Emerging Value Capital Management Q2'16 Letter

by: ValueWalk

By VW Staff

Dear Partners and Shareholders,

For the second quarter of 2016, EVCM fund returned an estimated +0.1% net to investors. Stock markets worldwide were slightly up in the quarter, with the All Country World Index (NASDAQ:ACWI) and the HFRI Equity Hedge Index up +1.0% and up +1.4% respectively.

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Since inception (10/15/2008), EVCM fund returned an estimated +98.1% (net to investors). During this same time period, the MSCI All Country World Index (ACWI) and the HFRI Equity Hedge Index returned approximately +85.3% and +42.4% respectively.

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Emerging Value Capital Management Q2 Market and Portfolio Overview

The big story in Q2 was the "Brexit" - the surprise vote in the United Kingdom (UK) to leave the European Union (EU). The UK was always a somewhat reluctant member of the EU, and even declined to adopt the euro in place of the British pound. Still, investors and markets were surprised by the vote's outcome and responded negatively, with market declines of 5-15%. It remains unclear what the Brexit will look like and when it will occur (with some analysts even doubting it will really happen). Of even bigger concern is the possibility of a domino effect that will lead additional countries to also decide to leave the EU (Italy, France, Hungary, etc). One or more potentially messy "divorces" could have severe and unforeseen circumstances and could lead to a recession, or worse.

Possible member country exits are only one of multiple severe problems faced by the EU. No less worrisome is the inability of most European countries to embrace capitalism and, instead, persist with economically stifling socialist policies. We can look at the rapid economic recovery of the US since the financial crisis of 2008 and compare it to the slow economic stagnation of most European countries to clearly see the vast economic benefits of capitalism over socialism. Additionally, Europe faces a migrant crisis of frightening proportion. Millions of refugees flood Europe every year, overwhelming its capacity to absorb and integrate them. Completely open borders, poor screening, deficient tracking, and minimal cultural integration are subpar mechanisms for dealing with such a large influx of refugees.

Finally, Europe is facing a growing wave of terrorist attacks. Much of this is home-grown terrorism inspired and aided by Islamic terrorist groups. As far as we can tell, Europe's response is mostly rhetoric, with little concrete and effective action being taken to deal with these attacks and prevent the next ones. Europe should learn from Israel as the world's most effective model for fighting terrorism.

We remain pessimistic regarding Europe's future, and continue to have no investments in the continent. Given its multiple severe problems, we would expect to find European stocks trading at dirt-cheap levels. Instead, we find them to be only somewhat cheapish. We can find cheaper stocks in other, non-distressed areas of the world, such as the US, Israel and South Korea, and prefer to invest our capital there.

While we have no direct investments in Europe and minimal indirect exposure, our portfolio did decline with the markets, particularly our financial stocks. We view these declines as short-term market fluctuations (our stocks have already mostly recovered), and they are not a cause for concern.

We made few changes to our portfolio in Q2 because we like what we own and did not find anything better to buy. With very few exceptions, all companies in our portfolio are performing well, continuing to generate strong cash flows and increase intrinsic value. Since stock prices were mostly flat in Q2, this means the stocks we own became cheaper (intrinsic value increased and stock prices remained constant). Over time, we expect this increase in value to be fully reflected in the price of our stocks. We continue to think we have the highest-quality portfolio in our history, that our companies trade at large (and growing) discounts to their intrinsic business values, and that we are invested in the best economies in the world (the US, South Korea, and Israel). Therefore, we remain optimistic about future performance.

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In the next section, we will go into greater detail on some of these positions. For now, however, we think it is important to point out that our top 10 longs make up over 70% of our long exposure, as we have increased the position sizes of our highest conviction ideas. As of quarter end, we were 83% long and 5% short. Our overall net exposure level of 78% reflects the compelling bargains we are finding in global stock markets, combined with a reasonably sized cash position (17%) that we will utilize to take advantage of any downside volatility.

Our main contributors in Q2-2016

Despite our overall bullishness on our current portfolio, it remained flat and slightly underperformed the markets in the second quarter. Our main contributors to performance in the second quarter were Amerco (NASDAQ:UHAL), Isras Investments, Howard Hughes Corp. (NYSE:HHC) and Samsung Electronics (OTC:SSNLF).

