GreenWood Investors 2Q19 Letter: Pent-Up AlphaJacob Wolinsky
GreenWood Investors letter to investors for the second quarter ended June 30, 2019, titled, “Pent-Up Alpha.”
Dear GreenWood Investor:
Our quarterly performance, in addition to our performance over the past 6, 12 and 18 months, is not acceptable. The underperformance this year reflects irrational prices that have become even less rational.
An Insider’s View on Inefficiency
During the quarter, we took a seat on the board of our largest position, installed a new CEO and accelerated investments in growth and restructuring immediately. As we have made very encouraging progress on a transformational plan behind the scenes, we have watched the market continue to sell or short the stock. In the month of May alone, insider purchases represented nearly half the trading volume while increased short interest represented over a quarter of the volume. We have witnessed market irrationality from a whole new perspective.
Excluding the value of two strategic assets our company owns, the market is giving a negative valuation to a company that produces over €100 million in EBITDA. New management has flipped the EBITDA result from a contraction in the first quarter to modest growth in the second quarter. We have confidence that cash flow will continue to accelerate in the coming quarters and years. And we hope the company can clear a few legal hurdles in the near future so that it will soon join us on the bid side of this deeply irrational market.
Eugene Fama and Ken French developed the Efficient Market Hypothesis, which suggested that stocks always trade at fair value and reflect perfect information. While the two economists pointed to investment funds underperforming indices as proof their hypothesis was a rule, their beliefs about the cause of the effect was deeply naive and has largely been discredited by well known super-investors and behavioral economists. Perhaps Fama and French should have studied European stocks, or served on the board of one and watched the market do a very poor job of reflecting the information at their fingertips. Yet, their hypothesis, for which they won the Nobel Prize in Economics, has become a popular illusion that continues to be taught at business schools today.
If the efficient market hypothesis were correct, then a stock should be priced at the present value of its future cash flows. That concept, if correct in practice, would have been fantastic had it had rippled through our investment returns over the past year.
Unfortunately it did not.
Higher Growth, Higher Yield, Lower Performance
From the end of 2017 to today, when our performance has been frustratingly close to flat, free cash flow of our portfolio constituents has increased 61%. Net operating income has increased 66%, and because our portfolio has virtually no net debt, and overall conservative balance sheets, net operating income growth basically approximates normalized earnings growth. This ramp in FCF includes important investments being made by many of our holdings, which has diluted this growth somewhat.
If our portfolio was an individual stock, it would trade at a 14% free cash flow yield. This figure includes the dilution associated with our short positions. In this mad (mad, mad, mad) world, where other investors are trying desperately to find a few basis points of positive yield for their portfolio, we have yield in spades. But we haven’t had to forgo growth in order to capture this cheap opportunity set, revenue growth of our portfolio is 14% and is set to accelerate at nearly every single holding over the next 18 months.
These solid portfolio fundamentals contrast to the S&P 500, which has returned 10% over the same period, with only 14% free cash flow (FCF) growth (versus our 61%) and 12% sales growth (versus our 14%). The S&P currently trades at a 3.8% FCF yield, leaving a very narrow margin for error. In Europe, where over 80% of our portfolio trades, the S&P 350 performance is even worse. Revenue growth has only been 2.1% over the same period, and FCF has only grown 2.9%. The index trades for a 4.0% FCF yield today.
As a whole, low-growth and low-yield Europe leaves even less room for error. Our European securities are not chosen for macro reasons. We look for ideal combinations of value, quality and behavioral advantages. With European markets less efficient at accurately pricing-in information, we have found more convergent opportunities there. But our portfolio doesn’t reflect the low growth and low yield reality of Europe today. Not only does our portfolio growth and yield outperform its European peers, it outperforms corporate America. This is important, because even as we continue to investigate American securities, when the political pendulum swings back in the equal and opposite direction from its more recent corporatist agenda, we will likely have minimum direct exposure.
