Emerging Value Capital Management December 2015 And Annual LetterVW Staff
Ori Eyal’s Emerging Value Capital Management letter to partners and shareholders for the month and year ended December 31, 2015.
Emerging Value Capital Management 2015 Annual Letter
Dear Partners and Shareholders,
For 2015, Emerging Value Capital Management fund returned an estimated +3.7% net to investors. Stock markets worldwide were down with the All Country World Index (ACWI) and the HFRI Equity Hedge Index down -2.4% and -0.8% respectively.
Since inception (10/15/2008), Emerging Value Capital Management Fund returned an estimated +105.2% (netto investors). During this same time period the MSCI All Country World Index (ACWI) and the HFRI Equity Hedge Index returned approximately +83.0% and +43.2% respectively.
Emerging Value Capital Management - 2015 Performance Overview:
Emerging Value Capital Management Fund significantly outperformed its benchmarks in 2015 despite our conservative positioning, less than market exposure, cash, and short positions.
The five key elements leading to this outperformance were:
- Our investment focus on the US, Israel and Korea.
- Our avoidance of the commodities and energy sectors.
- Our short oil position.
- Our gradual shift towards investing in higher quality value companies.
- Our deep fundamental research and analysis of every investment.
We think all five of these decisions were more than vindicated in 2015 and all five remain valid for 2016.
Towards the end of 2015 (and into 2016), the markets became concerned that the price of oil had fallen too much which led to steep declines for many stocks. Despite having little direct exposure to oil, gas, or commodities, we did get hit as some of our investments suffered due to indirect exposure. For example, our basket of US banks declined due to write downs that these banks will have to take from loans made to companies in the oil & gas sectors.
We think market worries over low energy prices are misplaced. Low energy prices are a gift to the world which consumes about 95 million barrels of oil every day, mostly for transportation and industrial uses. Eighteen months ago, the world was paying over $100 for each of those barrels of oil. That’s a cost of about $10B every single day. This $10B was a real cost that each of us had to pay at the pump and through higher prices for every good and service (since every good and service requires some energy input to produce).
With oil prices now around $30 per barrel, the world is paying just $3B every day for its oil needs. Compared to 18 months ago, that’s a direct saving of $7 billion every single day! This massive cost saving will take time to fully trickle down into consumers pockets, but it will do so in time and it works as a powerful global economic stimulus.
Like all economic disruption, these changes are causing some temporary pain, particularly to companies with direct and indirect exposure to the oil & gas sectors. However, over the longer term, low oil & gas prices are an economic blessing.
Emerging Value Capital Management - Finding Value Around the World:
Both Israel and South Korea performed very well economically in 2015 during a year were practically every other country in the world (except the US) suffered. The expanding wars in the Middle East and North Africa, the collapse of commodity and energy prices, the massive refugee immigration into Europe, China’s slowdown, and Russian and Chinese belligerence left few countries and economies unhurt.
The secret to the success of Israel, South Korea (and, largely, the US) is their focus on technological innovation. In our view, the age of energy has ended and the age of technological innovation has begun. With technology comprising an ever growing portion of the economy, with more and more “old economy” sectors getting technologically disrupted and with the end of the commodity and energy super cycles, economic success in the future will be based on the ability to innovate and stay ahead of the advancing technological curve. Israel, South Korea, and the US are the best positioned countries to do so.
We wish to specifically highlight Israel’s excellent performance in 2015. Israel is located in the most volatile and dangerous region in the world and is surrounded by imploding countries and many enemies from within and without. Yet Israel had the best performing currency for 2015 (excluding BitCoin). It also has the highest fertility rate among all OECD countries. Israel achieved 2.3% GDP growth for 2015, continuing a multi-year string of good GDP growth numbers.
As a global fund with a fairly wide investment mandate, we are able to invest in almost any country in the world. This large menu of potential investment destinations provides us with a competitive advantage (compared to geographically constrained investors), as long as we carefully pick and choose where we ultimately do invest. Not surprisingly, the majority of our capital is currently invested in the US, Israel, and South Korea.
Emerging Value Capital Management - Fund Exposure Levels:
Fund Exposure by Geography
Top 10 longs and shorts
In the next section, we will go into greater detail on many of these positions. For now, however, we think it is interesting to point out that our top 10 longs make up over half of our long exposure. As of month end, we were 90% long and 5% short. Our overall net exposure level of 85% reflects the large number of compelling bargains we are finding in global stock markets.
Emerging Value Capital Management's main contributors in 2015:
Strong positive returns were generated in 2015 by most of our investments in Korea, Israel, and from our short oil ETF. In contrast, we struggled in 2015 to make money from our investments in the US.
