2014 Mid-Year Letter. Pelerin Global Value Fund

Transcription

1 2014 Mid-Year Letter To enjoy a reasonable chance for continued better than average results, the investor must follow policies which are (1) inherently sound and promising, and (2) are not popular on Wall Street. Benjamin Graham When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it s not risky at all. Broadly negative opinion can make it the least risky thing since all optimism has been driven out of its price. And, of course, as demonstrated by the experience of Nifty-Fifty investors, when everyone believes something embodies no risk, they usually bid it up to the point where it s enormously risky. No risk is feared, and thus no reward for risk bearing no risk premium is demanded or provided. That can make the thing that s most esteemed the riskiest. Howard Marks Invest at the point of maximum pessimism. John Templeton Pelerin Global Value Fund

2 Dear Investor, Pelerin s NAV increased by an estimated +22% in USD and +23% in EUR, before expenses, in the first 6-months of The key drivers have been (1) a rebound in our small-cap gold mining stocks from extremely depressed and over-sold levels at the end of 2013, (2) continued appreciation of Actelion s share price (+48% year-to-date), (3) and a lack of any material share price declines. It has also been a productive period of research with a number of promising ideas in the research pipeline. We continue to have ample cash on hand to deploy into new opportunities. More on the current opportunity set below. Actelion and Elgin Mining Pelerin s largest position for the last three years has been Swiss pharmaceutical company Actelion. In early June the company announced positive Phase III study results for Selexipag, their oral prostacyclin. Following the data, the stock price has hit new highs in excess of CHF 110/share (our cost is 35-40/share). The company now has a young, high-barrier-to-entry, and very high margin drug franchise in the field of Pulmonary Arterial Hypertension (PAH), with potential peak sales of $3bn. Actelion is a prime acquisition candidate and I would be surprised if they are able to remain independent. Intrinsic value continues to exceed the current share price. In my October letter I discussed Elgin Mining, a small gold mining company with production located in Sweden. During the second half of 2013 we accumulated a stake in the company at an average cost of $0.17/share, a discount to estimated liquidation value. In late May the company announced that it would be acquired by Mandalay Resources for $0.37/share in stock and cash (the offer was worth $0.41 as of June 30 th, due to the subsequent increase in Mandalay s share price). Mandalay apparently saw the same things that attracted us to Elgin: a simple mine in a politically safe jurisdiction, upside to production, exploration potential, hidden assets, solid management, and sunk capital available at pennies on the dollar. Actelion and Elgin are two seemingly disparate examples one being a pharmaceutical company, the other a small-cap gold mining company of a typical Pelerin investment: deeply out-of-favor, historic sunk capital available for purchase at a big discount, limited downside, and free optionality on things getting a little bit better. The Madness of Crowds All through time, people have basically acted and reacted the same way in the market as a result of: greed, fear, ignorance, and hope. Jesse Livermore As stock market investors we must ask ourselves why a given stock is undervalued. In other words, why has the market made a mistake and why do we possess some special knowledge or edge over the market that results in us being able to spot a bargain? Many market mistakes are emotional, as Jesse Livermore stated at the beginning of the 20 th century. Human nature and psychology is a powerful guide to efficiently discovering the market s mistakes. Emotional decision making is the basis for many mis-pricings. The market, as Ben Graham famously said, is a voting machine in the short-term. It sets prices based not only on available information, but on how market participants react to this information (and on expectations of how the market will react.) Introduce emotions and stress into a situation and the less rational investor behavior becomes and the further from intrinsic value prices move. Allocating significant time to looking at whatever is currently most out-of-favor, feared, or neglected (and conversely, to ignore what is currently popular) is an efficient way to look for the market s mistakes. The largest mis-pricings often occur where there is prevalent and intense fear. The investor s protection (margin of safety) becomes the low prices created by the exodus of investors who are happy to get out at

