the portfolio, the company does have a big moat for a small company with over 90% market share in the automotive dimming windows niche and is experiencing unexpected growth in its defence business unit (Pentagon recently bought $40 million worth of sophisticated helmets from Gentex). As a result, we may hold this company for a lot longer as we acquired the name below $18.90/share.
The Way Forward
As usual, we cannot promise that we will have the same returns next quarter, next year or that we will beat the market overall in the short/medium-term. However, we are committed to all partners within the partnership to plant the “right seeds” and avoid any dangerous expectations proffered by “the Sirens” of the market.
We currently have a few Canadian names on our watch list and are looking at replacing a certain core position with a peripheral, but as of now we are increasing our cash reserves.
Our “fifth year” goal remains to compound at double digits unlevered over the long-term, and we will use the appropriate amount of leverage as a risk mitigating tool to dollar cost down on either certain cores or peripherals that we believe have the largest upside over time.
We will continue to monitor our names and any global events affecting our portfolio yet maintain that a strong job market, subdued inflation, low borrowing costs and healthier finances will be a tailwind for consumer spending while business investment, a laggard so far, should soon join the drivers of growth. Our outlook remains constructive.
Let us know if you have any questions and we look forward to hearing from you.
Chief Investment Officer
Head of Strategy