Isras is a leading real-estate company in Israel. It develops and owns quality residential, commercial, industrial and office real-estate assets. The company assets and development projects are spread throughout Israel with most enjoying high demand and low vacancy rates. Isras is reasonably leveraged and has been taking advantage of the very low interest rate environment to refinance, thus reducing interest costs and extending debt maturities.
Until two years ago, Isras was focused on extensive asset development and therefore re-invested all cash flows and did not pay dividends to shareholders. This resulted in the company being underfollowed and mostly neglected by investors that often view real-estate holding companies as proxies for bonds. We invested in Isras right after management announced a new dividend policy where they will pay out an annual dividend equal to 35% of FFO (about 3% dividend yield).
Isras’s book value is about 1.5B ILS. Book value understates true economic value for several reasons. First, Isras values its yielding assets at 8%-9% cap rates which are above market rates. Second, Isras owns land assets recorded at low historical purchase costs which have not yet been marked up on its books. Third, Isras has tax loss assets that are not on its books. The company trades for 83% of reported book value and about 70% of our estimate of adjusted book value. In comparison, peers trade for about 120% of book value implying significant upside for Isras.
We are happy to report that Isras finally became a member of the Tel-Aviv 100 stock index last month. This was a key element of our original investment thesis which took longer than we expected to play out. This inclusion will serve as a strong catalyst since it now puts the company on investor’s radar screens and will further highlight its cheapness in comparison to other real-estate companies in the Tel-Aviv 100 index.
Hilan Tech LTD (Tel Aviv: HLTC) is Israel's leading payroll processing and HR service provider. US investors might think of it as the “ADP of Israel”. The company provides an array of solutions for organizations: payroll, human resources, time & attendance and pension administration. Hilan Tech possesses the most advanced and comprehensive system of its kind in Israel, rendering services to 2000 organizations and companies, which together employ over 700,000 employees.
Payroll processing and HR services is a predictable, slow growth business which generates a lot of recurring free cash flow, requires minimal capital investments, is recession resistant, and provides a high return on capital invested. Customers are very “sticky” since it would require a lot of time, effort, and expense to switch service providers.
We have begun trimming our investment in Hilan-Tech as its market valuation is finally catching up with its intrinsic business value.
Short USO (Oil ETF)
United States Oil Fund (Ticker: USO) is an ETF that is supposed to track the price of a barrel of oil (WTI - west Texas intermediate oil). In theory, it is an interesting financial product that allows investors to easily invest in (or bet against) the future price of oil. It is mostly owned by retail investors that view it as a proxy for directly owning barrels of oil.
Like many Wall-Street “products”, USO is a wolf in sheep’s clothing. USO does not own any oil directly. Instead, it uses futures contracts to gain exposure to the price of oil. Because these futures contracts are usually in contango (front months cheaper than later months), USO suffers from “roll decay” which makes it lose value over time. Every month, USO needs to sell the front month futures contracts that it owns and replace them with futures contracts that are one month further out, and therefore more expensive. As the month goes by, the newly purchased futures contracts become the front month futures contracts and the process repeats again, every month, forever. This can be summarized as “buy high, sell low, repeat every month forever”. Simply put, USO does not accurately track the price of oil and is likely to cause large losses over time to its investors. Given enough time, USO will probably go to zero.
We have been short USO on and off in the past and it served us well, especially towards the end of 2014 and again in 2015 as the price of oil fell sharply. We closed out most of the position at a nice profit at the end of 2015 and are patiently waiting for future spikes in the price of oil so that we can re-establish our short position yet again. Over the years, shorting USO has proven to be the gift that keeps on giving.
Basket of Korean Preference Shares
Our thesis about Korean Preference Shares has been playing out exactly as we expected. Recall that when we purchased our basket, many of them were trading at 60% - 70% price discounts to their respective common stocks. The current price discount in our basket has narrowed to about 53% which has provided a boost to the strong returns of the stocks that we selected. Overall our basket is up about 100% since we started investing in Korea and we think there is another 100% upside remaining.
The management of Samsung Electronics, South Korea’s largest company, recently confirmed our investment thesis in their Q3 comments to investors. They said: “…many shareholders have expressed a view that buying back and cancelling preferred shares, which are traded at a discount to common shares is a more efficient use of capital as we can buy and cancel more number of shares with the same amount of money, thus increasing the effectiveness of any future capital return to the remaining shareholders. The company shares the same view. Therefore, we plan to increase the portion of preferred shares for repurchase and cancellation under this buyback program, as long as the price discount to common share is greater than 10%”. Please note that they view any price discount about 10% to be a buying opportunity. For reference, our basket trades at a price discount greater than 50%, confirming that huge upside remains.