3 any price. Consequently we are often able to buy superior businesses and invest alongside the very best industry operators at discounts to underlying value. A round-about way to investing nirvana. With this approach it is important to have as broad an opportunity set as possible and to remain flexible. This is why Pelerin invests globally across multiple industries. We cannot know where tomorrow s best opportunities will be, so we must remain open-minded and flexible in our willingness to look where others will not. For the same reason, we must also remain flexible in considering the purchase of businesses of varying quality. And finally, we must be mindful that opportunities can arise even when there are serious valuation problems in the broader markets and unresolved macro-economic issues. Perceived Safe-Havens are often Anything but The greatest risk doesn t come from low quality or high volatility. It comes from paying prices that are too high. Howard Marks The USA is the world s most expensive stock market due to wide-spread perception of its safety. Risk (or safety) is, however, primarily a function of price paid, and on this measure the USA is anything but safe. The Shiller PE exceeds 25x, historically an extremely elevated level from which expected returns in the next 7-10 years are close to 0% (see the 2013 Investor Letter for a more thorough discussion). Add to this the headwinds from unsustainable debt levels, divisive politics, and distortions created by years of government and Federal Reserve intervention into the economy and markets. For perhaps the first time in my life I do not own a single US stock (excepting foreign ADR s.) There are other perceived safe havens today that may disappoint investors over the next 5-10 years. Government bonds are the obvious one, and I have covered this topic in past letters. So called Quality Stocks, by which most investors mean consumer product companies, are another, less obvious one. While not taken (yet) to the extremes of the Nifty-Fifty craze in the 1970 s, perhaps we are experiencing a mini-echo of it. Over the past few years there has been a trend in the value investing community towards buying quality. This likely stems from Warren Buffett s observation that he evolved from buying cheap stocks to buying good businesses, and the understandable desire of many investors to emulate the Oracle. Buffett rightly attributes some of Berkshire s superior returns to this change of mentality. What is not discussed are the prices at which quality US consumer franchises were available in the 1980 s vs. today. Nor is the relative suitability of the return profiles of various types of businesses and stocks to Berkshire s insurance float-driven holding company structure well understood. The currently elevated profit margins of many of these companies relative to history are also frequently neglected in analysis. High-quality businesses which are undervalued are investing nirvana due to the power of long-term compounding and minimum increment of additional research effort. The problem with high-quality companies and consumer franchises is that today everyone knows they are great businesses, and a large part of the investment world is consequently attracted to owning them. It is pretty tough to have some unique insight or advantage in this area. High-quality businesses which are over-valued contain no margin of safety and can produce very mediocre and even negative returns for extended periods of time. By way of example, Coca-Cola s all-time high stock price of $42.75 was June 30, On June 30, 2014 the stock traded at $ For 16-years anyone who bought shares in June of 1998, of what is arguably the world s premier consumer franchise, has been left with returns derived entirely from a dividend that has averaged 1.5% of the 1998 purchase price. That 1.5% is pre-tax and before considering the effects of inflation. At its current share price, Coke still trades at a trailing PE of 20.5x. Price paid matters in investing. A lot.

