Perea Capital Partners 2015 Annual LetterVW Staff
Perea Capital Partners annual letter for the year ended December 31, 2015.
Thank you for your continued trust. In the year ended December 31, 2015, Perea Capital Partners returned 12.2% net of fees and expenses. At this time, we are nearly fully invested.
Perea Capital Partners – Sources of competitive advantage
Each time we analyze a business, we must ask ourselves if it has a competitive advantage. All else equal, a business with one or more competitive advantages is likely to generate higher returns on capital over time than one without. Our own business at Perea Capital should not be spared when asking this question: after all, we aim to compound our capital at high rates over long periods of time, while minimizing any risk of permanent loss. In this pursuit, I believe that there are three primary sources of competitive advantage: more information, better analysis, and patience.
The first source of competitive advantage is more information. Each time we buy or sell a security, we must be confident that we know more than the person on the other side of the transaction. This is more likely when the security in question is small, illiquid, and less followed. For example, consider that Apple is valued at over $500 billion and has sixty banking analysts publishing reports about the company. The likelihood of discovering relevant incremental information about such a company is quite low. Even if we were to count the number of iPhones coming off Foxconn’s production line in Shenzhen, we might find ourselves in the company of several other determined analysts. Instead, we prefer to study businesses outside of the spotlight, where research can provide valuable information unbeknownst to the rest of the market. Simply put, we want to fish where nobody else is fishing.
The second source of competitive advantage is superior analysis. Because the consensus opinion is sometimes wrong, true understanding of a business can lead to outperformance even when the stock is large, liquid, and widely followed. Consider the case of Microsoft in 2011. The market consensus held the view that tablets and smartphones would render computers obsolete, and as a result, Microsoft’s dominance was at risk. The investors that correctly understood the breadth and resilience of the company’s franchise – from its suite of Office software to its Windows Server business – doubled their money over the following five years. Such superior analysis is rewarded even more handsomely in the case of smaller companies where fewer analysts are digging.
The third but perhaps most important source of competitive advantage in the stock market is patience. Because most market participants are focused on making money quickly, their judgment and estimates of a given company’s earnings power are highly influenced by its most recent results. Just as lottery winners believe they will be happy forever, market participants tend to extrapolate recent events forever into the future. In reality, it doesn’t take long for the happiness levels of lottery winners to revert to historical levels. The analogy in the stock market is that the value of a business is not determined by the earnings of its most recent quarter or year, but rather by the earnings it is expected to generate over its lifetime. Undue weight should not be placed on short-term results unless they truly are indicative of a company’s long-term earnings power. It is therefore important to understand not only the current economics of a business, but also its economics years into the future.
When undertaking such analysis, our goal is to discover securities that we believe will generate an attractive return on our capital with as little risk as possible. Not surprisingly, many others would say the same. But risk is defined differently by market participants with different time horizons. Consider the distinction between a trader and an investor. A trader buys a stock (a piece of paper) with the hope of selling it to someone else at a higher price. An investor buys a stock (a piece of a business) because its price undervalues the present value of the cash profits it will generate over its lifetime. With a six-month time horizon, a trader views risk as the prospect that a stock price declines. With a six-year horizon, an investor views risk as the prospect of overpaying for a company’s assets, earnings, or growth and permanently impairing capital.
Perea Capital Partners – Investment Philosophy
As long-term investors with patient capital, we are able to minimize the risk of overpaying for a business because we don’t have to chase the most popular stocks of the day. Instead, we are able to make heavily contrarian investments – positions that may be unpopular in the short term, but in the long run offer vindication in the form of a higher reward. The only risk that one mitigates when buying what everybody else is buying is the risk of looking foolish. On the contrary, companies that are en vogue tend to lack a margin of safety in their stock prices. We invest only when the price meets our return requirements and in the meantime will not lower these requirements (in other words, overpay). The times when investors believe it is acceptable to lower their return requirements tend to be the times when it is most imprudent to do so. These are times when the market is excited, stock prices are rising, and attractive investments becomes elusive. At the prospect of underperforming the general market or their peers, investors begin to relax the criteria by which they would buy a stock. In the short run the strategy may succeed, but in the long run it is destined for failure.
