GreenWood Investors 2Q15 Letter: Long Fiat ThesisVW Staff
Dear GreenWood Investors letter to investors for the second quarter ended June 30, 2015.
Dear GreenWood Investor:
While this quarter was a much less interesting than the first quarter, looking forward, our portfolio has been restacked with opportunities and has a better collective risk-adjusted return profile than ever before. When we began the year, our risk-adjusted return profile was 13.8 to 1. As we head into the third quarter, the ratio has been restored to a new peak, an outstanding 15.2 to 1. Our portfolio’s estimated year-end fair value is 55% higher than its current net liquidation value, with even better gains available through good management execution next year. These estimates are primarily fueled by the increases in profitability at Fiat-Chrysler (FCA), Finmeccanica, Flybe and Exor. These four horsemen represent roughly two-thirds of the projected return potential for the next year and a half. Of course, the complexity of the world is one which guarantees these estimates will only be theoretical, but I share these statistics because I care more about future performance than past. The view from the cockpit has never looked better, and as FCA beats estimates in the upcoming quarter, spins off Ferrari in October and crushes 2016 income estimates, Marchionne will be working for us harder than ever before.
The gentleman that provided much of the inspiration for starting GreenWood Investors, Walter Carucci, would be pleased with the pace of activity at GreenWood. The flow of ideas through our diligence and ranking framework has accelerated markedly in the most recent quarters. This has allowed us to continue ensuring we prune our portfolio of any aged ideas that are no longer as attractive or timely. We’ve exited our positions in Audika (ADI FP), Approach Resources (AREX) and Heron Therapeutics (HRTX), and have reduced our stakes in Ambase (ABCP) and Internet Patents Corp (PTNT). We think all of these investments have further upside (or in AREX’s case, rebound potential), but we are finding far better value on the other side of the Atlantic.
GreenWood Investors: Portfolio activity
As exhibit 2 clearly demonstrates, our portfolio has become almost entirely international, as nearly all of these companies are based in Europe. We aren’t trying to become a solely European-focused investor, and have done diligence on numerous domestic companies recently, but only European markets are priced highly attractively right now. Latin American markets have gotten more interesting recently, and I’m eager to take a diligence trip in the upcoming quarter. During the quarter, we attended a conference held by the staff of the New York City Comptroller (which controls the city’s pensions), where they explained they don’t prefer “global,” mandates and instead liked to segment funds in geographical buckets. While we can tailor our portfolio to any specific situations an investor wants (given our ability to manage a separate account), we will never give up our global mandate. Continuing to evaluate US companies next to European or even Asian firms allows us to go where the tides are low. This bottoms-up analysis helps us make better-informed decisions about the opportunity sets available in various industries and countries.
It will come as no surprise that it’s currently high tide for the U.S. equity markets. Yet, there are a lot of sand-dollars exposed by the low-tide in Europe. These “dollars,” also happen to be trading at fractions of their dollar value, and at far lower valuations than their U.S. competitors, who are frequently more poorly managed, particular in the automotive industry.
Nearly three years after our investment in the shares, FCA remains the most attractive position in our portfolio. As has been very typical from our experience over the last few years, negative and false news stories have been recirculating about the company’s prospects. The media is claiming CEO Sergio Marchionne is desperate to merge FCA into a larger company, with ensuing speculation that his industrial plan is about to fail. First off, most of the reports that FCA is reaching out to shareholders and activists are completely false. Secondly, if Marchionne was about to miss his ambitious targets set last year, he wouldn’t have let his CFO commit to doubling North American operating income by the end of the year, just five minutes before he gave his ground-breaking merger presentation. North American profit margins have been a key overhang for the company, as they are less than half of Ford’s and GM’s with a similar product mix. As we detailed last August, North America is really just a pricing story for FCA. As the company refreshes the ghosts of its under-invested past, incentives on these ancient cars are rolling off. We demonstrated how by Q1 2015, pricing would be increasing by $281 million a quarter. In the first quarter, the company has gotten over 80% of the way there, and will be exceeding this in the second quarter. If we take global economic factors out of the equation, modeling out FCA’s results has actually been quite easy. We continue to be astounded that the sell-side analyst community continue to do such a poor job analyzing FCA and its trajectory. Current estimates for 2016 operating profit at the company are 38% below our estimates and we think shares of FCA will at least double by this time next year. While we trimmed our position earlier in the quarter, as it became apparent to us that the company would miss these inept sell-side estimates of the first quarter results, we have used the subsequent weakness to repurchase much of these shares. FCA and Exor remain our largest positions, collectively representing 21% of the portfolio (23% for our Global Micro strategy).
Speaking of Exor, venerable CEO John Elkann has made an aggressive push to take-over the world’s largest independent reinsurer, PartnerRe (PRE), in a superior deal to a previous arrangement the management team had made. PRE’s management has continued to make a bad decision in recommending an inferior merger proposal, and upon successful completion of the deal, we expect John to replace them expediently. While being the great-great-grandson of Giovanni Agnelli (the founder of Fiat and many other large Italian industrial businesses) didn’t properly qualify Elkann for the job, he is proving to be adept at investing and managing his investments in a way that puts value creation first. His style is concentrated, contrarian and deep-value oriented, as he’ll only have three major investments after the deal is completed. We love all three. He’s following a path that Warren Buffett followed early in his career, but starting with better investments and a lower base of capital (his holding company is also trading at a discount, enabling accretive share repurchases) and in a better tax domicile (that’s right, Italy has a superior tax code to America for holding companies). We will ideally hold Exor shares forever, and we think Elkann has a shot at beating Berkshire’s own track record which created countless billionaires.
