Emerging Value Q2 Letter: Middle East Is Imploding; Short Poorly Designed ETPVW Staff
Emerging Value Capital Management letter to investors for the second quarter ended June 30, 2017.
- Autonation Value Despite Sector Worries?
- If Demographics Are Destiny, The Future For South Korea Is Not Good
- Lakewood Capital Bets Against One Of China's Richest Billionaires
- Andy Hall Is The Latest Victim Of Fake News
Dear Partners and Shareholders,
For the second quarter of 2017, Emerging Value Capital Management fund returned an estimated +5.1% net to investors. Stock markets worldwide were up with the All Country World Index (ACWI) and the HFRI Equity Hedge Index up +4.3% and +2.3% respectively.
Since inception (10/15/2008), Emerging Value Capital Management Fund returned an estimated +138.5% (net to investors). During this same time period the MSCI All Country World Index (ACWI) and the HFRI Equity Hedge Index returned approximately +120.0% and +60.2% respectively.
Emerging Value Capital - Q2 Market & Portfolio Overview:
Tensions between North Korea and the US flared as the rogue state accelerated its development and testing of various missile systems, including those that could, hypothetically, strike the US and its allies with a nuclear war head. With diplomatic efforts showing no results, president Trump must either accept the new military capabilities of North Korea or else launch a massive air-strike which would likely lead to war involving the US, North Korea, South Korea, Japan and possibly China.
We continue to think that a full scale war is an unlikely scenario, but must admit that the probability of such a war has significantly increased. If a war broke out, North Korea would lose and its regime would likely topple, but not before it could cause great damage and loss of life to South Korea. There is also a small risk that North Korea strikes with various weapons of mass destruction.
To protect our portfolio from this risk, we established an 11% short position in EWY, the South Korean ETF. We are still net long South Korea, via our Preference Shares Basket and our investment in Samsung Electronics, so this is only a partial hedge. Even in a scenario of all-out war on the Korean peninsula, we are confident that the US and South Korea will win decisively and will recover from any temporary damage. Therefore, in the unlikely event that war breaks out, our plan is to wait for the Korean stock market to drop, then remove our hedge and wait for the recovery.
We made few changes to our portfolio in Q2 because we like what we own and did not find much that is better to buy. We did re-establish investment positions in General Motors and Fiat Chrysler when their stocks temporarily declined due to slightly disappointing monthly car sales numbers. Both companies are exceptionally cheap and have much improved business operations. While we agree that self-driving electric cars pose a long term threat to their business models, we do not think this threat is imminent.
We also increased our short positions in USO (United States Oil Fund) and UNG (United States Natural Gas Fund). These poorly designed ETF’s continuously lose value verses their underlying commodities due to management fees, trading costs and futures contracts roll-decay. We think that Oil (WTI) around $50 per barrel and Natural Gas (Henry Hub) around $3 per Million Btu have little fundamental upside, which makes holding these short positions, while the ETF’s decay, low risk.
Below, we will go into greater detail on some of these positions. For now, however, we think it is important to point out that our top 10 longs make up over 79% of our long exposure. As of quarter-end, we were 99% long and 30% short. Our overall net exposure level of 69% reflects the compelling bargains we are finding in global stock markets combined with our short and hedge positions.
Thoughts on Global Investing:
The number of trouble spots around the world continues to increase. A decade ago it looked like the world was entering a new era of global trade and world peace. Europe was uniting, emerging markets were rapidly developing, China was a benign and peaceful emerging superpower and Russia was joining the west. Today the trend has reversed. Europe is struggling to hold together, Russia and China have become belligerent powers, South American economies have imploded, Africa is undergoing Islamisation and the Middle East (excluding Israel) is in shambles.
If these were all temporary issues, they might have created compelling investment opportunities. But sadly, with few exceptions, we think these issues are permanent and getting worse.
Therefore, it is critical that we carefully pick and choose those countries in which we invest our capital. We continue to conclude that the US, Israel, and South Korea are the three countries were most of our capital should be invested. All three are true capitalist democracies, enjoy favorable demographic trends, and are the world leaders in technological innovation – the driving force behind today’s economic growth. Two of the three (Israel and South Korea) also offer plenty of cheap stocks.
The following table shows how our capital is allocated geographically.
Our main contributors in Q2 - 2017:
Main contributors to Emerging Value Capital Management returns in Q2-2017 include: Hilan, Israel Discount Bank and our basket of Korean Preference Shares. Below are short discussions of these positions. We had no significant detractors from performance in Q2.