The reality is that most stock market participants are focused on the short run. It is easy to imagine the joy of winning the lottery, but more difficult to imagine the slow compounding of wealth over several decades. This common desire for instant gratification is both a function of nature and nurture and has been well researched. In the 1960s, Stanford professor Walter Mischel and his team of researchers tested the ability of children ages 3 to 5 to delay gratification in a series of experiments that became known as the “Stanford marshmallow experiment.” The study began by leading each child to sit alone in an empty room. The researcher placed two marshmallows (at other times, pretzels) on the table and told the child that he or she would return in fifteen minutes. During that time, the child was welcome to eat one of the marshmallows; if he or she waited for the researcher to return, the reward would be both marshmallows. In other words, the child could have one treat now or two treats in fifteen minutes.
Less than one in three children was able to delay gratification and earn the second treat. Some found it easy, while others tried to avoid the temptation by sitting on their hands or even smelling the marshmallow to satiate their desire. While the experiment itself was interesting, its most pronounced insights did not transpire until decades later as the researchers tracked the progress of these same children during adolescence and adulthood. They discovered that the children that were able to delay gratification (that is, those who waited for the second marshmallow) developed into more cognitively and socially competent adolescents, achieved higher scholastic performance, coped better with frustration and stress, and were healthier even as adults.
How is this relevant to us? Simply put, the majority of participants in the stock market want to eat the first marshmallow. As a result, many hedge funds offer monthly redemptions, investment bank research reports focus on quarterly price targets, and one prominent investment company is currently promising to reimburse investor fees in the case of two consecutive quarters of negative performance. Such a promise has likely prepared these investors for mediocrity. Because both outperformance and underperformance can result only from contrarian investment, this investment company has implicitly promised to track the market while charging fees. We can unabashedly make the opposite guarantee, which is that we are certain to underperform the market at various points in time. Because we are contrarian investors, we often invest where the sentiment is negative. As a result, there will be times when the stocks we own continue their decline, even after we buy them. This does not mean we are wrong; it just means that we have no idea what the stock will do in the short run. In the long run, if we believe that our purchases were made at a great discount to the true value of a business, we do not concern ourselves with these short-term fluctuations in price. The following example of our investment in an unloved market should highlight our pursuit of more information, superior analysis, and patience.
Perea Capital Partners – Portfolio Holdings
In a previous letter to partners, we detailed the partnership’s investment in Indeks Bilgisayar, Turkey’s largest information technology (IT) distributor. Our interest in Turkey was piqued following a government corruption scandal in late 2013 that led to substantial declines in the Turkish stock market. At that time, Indeks’s market value dropped to a mere 180 million Turkish lira (TL), although the company owned at least 130 million TL worth of land and earned 17 million TL per year in its core IT business. Excluding the value of the land, we were paying less than 3x annual earnings for the operation, and the earnings had a long runway for growth. The company’s land sale was contracted in U.S. dollars (USD), so any depreciation of the Turkish lira would result in more money to the company in Turkish lira terms. As a result, we had a partial natural hedge in case of currency depreciation – a likely outcome in a high inflation market like Turkey. Furthermore, Indeks management had committed to paying half of the proceeds from the land sale as a special dividend, equivalent to one-third of the market cap – not an inconsequential amount.
In late 2014, I discovered a separate investment opportunity in one of Indeks Group’s subsidiaries called Datagate Bilgisayar. At the time of our initial investment, Datagate had a market cap of 75 million TL, equivalent then to 30 million USD. Indeks owned nearly 60% of Datagate, and Datagate’s founder owned 6.5% of the company, leaving only 10 million USD available in the public market. The company had historically been a hardware components distribution subsidiary of Indeks and was losing money. As a result, most Turkish investors were not aware that Datagate existed. While Indeks was considering liquidating Datagate (a sign of rational management), something very fortunate happened: Datagate reached an agreement with a company called Avea to distribute its mobile phones throughout southwest Turkey. Avea is Turkey’s third-largest mobile phone operator (behind Turkcell and Vodafone) but is the fastest growing, having increased its market share from 16% in 2007 to 23% today. The agreement would last a minimum of 5 years and would generate at least 1 billion TL of annual revenue for Datagate, translating to 20 million TL of annual profit. At the time of the announcement, Datagate was valued at 40 million TL, or a mere 2x earnings.