As it relates to operating income and FCF growth, our portfolio has even outperformed FANG (Facebook, Amazon, Netflix, and Google) over the past 18 months. The FANG four have grown operating income “only” 43% (vs. our 64%) and FCF by 30% (vs. our 61%) respectively over the last 18 months. While these four owner-operators have reinvested their profits back into growth, revenue has grown a torrid 40% over the same period. Rather than other value investors that take umbrage at these results, we frankly want to emulate them. Yet rather than buy FANG, we have been able to emulate these high growth owner-operators with substantially more downside protection. The hardtruth is that when momentum trades such as these unwind, the drawdowns reach north of 80%. Trading at just a 1.7% FCF yield today, this low yield does not offer much downside support.
The portfolio has pockets of revenue growth that are similar to the higher rates seen by the growth leaders of the market, but the prices we’ve paid for these assets are so cheap that we’ve gotten the lower-growth areas for free. Shares of Bolloré trade at a discount to its own shareholding in Vivendi, whose stock only attributes value to its Universal Music Group business (UMG). Over the past 18 months, UMG’s revenue has grown 22% and operating income by 42%. Vivendi has recently agreed to sell up to 20% of this business to Tencent at a €30B valuation, meaning the market has given zero value to its €5 billion portfolio of undervalued securities and its other businesses generating €660 million in operating income. Bolloré’s own stock gives us its African ports and Logistics businesses, which have grown revenue at an estimated 14% over the part 18 months, for free. Sure, the revenue growth is lower than FANG, but these businesses are free. There are numerous buyers for these assets were the group to decide to sell them.
Our entire portfolio has examples of this, almost without exception. Cairn Energy is about to increase its oil reserves by 3x, and its entire African discovery, of over 1 billion barrels of oil reserves, is free at today’s stock price. MEI Pharma has four cancer drugs in development, and the enterprise value has converged to zero. Attempting to cure leukemia and lymphoma for free sounds like a pretty good bet, no matter how speculative it may be.
A Builders’ Approach to Irrationality
In a white paper which we’re submitting for peer review in the next few weeks, we will demonstrate that business Builders intentionally incur lower profit margins in exchange for faster revenue growth. At our coinvestment, while there are some quick wins we will make on restructuring, we will redirect a substantial portion of these wins into untapped areas of growth. The faster the earnings and free cashflow growth, the faster we can redeploy these earnings into further growth. The good news is, our portfolio’s operating earnings are grow ng quite quickly and we have partnered with owner operators that are keen to opportunistically invest in growth.
When looking at a chart that has outperformed peers dramatically, pockets of 20% or even 40% under-performance look like immaterial moves after the company has risen 10x. While I don’t want to minimize our under-performance this year, now that a good portion of our future Alpha is in our control, and the fundamental outlook has only improved from our initial view, we believe the last six or even eighteen months will be looked at as a minor rounding error. We have the data that confirms it, with a portfolio weighted risk-reward at a record level and some of the catalysts now
under our influence.
What we don’t have control over is the irrationality of the stock market. Irrational prices often get even less rational in a marketplace of emotional humans and algorithmic trading systems that accentuate these emotional reactions. While we can predict the fundamentals, we cannot predict the market reactions, though we certainly try. This quarter, we exited our position in Ferrari as the stock has nearly perfectly priced-in the growth over the next few years. This ends a journey that began in 2011 with an investment in Fiat at a valuation of €4.5 billion. The fundamentals of the company steadily improved throughout the entire holding period, but a good portion of the gains to the current combined market capitalizations of €47 billion (excluding dividends) occurred when no announcements were made and the story changed very little. Roughly 2/3 of these gains occurred in 2017, a year with few fundamental surprises, and even fewer announcements. The market just decided that the fundamentals finally mattered.