GreenWood Investors: European volatility
We have used the recent double punch of European volatility and a guidance reset at Rolls Royce (RR/ LN) to build a core position in the company. We’ve done extensive work on the significant profit margin opportunity ahead of Rolls and have constructively engaged the company to share our conclusions. Just last week, the company replaced its underperforming CEO with Warren East from ARM Holdings. Warren built ARM from a small British company to the dominant designer of mobile microchips, making a mockery of the Intel Goliath. Notably, East achieved such a feat while also returning substantial sums of cash back to shareholders through dividends and stock repurchases. Warren enters Rolls at a time when the company is embarking on an unprecedented growth rate in its installed base of jet engine, as it currently has the most efficient large engine in the world. As a result, the company has been able to secure exclusive positions on most of Airbus’s wide-body planes, which are also the most efficient in the world (despite Boeing always trying to deny this). Rolls will be the fastest grower in the commercial aerospace industry, yet its shares are the cheapest in the industry and the valuation reflects deep pessimism today.
Similar to FCA’s North American profit margin opportunity, traders have lamented Rolls Royce’s profit margin gap vs. its main competitor, GE Aviation, as well as its poor historical management which dramatically lowered the firm’s return on invested capital (ROIC). Simply by following his own playbook used at ARM, we believe East will be able to nearly double the profit margins of the company’s civil aerospace division and restore ROIC back to attractive levels north of 20%. With just a few small acquisitions, large-scale 3D printing and some share repurchases, we think Rolls shares are worth nearly five times today’s price over our typical time horizon. If we ask any American investors which blue chip companies can quintuple in a few years, all we get back are blank stares. The jet engine business has some of the highest competitive barriers to entry in the world, and as Rolls seeks to improve the fuel efficiency of its industry-leading engines into the next decade (with a 25% reduction in fuel burn), the company has a decent chance at monopolizing the wide-body engine market, the fastest growing segment of the civil aerospace industry. Thankfully, East will have a daily reminder on his morning commute to, “mind the gap,” between his margins and GE Aviation’s. We’ve mailed our report to investors and friends concurrently with this letter, but please feel free to email us if you didn’t get a copy.
GreenWood Investors: Greek government's incompetency
We are thrilled with the volatility recently introduced by the incompetent Greek government's actions to shut down all economic activity. It has allowed us to continue to build European positions at great prices and also looks set to destroy populist movements in Europe. This will be the key to restoring fundamental and robust economic growth to the region which has failed to escape the recession that began eight years ago. Plato predicted that democracy was unsustainable over the long-term, as it was dependent on an uninformed population making intelligent decisions. As we know from the stock market irrationality, not even the brightest minds can always get it right. Plato’s country has proved him right, as have the French, as they’ve both elected leaders which have pursued highly unintelligent policies. But when push comes to shove, democracy doesn't control the world, capitalism does. Capital markets have all but shut down any ambitions the Greeks have for communist policies. The French electorate elected a socialist president who incredulously tried to pass contractionary economic policies, such as lowering the retirement age. Last fall, he had a lower approval than the notoriously abysmal US Congressional approval rating, and his economy has remained stagnant. Let's contrast his actions with England, Spain and even Italy (lately). All have passed deficit-reducing budgets with pro-growth economic policies and their economies are at various stages of recovering. The British have smartly and unexpectedly given its pro-business government an enhanced mandate for a second term, and the extreme juxtaposition of British robust economic growth with that of Europe’s must be giving the Brits smiles today. Italy is far behind Britain with reforms, but the government has used its popular support to pass business-friendly labor market reforms and payroll tax reductions. Italian consumer sentiment and auto sales are starting to reflect a significantly better economy, and the recovery from an effective depression will lead to very significant growth for the country.
By not caving into socialist demands, the Germans and Europeans have very effectively shown the Greek population what the result of socialist/communist policies do to a society. These past two weeks they were treated to a shut down of capital markets and banks and dwindling stocks in the grocery store, all while they get to live with an inept government bureaucracy and a very large black market that increases the cost of living. We imagine the discussion between German leaders with the Greek government have been akin to Apple executives meeting with AT&T or other wireless carriers. While their counterparts may be wondering where the power in the negotiations sit, there’s no doubt on Apple’s side.
As we celebrate our American freedom in the wake of our Independence Day, let us be thankful we live in a capitalist world where everyone is free to contribute to society by creating value. Outside of this week, even the Chinese Communist party has embraced mostly capitalist policies, and in doing so, has lifted the living standards of the largest population on the planet. We endeavor to aid in the wealth creation process by backing great management teams pulling operational levers to create meaningful value for all of its stakeholders, and do so at very cheap prices, thanks to the irrationality of crowds. We would also love to participate in the value creation process, and Rolls is our first step in that direction. We are hopeful that our latest investment will join our other related investments in Flybe and Finmeccanica, and help our results this year truly take flight. Thank you for your trust and interest!
Steven Wood, CFA