The 5th Annual Cobas AM Investor Conference took place on 5 May 2021. As always, the investment team updated all investors on the fund manager’s status, how the funds have performed during 2020 and how the portfolio companies have coped with a year marked by the pandemic.
The conference began with a review of the fund manager’s key data. Francisco García Paramés congratulated all unitholders for their stoic market performance. He pointed out that in March last year, when we were all suffering the most both personally and financially, the fund manager saw net inflows and ended the year with a significant stability of assets, close to 97% of continuous.
We moved on to the review of the new fee structure (link), long awaited and eagerly anticipated by participants, which finally saw the light of day in 2021. It is worth noting that Cobas is the first fund manager in Spain to align the fees paid to unitholders according to their commitment to the long term, which is an essential characteristic of our investment style. You can see the explanation of the new fee structure on our YouTube channel (link).
After a review of the Santa Comba Group’s initiatives, Francisco García Paramés announced the creation of the Mayte Juárez Awards for financial education. Our companion has been watching over us from Heaven for a year now.
The time has come to go into detail. The returns of the international portfolio during 2020 were -22.8%, leaving the return since inception at -20.6%, compared to the benchmark, which respectively made -3.3% and accumulated 33.6% since inception.
The Iberian portfolio for the same periods returned -21.6% and -4.4% respectively, compared to the benchmark which returned -9.3% and 11.9% for the same periods.
The market situation and developments over the last few years serve to put the results into perspective. Over the past four years, a headwind has been blowing against our “Value Investing” investment style.
Value Investing has outperformed throughout the recorded history of the markets. From the investment team’s point of view, things that are cheap tend to appreciate in value and things that are expensive should return to their rightful price. How can this be explained? With capital cycles, whereby capital ends up entering where it seems to be highly rewarded, this excess profitability is arbitraged away by the emergence of new competitors, and the additional profitability that the market perceived disappears. So when you set up a Japanese restaurant and it is very successful, new competitors come along and reduce its attractiveness. As a result, the return obtained by the initial investor is diluted.
Financial markets are no stranger to this. When a company trades at 30x earnings, it causes its competitors to want to create a similar business to pay for it at that “exorbitant” price. These multiples are not sustainable over the long term, which makes buying companies at low prices often more profitable in the long run.
As we explained at the 4th Annual Conference, the last 10 years have been bad for value investing, because of the superior attractiveness of growth companies in the eyes of the market this decade. But what explains this market benefit for growth investments? The three key points would be:
· The momentum, or “grace period” that growth investment has had, which, like all good things, comes to an end.
· Passive or index-linked investing, which by its nature does not rationally arbitrage value and price, simply buys the market as a whole, feeding back momentum.
This road through the Value desert of recent years was joined last March by the coronavirus. This totally unpredictable situation, which, fortunately or unfortunately, has favoured investment in growth focused above all on those businesses linked to the internet, etc.
These businesses are precisely the ones that were being most favoured by the two previous points, further increasing the gap between price and value.
· The third point would be the historically low levels of interest rates. This makes it possible to justify otherwise very demanding valuations in businesses that are not going to make money for a long time.
The vaccine has been a turning point in all these trends. Now, what the whole market is wondering is whether this turning point will be extended in time or not.
Let us try to answer this question. In August 2020, before the approval of the vaccines was announced, we were at the worst point in the history of Value since data has been collected. According to comparative records, the spread between Value and Growth went to the 100th percentile, i.e. there has never been a worse period for value investing relative to growth investing.
If we read the report proposed during the Research Affiliates presentation (link), we see that by moving to the 95% percentile, Value should make an extra 37% return over Growth, and if we were to reach the historical average level that extra would be 76%.
This is very interesting as after the dotcom bubble, with the market falling, Value’s excess return was 80%, precisely the excess return that the portfolios managed at the time by Francisco García Paramés had over the same period.
Since November, Value’s relative return has been 16% and our portfolios around 60%. What has happened in the past is that the more time passes, the more abrupt and long-lasting the rotation becomes.
The average of the periods in which Value outperforms Growth is 62 months, this is not unusual because, as we have explained before, when something gains traction it tends to extend over time. The average revaluation was 213% for Value versus 75% for the overall market; a relative return of 138%.
All this is nothing more than what happened in the past and only the future knows what the future holds for each of us. In any case, we can say that a portfolio at 6-7x earnings seems to us to be a good starting point, in order to lay the foundations for future profitability.
We are Value investors because we buy cheap, but we don’t shy away from investing in companies that grow. We do not invest in Warren Buffett’s mythical “cigar butts” that we squeeze the last two puffs out of. Our companies are a combination of value and growth, clearly visible in the three largest positions of the international portfolio.
As we have said, we invest in growth companies, but not at any price. One example is Golar, a world leader in the niche in which it operates. In 4 years it has achieved an EBITDA of 200 million euros and for the next four years it expects to double it, and without paying an excessive multiple for it.
CIR, our second largest investment, has KOS as its main holding asset. This is a nursing home and intensive care business. This is a curious case, as we have been investors for 15 years, and at that time we did not even talk to the company about this business as it was barely making 10 million euros of EBITDA. Before the coronavirus crisis, it generated more than 100 million euros. This reflects how companies evolve over the long term and that things take effort and patience.