We wrote about specific companies in our Korea basket in our Q3-2015 letter to investors so we will not repeat these here.
Emerging Value Capital Management's main detractors in 2015:
Main detractors from performance in 2015 include: Howard Hughes Corp, Samsung Electronics, Qualcomm, Horsehead Holdings and Golf & Co. Below is short discussion of these positions.
Samsung continued to suffer from weak smart-phone sales and margins as both Apple and Chinese phone manufacturers ramped up their competitive offerings. The semi-conductor division also disappointed due to industry oversupply issues that we think are temporary.
Samsung is a complex conglomerate with many moving parts and is difficult to fully analyze and follow. Most investors seem focused on Samsung’s smartphone business while paying little attention to its many other highly valuable business segments (DRAM, NAND, chipsets, displays, digital cameras, television sets, tablets, laptops, networking equipment and home appliances).
Thanks to its size, Samsung enjoys low manufacturing costs (economies of scale) and high bargaining power with suppliers. To put its size in perspective, Samsung sells twice as many smartphones as Apple. Samsung gains additional competitive advantages from its vertical integration, with internal production of many of its own chipsets, memory circuits, and displays.
Samsung is cheap by any valuation metric. It trades for 8 times earnings, 90% of book value, and 2.6 times EV to EBITDA. At the current cheap stock price we are paying a fair price for the non-smart phone businesses and essentially getting the smart-phones business for free. Samsung is the world’s largest integrated electronics manufacturer. It has created tremendous shareholder value over the years and will continue to do so in the future.
Golf & Co
Golf & Co (“Golf”) is a leading group of retail chain stores located in Israel, all under the umbrella brand “Golf”. The stores fall into two main retail categories: fashion clothing and home accessories. Golf has 356 stores today across all its sub-brands. Sub-brands include Golf Kids & Baby (kids clothing), Intima (lady undergarments), Polgat (men’s suits), Max Moretti (lady shoes, purses and accessories), Blue Bird (surf wear), Golf & Co (home accessories), and others.
As one of the largest retail chains in Israel, Golf enjoys multiple competitive advantages including: a strong and well recognized brand, excellent mall based locations and economies of scale in operations, advertising and purchasing. The Golf brand is generally associated with good value for money, but is not necessarily the most fashionable or cutting edge. Golf is also one of the leaders in Israel in online retailing.
Golf’s is executing a multi-year strategic turnaround plan. This plan includes large investments in new and existing stores, more advertising and acquisitions, and a strong push into online retailing. The plan will ultimately result in much higher revenues and profits. Meanwhile Golf’s 2015 profitability has been heavily depressed since the company is bearing the increased costs of the plan while not yet enjoying the expected increase in revenues and profit margins. If Golf manages to even come close to achieving managements projected sales and margins then the stock price should triple from where it is today.
Qualcomm designs, manufactures, and markets advanced integrated circuits and chipsets used mostly in networking and wireless products. The company owns an extensive technology patent portfolio which it licenses to other manufacturers. QCOM had a difficult 2015 due to sales declines in its wireless chipset business, Samsung’s decision to use in-house technology for its cell phones, and royalty collection delays in China. We think 2016 could provide to be the turning point for the company as its 3G mobile chips gain traction in emerging markets, it resolves collection and regulatory issues in China, intellectual property rights get better enforcement in China, and it proceeds with its aggressive cost cutting plans.
Jana partners, a highly regarded activist investment firm, is actively involved with Qualcomm. Jana now has two members on QCOM’s board and has been pressuring QCOM to take shareholder friendly actions. These include large share buy-backs, cost cuts, reductions in management option grants, and a possible spin-off of the technology licensing segment.
At current prices we are paying for just the licensing business and essentially getting the chipset business for free. With Jana partners acting as a catalyst for unlocking value, we find the risk reward balance in QCOM to be compelling.
Our investment in Horsehead Holdings was a painful mistake. Fortunately we recognized that it was a high risk investment and kept the investment fairly small.
Our investment thesis had been based on the company’s new Mooresboro facility in North Carolina being able to generate $150M of EBITDA at full capacity. As with all new facilities, we expected some setbacks, delays, and cost overruns, but were surprised at the massive extent of these. The final nail in the coffin for Horsehead was the rapid drop in Zinc prices. The company recently announced that they are temporarily idling the facility due to cost overruns and low Zinc prices and the stock fell sharply.
