We are publishing 3G Capital Management's most recent annual letter. We welcome shareholder updates from fund managers; the updates can be emailed directly to email@example.com
January 18, 2013
The Partnership’s gain net of fees for the year of 2012 was 25.1% versus a gain of 16.0% for the S&P 500. Your actual performance may differ depending on the date you became a Partner.
The table below summarizes the Partnership’s historical performance (net of fees) since inception:
3G Capital (net of fees)2
The Partnership produced a strong result in 2012, but we do not necessarily see it as a cause for celebration. As we said before, we are focused on producing strong returns over the long-term – which we define as three to five years – rather than in any single year.
In the past five years beginning January 1, 2008 the Partnership generated an annual return (net of fees) of 14.6% compared to 1.7% for the S&P 500, and outperformed 99% of all American equity funds4. Over time the percentage difference adds up to a staggering number. If an investor was to give us $1 million five years ago, he would have accumulated $2.0 million vs. a mere $1.1 million had he chosen to invest in the S&P 500 instead, resulting in profits of $1.0 million and $0.1 million, respectively.
Notably, this outsized performance occurred during what was probably the most turbulent market environment since the Great Depression, as it witnessed the Lehman bankruptcy, the virtual closure of the credit markets, the Euro crisis, and the debt ceiling debacle, to name a few. Yet, the Partnership trounced the market by a wide margin during both the downturn and the recovery.
We achieved the above results by investing in a highly concentrated portfolio of high- quality well-managed businesses purchased at a discount to the intrinsic value. Equally important, we had the discipline to make investment decisions based on hard data and sound reasoning as they apply to specific businesses, as opposed to worrying what the global economy or the Fed are about to do next.
We are confident that our track record of long-term outperformance will continue. The volatility experienced last year by the global equity markets enabled us to add to our collection of high-quality businesses at bargain-basement prices. Hence, as we enter 2013, we expect to do very well over the next three to five years.
We expect to deliver above-average returns going forward by following the same approach that produced superior performance in the past:
- Invest in high-quality, easy-to-understand businesses, whose products and services are virtually guaranteed to be desired or needed 5, 10, and 20 years from now – regardless of changes in technology, demographic trends, or commodities prices;
- Focus on businesses that carry little debt, and preferably enjoy substantial cash positions;
- Partner with management teams whose interests are aligned with those of shareholders’, preferably through meaningful equity ownership;
- Purchase these businesses at attractive valuations, defined as less than 10X normalized sustainable Free Cash Flow.
As of the end of 2012 the Partnership was 106% invested compared to 103% invested at the end of the first half of 2012. The percentage of assets invested experienced a slight increase primarily due to the timing of asset inflows. Despite our general reluctance for using leverage, we used a small margin at the end of the year to take advantage of the opportunities, which we do not expect to persist for an extended period of time.
[The table with the Partnership’s portfolio composition as of December 31 has been redacted, at the fund's request]
Performance and Positions Discussion
While virtually all of our holdings appreciated in the second half of 2012, the largest positive contributor to the overall performance of the Partnership during the period was HomeServe PLC (HSV.United Kingdom) (OTC:HMSVF, OTC:HMSVY).
HSV is the largest independent provider of home emergency repair services in the United Kingdom. HSV teams up with utility companies through an outsourcing arrangement to service the needs of the utilities’ customers with respect to home emergency repairs related to plumbing, heating, electrics, etc. In exchange for a small monthly fee, HSV guarantees homeowners that if a pipe bursts or a boiler breaks the company will fix the problem in a timely manner and to a high standard.
A central element to the business of emergency home repairs is to persuade utilities (also known as “affinity partners”) to outsource such services to a third party and provide access to branding and customer database, as this significantly lowers the cost of customer acquisition. HSV is the premier player in the space due to its track record of providing services with a high degree of customer satisfaction (over 95%) and growing the book of businesses (which means higher referral fees for the utility). Since there is not an independent provider in the industry who can match HSV’s qualifications, the affinity partners have little incentive to risk their reputation by outsourcing emergency repair services to a competitor. Further, the fact that HSV owns the book of business introduces an additional switching cost, as a utility that changes providers faces a substantially lower referral fee stream for at least a few years.
As a result of the aforementioned advantages, HSV has been able to grow its revenues at double digit rates over time while generating returns on equity of well above 20% while carrying little debt. Further, the company should be able to maintain a decent pace of growth going forward as it expands in international markets, which have a much lower penetration rate of membership-based repair services than the United Kingdom.