We began to study Datagate in detail, and given its small size, few others joined us in the process. We learned that Avea had been working with two companies to distribute its mobile phones throughout its retail stores in Turkey and was not pleased with their overall performance. Avea took notice of the IT distribution capabilities and financial strength of Indeks and believed that Datagate, as its subsidiary, could succeed similarly in the distribution of mobile phones. In July 2014, Avea granted Datagate an exclusive mobile phone distribution contract for 26% of Turkey’s geography. The remaining 74% of Turkey would continue to be served by the two existing distributors, both less qualified and less financially capitalized than Datagate. Financial strength is imperative in this industry because distributors must finance the large upfront cost of mobile phones, while end customers buying the phones pay them off monthly over an average of twelve to eighteen months. A distributor short on cash would buy fewer phones to distribute, leaving Avea with fewer customers. Since it makes little sense for Avea to continue employing weakly-capitalized distributors and for the strongest distributor to cover only 26% of the country’s geography, I expect Datagate to gain a commanding share of Avea’s distribution in due course. Turkcell successfully operates with 2 distributors (down from 5), while Vodafone has only 1 (down from 4); there is little reason for Avea to have 3. As a result, we believe Datagate’s earnings can rise materially from their current level as the company’s geography expands across Turkey.
Despite Datagate’s attractive valuation, most investors would likely ignore the company after a cursory look at its financials. The business appears to have low profit margins (2% of sales), substantial debt (3.5x net debt to equity), and high customer concentration (most of the revenues are from Avea). In reality, these factors all obscure the simplicity of the business. The reality is that Datagate is simply a middleman for Avea. Avea tells Datagate how many phones to purchase from manufacturers such as Apple and Samsung, so Datagate takes no inventory risk. All the purchasing is done in Turkish lira, so there is no currency mismatch that an emerging market IT distributor may have when buying in U.S. dollars. And, unlike an IT distributor which must collect payment from thousands of different resellers, Datagate has one strong counterparty in Avea. Thus the business has very little operating risk. Because the cost of phones is passed through at a markup, it is mere accounting convention to consider the cost of the phones as a cost of sales for the company. If we divide Datagate’s net margin by its gross margin (to ignore the cost of the phones), it becomes clear that the company keeps 50 kuru? (cents) of each lira that it sells. More importantly, returns on equity exceed 40% as a result of the company’s efficiency. Furthermore, Datagate’s debt is also an accounting convention: although included in Datagate’s financials, the debt is guaranteed by Avea, a well-capitalized subsidiary of government-controlled Turk Telekom.  To mitigate this appearance of leverage (thereby comforting its suppliers, such as Apple and Samsung), Datagate is now selling its receivables to pay down debt and will soon be in a net cash position.
The issue of customer concentration requires careful analysis. After all, the loss of an important customer can destroy any company’s value. I believe the risk here is small for several reasons. Companies like Datagate exist because the mobile phone operators do not view the distribution of mobile phones as a part of their core business. Avea’s objective is to constantly improve its telecom infrastructure while successfully marketing its product, not to coordinate the purchasing and logistics of mobile phones to 700 different stores, which is why it signed a 5-year agreement with Datagate. But it is important to note that Datagate is not simply driving a big truck around Turkey and dropping off phones at Avea’s shops. Rather, the company is integrated into the software at each of the individual shops, managing the supply chain for physical hardware, as well as delivering credit electronically for customer SIM cards. Any process to replace Datagate’s footprint would require months and would result in foregone sales for Avea, which is what happened when Datagate was granted its contract to replace the existing distributor. Datagate has now also signed distributorship agreements with other parts of the Turk Telekom organization, strengthening its long-term relationship with the company. Whether specific terms such as pricing and bonus eligibility remain the same in five years is difficult to predict. However, Datagate’s net margins are in line with global competitors, so the risk of a major change is small. Finally, although it may seem counterintuitive, customer concentration has its benefits: unlike most companies which must spend a reasonable amount of their income on sales and marketing to win new business, Datagate doesn’t have to.
We are likely to have more information and better analysis on Datagate than most participants in the market. We also have a longer term view, especially as it relates to Turkey. The country is suffering from political turmoil, slow growth, rising inflation, and a weakening currency. With a 6-month horizon, we would not be investing in Turkey. Fortunately, our time horizon is measured in years and our analysis does not involve speculating whether we would be able to sell our shares to someone else in the near future (as a trader would) at price levels that fluctuate daily with macroeconomic news. Instead, our analysis of Datagate is simplistically summarized as follows: the present value of all the cash profits generated by the company over its lifetime is likely to be a multiple of the price we paid to acquire its shares. In a likely worst case scenario, Datagate will earn over 20 million Turkish lira per year; at our purchase price below 100 million TL, we paid a multiple of less than 5x annual earnings. Given Avea’s growth and Datagate’s increasing integration with Turk Telekom, the company’s annual profits could reach 50 million TL several years down the road, implying a purchase price of less than 2x earnings. In either scenario, Datagate was a bargain.