Hilan 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 possesses the most advanced and comprehensive system of its kind in Israel, rendering services to about half of the mid-size and large businesses in Israel.
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.
Leveraging its existing customer relationships, Hilan has expanded into software services and IT infrastructure services. These newer segments are more competitive and lower margin than payroll & HR, but do provide more rapid growth. Hilan is a cheap, high quality business trading about 10 times our estimate of 2018 operating earnings with a 2.8% dividend yield.
Israel Discount Bank
Israel Discount Bank (IDB) is the third largest bank in Israel. Operationally, it is the least efficient major bank in Israel. Its employees belong to a fairly militant union and they make cost cutting and operational improvements an always difficult undertaking. As a result IDB suffers from a bloated cost structure and earns sub-par returns on equity (ROE). When we invested, sustainable ROE was below 6%.
IDB continues making slow progress with its multi-year strategic cost reduction program. Based on this program, 350 redundant employees have already retired from the bank and 650 additional employees should retire by 2021. Excluding certain non-recurring expenses, adjusted ROE is now around 7%. The market is still not convinced that IDB will be able to permanently increase its ROE and therefore values IDB with a low price to tangible book ratio of only 0.72.
Basket of Korean Preference Shares
Despite the geo-political turmoil with North Korea, our Korean Basket of Preference shares (and the whole Korean stock market) increased significantly and are both up over 30% year-to-date. The current average price discount in our basket between preference shares and their respective common shares is about 50%. To put this large price discount in perspective, we note that the management of Samsung Electronics, Korea’s largest company, has said that it views any price discount above 10% to be a buying opportunity.
General Motors was in dire need of reform long before the global financial crisis. Its cost structure had become bloated and its vehicle models had difficulty competing with foreign competition. In many ways, GM was run by and for its unions rather than by and for its stockholders. Through the chapter 11 process, GM reduced its cost structure, renegotiated labor contracts, adjusted its dealer network and revitalized its new cars. It now has four key brands (down from eight) and its new vehicles are well regarded and accepted. Via acquisitions of Ally Financial and AmeriCredit, GM has also rebuilt its financing arm which is a strong driver for sales and profitability. GM also enjoys market leading positions in Brazil and China.
It appears that investors are worried about two issues with regards to GM. First, the threat of disruption from self-driving and/or electric cars. We agree that these are long term concerns but do not see either as an imminent threat. Furthermore, GM itself is investing heavily in both technologies and could be, at least partially, a beneficiary of both. Second, investors are worried that vehicle sales are at a cyclical peak. We agree this is likely the case, but expect them to remain fairly stable at current levels given that the average age of vehicles on the road is a record eleven years.
Today GM is a bargain hiding in plain sight. We estimate it can generate close to $10B of free cash flow per year which implies a 20% free cash flow yield on its $50B market cap. Much of this free cash flow is being used for dividends (4.2% yield) and share buybacks.
Special Opportunity to Invest and/or Add Capital:
New or existing investors adding capital into Emerging Value Capital Management fund Fund over the next 3 months will enjoy a permanently reduced fee structure of 1% management and 10% incentive fee (instead of our usual 1% management and 20% incentive fee). I think this is a great time to invest and personally just added over $100K to my existing Emerging Value Capital Management fund Fund account.
Emerging Value Capital Management Concluding Remarks:
Protecting out capital will always be our top priority which is why we established a Korea Hedge when geo-political risks increased. We are not interested in trying to boost returns by overly concentrating our portfolio, investing in low quality businesses or foregoing hedges when we think they are called for. Instead, our portfolio is designed and managed to generate good returns on a consistent basis while minimizing the risk of a permanent loss of capital. Emerging Value Capital Management fund Fund will probably never be the best performing fund in any given year yet over a multi-year period we expect that our “slow and steady” approach will continue generating market beating returns.
We are confident that our investment portfolio is in excellent shape, is deeply undervalued by the market, will realize its potential and will perform very well over the long run. Meanwhile our businesses continue to grow their intrinsic values by increasing revenues, widening their moats, generating cash flows and buying back their own shares.
Thank you, our investors and shareholders, for your continued trust and support of Emerging Value Capital Management fund fund. We continue to work tirelessly to protect and grow your capital and look forward to reporting continued strong positive returns in the future.
Emerging Value Capital Managing Partner
Emerging Value Capital Management See the full PDF below.