The third example is Dixons Carphone. Its electrical products sales business has seen significant growth over the last decade. It has a leading position in all the countries in which it operates. We could be accused of not investing in the evolution of e-commerce; however, more than half of Dixons’ sales are online, and it is growing faster than its competitors. They are absolute leaders in the markets in which they operate and are gaining market share. What we like is to pay 6-7x profit for these deals, not 40x.
Across our portfolio, time is on our side, as each year companies with this combination of value and growth should be worth a little more each year.
In the review of the portfolio ratios there is not much news. The potential remains above 100%, with a high ROCE and with control groups in many of the companies’ shareholdings.
In the Iberian portfolio we have been able to take more advantage of the opportunities generated by the pandemic; however, unlike the international portfolio, where companies presented solid results but that were not reflected in the share price. For example, Teekay LNG, a company with a 32% dividend increase in 2020 and record profits, fell 50% and traded as low as $8 with a dividend yield of 12%.
We now turn to the investment cases. The first to speak was Mingkun Chan, our Shanghai-based investment team member, who talked about the Asian portfolio, which today makes up 7% of the International portfolio, and 15% of the Large Cap portfolio. For the sake of completeness, you can read more about Mingkun’s comments in our Q1 2021 letter (Link).
In summary, the lessons learned in the LG Electronics case are worth highlighting:
· It is impossible to predict the market
· Patience pays by buying business at a discount.
· Family control, more often than not, helps to bring out courage.
Juan Huerta de Soto then presented the development of the automotive sector assumption. Two years ago we explained the reasons why the sector was trading at a significant discount. Among them, we found a fear of the end of the cycle, emission fines and the electric or autonomous vehicle. All this led to companies trading at a negative or close to zero implied value. Since then, of the four companies, three have performed reasonably well and Renault has performed poorly, although the company’s outlook is positive. The results are better because of the dividends paid by these companies.
The performance of the auto sector has been higher than that of the international portfolio in relative terms, and therefore, we have reduced the weight of the companies from 11% to 5%. This is part of our investment process, whereby we adjust the weights in the portfolio according to diminishing potential as the share price rises.
Finally, to close the automotive block, the Porsche assumption was explained, in which we invested to buy Volkswagen at a discount. This assumption helps us to see how the valuation gap is closing. The points that we thought needed to happen for value and price to converge have started to be fulfilled, and that is why we have seen this revaluation of the share price.
Juan highlights the difference between Tesla and Porsche (Volkswagen), where the biggest difference is in capitalisation, with Tesla’s capitalisation being up to 7 times higher than that of Porsche. The market reasons for these prices do not, in our view, justify the large divergence in valuations, let us see why:
· The sales superiority that Tesla used to have, but which will virtually disappear in 2021.
· The technological superiority in batteries. Different reports are already denying it.
· Software superiority: This will eventually be reduced due to Porsche’s higher R&D investment compared to Tesla.
Juan Cantus closed the investment cases with an explanation of Atalaya Mining. Atalaya is the first company that is present in all our funds and one of the main companies of Cobas Iberia. It has one main project, the thousand-year-old Rio Tinto mine, and an incipient project in Touro, Galicia.
The assumption focused on the explanation of Rio Tinto’s mine, which is the company’s core asset. We are confident in investing in a copper mining company, as we have the ability to anticipate very stable and growing demand over the long term. In addition, as with all raw materials, it is very important to study supply. In copper, it is relatively easy, because new projects are few and far between, and it is also easy to follow those that are coming to an end.
We started our investment at an attractive price, even after a revaluation that we have been able to take advantage of, the company is still cheap. It has no debt and has full political support in the area. It is worth noting that CEO Alberto Lavandeira has achieved all production and cost targets, which, given the mine’s two expansions, is remarkable.
Atalaya would have been a typical Value investment where we would have paid less than we received. In November the company announced a new technology, Elix. They have been working on it since 2015. This technology has the potential to transform the market.
The technology will make it possible to produce the final product directly at the mine without having to take it to China for smelting to obtain the final product. This would imply the capacity to extract other minerals that the smelter now kept, the most relevant being zinc. Moreover, this project does not require much investment and is more environmentally friendly than other solutions.
In short, if the technology is successful on an industrial scale, it would increase the value of the mine by recovering margins that are now being taken by other intermediaries such as smelters. It increases the quality and life of the mine by making it possible to exploit hitherto unprofitable deposits, thus making use of all the metals extracted.
Without being too aggressive in our assumptions, we can justify an investment in Atalaya, given the large safety margin with which it trades.
Finally, the closing of the valuation gap and the conclusions were explained. Value will be achieved because the market is efficient over the long term, and companies are taking advantage of this to buy back shares and owners are increasing their investment in them. We are seeing restructuring processes and corporate simplifications, and even takeover bids, which a priori are far from their target price, are interesting because they allow us to buy other things at a bigger discount. The most important thing for this gap to close is that the return of Value that started in November lasts for many years to come.
The conclusions reiterate the messages we have been saying over the years. The potential is high and we maintain our conviction on valuations, we expect the rotation into Value to continue, partly driven by inflation. Value is not at odds with growth. For all these reasons, we are convinced that if the convergence between value and price has not begun yet, it is about to do so. In the meantime, time is on our side as our companies continue to generate value.