While there are certainly some elements of bad luck in this poor investment outcome it does re-inforce our decision from a few years ago to avoid investing in any commodities producers. The commodity super-cycle, which was created by strong demand from China, has ended. Furthermore, over the long run commodity prices can barely keep up with inflation. Most commodity producers have proven to be terrible long term investments. Lesson learned.
Howard Hughes Corp
Combining unique and hugely valuable trophy development assets with an excellent and highly incentivized management team, HHC is arguably the worlds “best” real-estate company. Noteworthy assets include:
- Ward Centers in Honolulu – 60 acres of under developed ocean front property where HHC is building several towers with high end residential and commercial spaces.
- Summerlin MPC in Las Vegas – Developing 22,500 Acres of in demand residential, retail, and office space.
- South Street Sea Port in Manhattan – Developing over a million square feet of high end retail space.
- Houston, Texas MPC’s (Bridgeland and Woodlands) – Developing over 30,000 acres of in demand residential, commercial, office, and hotel spaces.
- Additional valuable assets under development in Princeton-NJ, New Orleans, Alexandria-VA and Columbia-MD.
As in previous years, HHC continued to make strong progress developing its assets into income producing properties. The stock fell in 2015 mostly due to concerns about the Houston MPC’s indirect exposure to energy. While we agree that low oil prices are not beneficial for the value of the Houston MPC’s, we think this concern is overdone since Oil & Gas account for only 11% of Houston’s economy and since the Houston MPC’s account for only about 25% of HHC’s assets.
We estimate HHC’s net asset value to be around $190 per share and growing. The current share price ($95) seems compelling to us and provides a potential double (or more) over the next few years. We recently purchased more HHC shares and it is now one of our largest investment positions.
We share our winners and losers with you for two reasons. First, to provide transparency into our portfolio. Second, to convey why we think we have one of the most compelling, high quality, and undervalued portfolios in the history of Emerging Value Capital Management Fund. In our view, recent market declines are not permanent and they are giving us an opportunity to add to names that we like at cheaper prices including Howard Hughes Corp, Interactive Brokers, Berkshire Hathaway, the Korea Preference Shares Basket, the US Financials Basket, and an undisclosed new investment in Israel.
Our current investment portfolio is the highest quality it has ever been. As we discussed, we believe we are invested in the right companies that are located in the right countries. Every company in our portfolio offers the potential for at least a double (100% return) over the next few years. We therefore feel confident that we will continue to outperform regardless of whether stock markets move up or down.
We have certainly had our fair share of winners and losers over the 7+ years since we launched Emerging Value Capital Management Fund. Yet despite the occasional volatility in results, we can clearly see that our global investing framework has proven capable of outperforming our benchmarks while protecting our capital. We have generated better than index returns (after all fees and expenses) with less than index risk & exposure – exactly what a hedge-fund is supposed to do.
As you know, I have the majority of my liquid net worth invested in Emerging Value Capital Management Fund alongside you (with the same terms and same fees). I can think of no better place to invest my personal and family money. I gladly eat my own cooking at Emerging Value Capital Management Fund – exactly as it should be.
As we enter 2016, we are fully energized and excited about our portfolio and its potential to generate outsized returns while protecting our capital if markets decline. Thank you, our investors and shareholders, for your trust and support of Emerging Value Capital Management fund. Please don’t hesitate to call with any questions, thoughts or comments.
Emerging Value Capital Management December 2015 Commentary
Emerging Value Capital Management is a focused global value fund. Our goal is to generate the highest possible long-term returns without risking a permanent loss of capital. Employing a disciplined value investing approach, we search the world for the best investment opportunities based on long term business fundamentals. We then construct a long-biased, concentrated portfolio consisting of 20-40 positions, mostly stocks, trading at deep discounts to their intrinsic business values.
Our in-depth research explores the merits of each potential investment in the context of a global market. Many of our investments benefit from multiple economic tail winds as they operate in emerging markets that are experiencing rapid economic growth and development. We use little or no leverage and demand a wide margin of safety for each investment.
For the month of December 2015, Emerging Value Capital Management fund declined an estimated -3.6% net to investors vs. -1.8% for the ACWI Index and -1.0% for the HFRI Equity Hedge Index. We had no large contributors in December. Main detractors include: General Motors, Basket of US Financials, Basket of Korean Preference Shares and Howard Hughes Corp.
Our portfolio investments are trading at large discounts to their intrinsic economic values. Despite higher market volatility in recent months, we see high potential returns from our portfolio over the mid-term. Please see the enclosed Emerging Value Capital Management Full-Year 2015 letter to investors for further details and analysis.
Happy, healthy and prosperous 2016.