HSV’s CEO, Richard Harpin, started the business with a £100,000 investment in 1993, and has great track record of creating significant shareholder value, as over the years he built the company into the largest independent home emergency repairs provider in the UK with revenues and pre-tax profits of over £500 million and £100 million, respectively. The CEO retains a significant equity stake in the business, thus aligning his interests with those of the shareholders’.
HSV shares plummeted in May of 2012 when the British financial watchdog FSA launched a probe to determine if the company had engaged in improper selling practices with respect to some of its home repair policies. The investing public’s fears were misguided in our view, as there was little risk that the outcome of the investigation would negatively impact the economics of HSV’s business in a material way:
- The company’s reputation has remained largely untarnished both with the customers and with the affinity partners. For example, less than 1/5 of 1% of customer policy cancellations were attributable to the FSA investigation; not a single utility discontinued its relationship with HSV over the probe (although one affinity partner put active marketing on hold pending the outcome);
- There was little risk that the profitability of the business would suffer permanent damage as a result of FSA-imposed restrictions on selling key products, something that happened to another British affinity marketer, CPP Group PLC. In HSV’s case, the FSA probe was limited to certain policies sold prior to the fall of 2011; the watchdog was satisfied with the company’s marketing and customer service practices from that point on;
- HSV should be easily able to handle an FSA fine, if one is imposed, and related costs. The expected total “clean up” cost is approximately £20 million, which is modest compared to the company’s annual EBIT of over £100 million and debt of only £60 million.
We were able to take advantage of the market dislocation and purchased HSV’s shares for less than 8X Free Cash Flow; the shares also sported a 7% dividend yield. While the stock appreciated significantly following our purchase, it remains undervalued, and we plan to hold our position until either the price approaches intrinsic value or better investment opportunities emerge.
Another notable contribution to the Partnership’s positive performance in the second half of the year is attributable to the preferred shares of AMOREPACIFIC Corp. (090435.South Korea). (In South Korea the term “preferred shares” refers to non-voting common shares – with the exception of voting rights, these “preferred shares” are virtually identical to voting common shares in terms of ownership claims.)
AMOREPACIFIC dominates the South Korean cosmetics industry with a 35% market share, which is more than 3X larger than that of the next biggest competitor, as the company boasts four of the country’s five top-selling cosmetics brands. The dominant scale lends the company a number of important hard-to-replicate advantages with respect to consumer awareness, marketing expenditures, distribution, and new product development. As a result, AMOREPACIFIC is able to consistently expand sales at the expense of its smaller rivals while generating returns on equity in the mid- to high-teens.
AMOREPACIFIC has a highly qualified and operationally astute management team. The company’s Cornell-educated CEO, Kyung-Bae Suh, was instrumental in turning the company from a debt-laden bloated conglomerate, which included an insurance company and a baseball team, into a cosmetics-focused company with a strong balance sheet. In addition, the CEO has an approximately 10% equity stake in AMOREPACIFIC, thus ensuring the alignment of interests with shareholders.
We purchased the shares of AMOREPACIFIC in the first half of 2012 at a highly attractive valuation of just over 5.5X CFY EPS. While AMOREPACIFIC appreciated significantly since our purchase, the company’s shares remain undervalued, and we plan to hold them until either the gap between the price and the underlying intrinsic value narrows or more attractive investment opportunities emerge.
You will find your year-end statement reflecting net asset value of your investment enclosed with this letter. As far as K-1s are concerned, you should be receiving them from us by mid-March.
As always, we welcome your inquiries about our activities this year, as well as about our general investing philosophy, so please do not hesitate to give us a call if you have any questions or concerns.
Pavel Begun and Cory Bailey
1) Cumulative since inception on July 1, 2004
2) The Partnership’s net return reflects the experience of an investor who joined the Partnership at inception, and did not add to or withdraw from the Partnership through the end of the most recently reported period
3) S&P 500 performance includes dividends
4) According to Morningstar only 1 fund out of its universe of 5,949 diversified U.S. Stock funds generated a return higher than that of 3G Capital (net of fees) for the five-year period ending December 31, 2012
- This information is provided for informational purposes only and does not constitute an offer to sell or a solicitation of an offer to purchase an interest in the Partnership. Such an offer, if made, would be made solely to prospective investors whose suitability has been established and solely by way of a confidential private placement memorandum approved for use by the General Partner.
- The financial performance figures presented in this report are unaudited estimates based on the best information available at the time of the letter, and are subject to subsequent revision by the Partnership’s auditors.
- Past results are not necessarily indicative of future performance.
- The S&P 500 Index (“Index”) return is provided solely because it is believed to be a widely used performance benchmark. 3G Capital traded securities that are not included in the Index and an investment in the Partnership should not be construed as an investment in the Index or a program that seeks to replicate, or correlate with, the Index. The Index includes dividends reinvested.