4 Current Opportunity Set People are always asking me where the outlook is good, but that s the wrong question. The right question is: Where is the outlook the most miserable? John Templeton As chronicled in my last several letters, small-cap gold mining stocks continue to look like one of the best opportunities I have come across in 20-years of investing. Many stocks trade at significant discounts to intrinsic value, assuming current production levels and gold prices. Additional upside exists in (1) internal operational improvements, (2) free optionality around discoveries, (3) mergers or acquisitions, and (4) any upward movement in the gold price. Rarely is sentiment towards any industry or group of companies as negative as it is towards small gold stocks. This negative sentiment is fuel for a future boom. Another area of research over the last several months has been in a niche area within oil & gas infrastructure. Following a 5-10 year period of poor industry returns driven by project cost over-runs, irrational competitive behavior, and an abundance of capital availability, several bargains appear to be available among the survivors in this particular niche. We have been buying shares of two companies with long-term contractual cash flows, which are trading at discounts to contract run-off values. Furthermore, the competitive dynamics have radically changed such that new contracts should generate 20%+ ROE s with far better terms and conditions than those of 5-years ago. Barriers to entry have increased considerably, demand is growing, massive consolidation has taken place, and there is a shortage of capital available for completing what are essential oil infrastructure projects. If returns do not improve, the industry will disappear, an unlikely event. If I am wrong about the changing industry dynamics, we should still do reasonably well given the discount to present values of the cash flows their existing assets will generate. If I am correct about the industry, then we can look forward to a period of growing earnings, increasing returns on capital, and a material reappraisal of corporate values by the market over the coming 3-5 years. I will write more about the individual stocks at year-end. In stark contrast to current bullish sentiment towards US capital markets, three of the four BRIC s (Brazil, Russia, India, and China), have fallen dramatically out of favor. While the S&P 500 has been hitting new highs, the stock markets of the world s major economic growth engines have experienced bear markets (India is the exception). Where just a few years ago investors viewed these markets as must own for their perceived superior secular growth rates, the focus is now on the endemic corruption, poor corporate governance, autocratic political rule, currency volatility, and non-western legal systems. While all of these aspects are undoubtedly true (though far from new), these major economies continue to have minimal debt in relation to Europe and the USA, hard-working young populations, growing economies, improving levels of corporate governance, and governmental drives to reduce corruption. Brazil s stock market declined -55% from its peak through early China is similarly down -54% and the market trades at 9x trailing earnings. Russia too saw its stock market decline -55% through early 2014 and is trading at just 5x earnings. Deeper bargains are available in specific stocks. The valuations the market is ascribing to select major, essential corporations are a fraction of similar companies in the USA or Europe. Electric utilities in Brazil and Russia trade at 15-30% of book value (and book values understate replacement cost significantly) and have dividend yields of 8-15%. Select oil companies in Russia can be bought at 3-5x earnings and ev/reserves of $2-5/boe with dividend yields of 5-10%. Utility peers in the US trade at x book, and oil stocks at 11-15x earnings and $25-40/boe of reserves. Dividend yields in Russia and Brazil are 3-4x those available on comparable US companies. The current sentiment towards the BRIC countries relative to the USA and Europe is similar to the 1990 s, the last time such an extreme divergence in valuations occurred. Investors in the 90 s who were brave enough to buy the extreme bargains available in places like Russia and Brazil were rewarded with share price increases of 5-10x in many cases as prices converged with the growing business values. Warren Buffett once said, You pay a very high price in the stock market for a cheery consensus. The corollary is that sometimes prices are so low that there is very little risk at all. With low prices comes a

5 margin of safety and asymmetric returns (far more upside than downside). It is an interesting feature of markets that often the scariest places are the least risky, while the seemingly safe havens are anything but. We currently have less than 5% of our assets invested in stocks in these countries, but this number may increase in coming months as individual company research advances. There were no other material additions to the portfolio in the first half of the year. We did acquire, as alluded to in my last letter, a small stake in a company in Cyprus called A&P Enterprises. This company holds the local Pepsi distribution franchise and has nearly 40% market share in the local carbonated beverage business (Coke having ~60%). We were able to purchase our stake at a discount to net working capital as a result of the combination of the complete collapse of the Cyprus stock market (-98% peak to trough) and a simultaneous restructuring of A&P s parent company s regional bottling activities. If the business were to return to historic levels of profitability in , we should have a 10-15% annual dividend yield and a stock trading at 6x earnings. This is a tiny position for us at ~1% of our assets. The stock is very illiquid and the limited market size means that it will always be so. We had a chance to acquire a much larger stake (nothing in between) but there is a mis-match between the liquidity of the position and our open-ended fund structure. I could not entirely pass on an opportunity to buy a Pepsi franchise at a discount to net working capital (and almost to net cash). We get the business for free. Organizational Notes It has now been six months since we changed our terms to emulate the original Buffett partnership structure 1. These changes have reduced expenses, altered the fee structure, and bring a less-frequent, more rational reporting schedule. Looking ahead, expenses will continue to decline in percentage terms and my goal will be to get them as close to 0% of assets as is possible over time. The expense ratio should see another significant decline in 2015 with a forecast higher asset base, lower operational costs, and no foreseen major legal expense items. I enjoy waking up each morning knowing that our investors have the most ethical (and most economical) deal in the investment world. I stand to make money only by doing really well for you over time. The next scheduled communication from Pelerin will be in early October with a reminder about our 2014 year-end subscription and redemption date. I hope you might consider adding to your investment in Pelerin in December, or perhaps refer like-minded friends and colleagues. We would all benefit in various ways from a slightly larger pool of assets. I spend no time marketing and therefore am entirely reliant on word-of-mouth. I prefer, instead, to spend as much time as possible on what really matters: investment research. I am grateful for your continued confidence and support in these still early days of our investment partnership. I am available should you want to discuss any aspect of our investment operation. Darren Maupin Executive Director 1 Unlike with investing in Buffett-style, high-quality businesses, almost no one has emulated Buffett s structure