Aside from customer concentration, the primary risk to our investment is depreciation of the Turkish lira. Given large interest rate differentials with the U.S., the cost to hedge currencies in high inflation emerging markets is prohibitively expensive. At this time, over 50% of the partnership is invested in emerging markets (a fact that causes people’s faces to contort in ways I never imagined possible), and strong declines in their respective currencies have reduced our gross returns by nearly 7 percentage points since inception. However, I expect the times in which we are most often buying emerging market stocks to correlate with the times in which their currencies are undervalued. When emerging markets are booming, the stocks tend to be held in high esteem, along with the currencies. During more dismal times, both the market and the currency head in the opposite direction. Ultimately, the greatest driver of our investment will be the success of Datagate itself, and less so the overarching macroeconomic, currency, or political concerns surrounding the country. It is important to remember that we are not investing in emerging markets as a theme; rather, we are investing in mispriced businesses that happen to exist in some of these emerging markets. The two strategies should not be conflated.
In 2015, the partnership made its first sales, as UE E&C and DelClima were acquired by other companies. I have discussed both investments in previous letters but will summarize them here. Based in Singapore, UE E&C was the construction and engineering subsidiary of property developer United Engineers. Given its significant cash holdings, long-term receivables, and claims to cash that were hidden from the balance sheet due to Singaporean accounting standards, the company was selling at an incredibly cheap multiple of its assets and earnings. Shortly following our investment, a local private equity group made a (low) bid of 338 million Singapore dollars (nearly 260 million USD) to acquire the company, and our attempts to block the takeover failed. As a result, we were compelled to tender our shares at the offer price, which led to a 16% return in just over a year – a satisfactory but seemingly unfair return given the higher intrinsic value of the business.
Our investment in DelClima also effectively came to a conclusion in 2015, as the company agreed to be acquired by Japanese industrial giant Mitsubishi Electric in a deal valued at 508 million euros (nearly 560 million USD). As I explained in our inaugural partnership letter, DelClima was an undervalued HVAC (heating, ventilation, and air conditioning) manufacturer spun-off from the larger Italian company DeLonghi. Our initial investment was at a share price of 75 euro cents (valuing the company at 100 million euros), and I began to trim the position at an average price of 2.30, 3x the price we originally paid for the business. This proved to be a costly decision, as the acquisition was announced at a 90% premium to the then trading price, a 5.5x multiple of our initial purchase. Our remaining shares in DelClima will be sold at the turn of 2016 in order to defer the tax obligation to partners for another year. Overall, our realized return on DelClima in local currency terms is 4x. However, given the large depreciation of the euro against the USD (which we hedged), our realized return in USD terms is closer to 3x.
In hindsight, it is easy to say that selling some of our shares too early was a poor decision. In fact, we had suspected that DelClima may be an acquisition target given its small size, strong technology, and growing distribution network. However, when we began to sell the position at 15x earnings, there was no longer a substantial margin of safety in the shares. Going forward, we would expect a 6.5% return (1 divided by 15) in addition to the satisfactory, but not great, growth prospects of the business. As a result, we decreased the position in order to invest in opportunities that offered a larger margin of safety. Perhaps we should have been more patient given the above-average quality of the business, but we are reluctant to reach a definitive conclusion from the case of only one investment. Over time, our investment process will have the benefit of incorporating more data points, which in turn will strengthen our decision-making process.
Hopefully this letter has shed more light on our investment philosophy and our desire to improve our competitive advantage as investors. I truly appreciate the trust of partners and look forward to updating you later this year. In the meantime, please contact me with any questions or concerns. The following depicts where the portfolio is invested at the end of 2015, with our Italian exposure in DelClima immediately turning into cash as we enter 2016.
 “Delay of Gratification in Children” (1989) by Walter Mischel, Yuichi Shoda, and Monica Rodriguez.
 At the time, 1 USD equaled approximately 2.20 TL.
 Avea’s government relationship is not a risk for Datagate. Datagate was granted distribution contracts despite its lack of support for the current Turkish leadership. Avea made a business decision, not a political one.
 In local currency terms our return was 28%. We did not hedge the Singapore dollar, which declined vis-à-vis the U.S. dollar while the acquisition was being finalized.
 The hedge protected us against the decline of the euro, but our investment became smaller in U.S. dollar terms, so the increase in the stock was off a smaller base and thus created lower absolute profits in USD terms.
 At the right price, a company lacking a competitive advantage may still be worthy of investment consideration.