We will still enjoy the performance of both Fiat and Ferrari through our position in Exor, which trades at a 42% discount to its underlying net asset value, of which cyclical businesses only comprise 30% of the NAV. Furthermore, Exor takes advantage of this irrational discount every day by buying back its own stock at highly accretive levels. Thus, our underlying economic exposure in PartnerRe, Ferrari, FCA and CNH grow every day by just sitting still. We are concurrently publishing a 29-page report to investors today on why Exor still has a healthy weighting in our portfolio despite our cautiousness on global automotive markets and our auto shorts elsewhere in the portfolio.
The Fiat and Ferrari examples only serve to underline that non-rational pricing can be equally non-rational in the timing of when the prices begin to reflect reality. Inevitably, reality sets in over time. While we can’t control the irrationality, we can take advantage of it. Builders routinely take advantage of the emotions of their counter-parties, whether or not they use it to buy or sell assets, or buy their own stock back at opportunistic valuations. Owner-operators actually return less capital to shareholders, surprisingly since they are often the largest shareholder of their company, but when they do pay a dividend or repurchase stock, they are far more opportunistic about deploying the capital than their less conscious competitors with ongoing buyback programs regardless of the stock price. Since we will never use portfolio leverage, we cannot responsibly effectuate our own “buyback,” program on our portfolio, but it has a lot of pent-up alpha in it, and we are using these circumstances to our advantage.
We are in the process of opening a Luxembourg fund at the exact right time. We care deeply about the realized performance of our investors, which is why we cheer the counter–cyclical flows that we’ve experienced. Our asset growth has been slower than it otherwise would have been had we tried to appeal to monthly-focused investors. But the assets come at the right time, when the opportunity set is highly compelling. This is exactly the right moment to be adding new investors to our group.
Another routine characteristic of Builders is their proclivity to defer gratification to a future date. Again, Exor has shown this in not having sold Ferrari, Magneti Marelli, or even Iveco when investors demanded it. They took time to properly grow these businesses, making their sale or eventual market debut far more impactful.
In many respects, our nearly flat performance while the fundamentals of our portfolio have grown substantially, is also unintentionally making us defer the realization of these gains to a future date. Hyperbolic discounting, a cornerstone of behavioral economics, suggests when the long wait is over, the pay-off will be far larger than it otherwise would have been has the market reflected the fundamental growth more rationally. That’s exactly what we experienced with Fiat-Chrysler. We did have to wait a while for our major payoff, but when it came, it came on strong.
While we have waited some time for the market to better reflect the fundamentals of the portfolio, we don’t believe we’ll have to wait much longer. Given our insight into strategic actions at our largest position, we cannot help but be optimistic for the portfolio’s prospects over the coming year. While the time frame for reality to set in can be unpredictable, execution is more predictable and gives us conviction that the fundamental value of our portfolio will accelerate in the coming quarters.
Our behavioral ranking framework seeks to better anticipate these market reactions. During the quarter, this behavioral framework saved us from incurring losses on Criteo and also mitigated losses on TripAdvisor and one of our Canadian shorts. Yet, as our recent performance demonstrates, there is still much room for improvement.
That’s why we can’t wait to announce a new partnership that will help us evolve this framework. Dr. Phil Tetlock of Superforecasting and Good Judgement Inc has shown that groups of well-informed people making forecasts will outperform experts in predicting outcomes. We have always supported full transparency to our investors, and have published very thorough research on the entire portfolio, so we are all well-informed. Furthermore, our investors are some of the most sophisticated investors and business builders in the world. We think we’re very well-positioned to continue improving our behavioral edge with Good Judgement and another looming partnership.
Dr. Tetlock will be at our investor day in New York on September 5 to explain his research and the first partnership. We will also have CEOs of the two companies which have detracted from our performance the most over the past year. We believe they will be two highly important sources of our alpha over the next year, and we look forward to you hearing directly from them and seeing what their vision for the future looks like in just a few weeks. We are eager for this pent-up alpha to translate to better returns in the coming months, just as we welcome a number of new investors into our collaborative group. And of course, at our coinvestment, we look forward to delivering performance that would please even Sergio Marchionne.
Steven Wood, CFA