Amerco

Operating under the UHAL brand, Amerco is the leader in the North America "do-it-yourself" moving and storage industry. The UHAL brand is by far the most well-recognized and dominant brand in the industry. With 20,000 locations and a fleet of over 200,000 moving trucks, Amerco has about 50% market share and is much larger than its main competitors, Budget and Penske (NYSE:PAG). Amerco enjoys multiple competitive advantages, including economies of scale, network effects, dominant brand recognition, cross-selling between self-moving and self-storage, and high-quality management.

Amerco has leveraged its domain position in moving truck rentals to expand into the self-storage segment. The company now owns over 38 million square feet of storage space at more than 1100 facilities. The self-storage segment is very synergetic with the self-moving segment, since many people who move also require temporary storage space for their possessions. Amerco's self-storage properties are a hidden asset. If the company spins them off into a REIT in the future, it could unlock shareholder value. Comparable self-storage companies trade around 14X revenues. This implies about $3 billion value for Amerco's self-storage real estate - about 40% of the company's current market cap.

Amerco's self-moving segment is growing at over 8% per year and its self-storage segment is growing at about 5% per year. We expect these growth rates can be sustained for many years into the future, since the company faces no material technological or competitive challenges. Amerco's business lines are recession-resistant, since more people choose to self-move in difficult economic times. During the 2008 financial crisis, its business was not materially affected. Valuation is also attractive, with Amerco trading at an estimates P/E ratio of 14, 8 times cash flow from operations and 8 times Enterprise Value to EBITDA.

Isras Investments

Isras is a leading real estate development company with a valuable portfolio of retail, residential and office properties owned and under development all across Israel. Following an excellent 2015, the company reported a strong Q1 2106. The recent addition of Isras into the Tel Aviv 100 stock index also helped push up the stock price as investors became aware of the company and its cheapness (both absolute and relative to peers).

We invested in Isras right after management announced a new dividend policy where they would pay out an annual dividend equal to 35% of FFO (about 3% dividend yield). Our thesis was that the company is shifting its focus from extensive real estate asset development to real estate asset management.

We continue to hold the stock today, as its book value of 1.83 billion ILS understates the company's true economic value for several reasons. First, Isras values its yielding assets at 7.75-9% cap rates, which are above market rates. Second, the company owns land assets recorded at low historical purchase costs which have not yet been marked up on its books. Third, Isras has tax loss assets that are not on its books. The company trades for less than book value and about 80% of our estimate of adjusted book value. In comparison, peers trade for about 120% of book value, implying significant additional upside for Isras.

Howard Hughes Corp.

Combining unique and hugely valuable trophy development assets with an excellent and highly incentivized management team, HHC is arguably the world's "best" real estate company.

Noteworthy assets include:

  • Ward Centers in Honolulu - 60 acres of underdeveloped ocean front property where HHC is building several towers with high-end residential and commercial spaces.
  • Summerlin MPC in Las Vegas - Developing 22,500 acres of in-demand residential, retail, and office space.
  • South Street Sea Port in Manhattan - Developing over a million square feet of high-end retail space.
  • Houston, Texas MPCs (Bridgeland and Woodlands) - Developing over 30,000 acres of in demand residential, commercial, office, and hotel spaces.
  • Additional valuable assets under development in Princeton, NJ; New Orleans; Alexandria, VA; and Columbia, MD.

As in previous years, HHC continues to make strong progress developing its assets into income-producing properties. The stock recovered somewhat in 2016 as concerns about the Houston MPCs' indirect exposure to energy proved overdone. Oil & gas account for only 11% of Houston's economy, and the Houston MPCs account for only about 25% of HHC's assets. While HHC did experience a slowdown in Houston area sales, it was not as severe as the markets initially expected.

We estimate HHC's net asset value to be around $190 per share and growing. The current share price ($118) seems compelling to us, and provides a potential double (or more) over the next few years as net asset value increases. We believe the company will restructure itself as a REIT once its ongoing NOI becomes significant, and this could serve as a catalyst for the markets to recognize its intrinsic value.

Samsung Electronics

Samsung Electronics, the world's largest integrated consumer electronics manufacturer, reported good Q2 results driven by strong Galaxy S7 smartphone sales, improvements in the consumer electronics segment, and the expectation that memory circuit sales (DRAM and NAND) are recovering from a cyclical low point. The company even surpassed Apple (NASDAQ:AAPL) in US smartphone market share, a strong indication that consumers love the S7.

While investors remain overly focused on smartphones, we feel they fail to notice Samsung's many other highly valuable business segments (DRAM, NAND, chipsets, displays, digital cameras, television sets, tablets, laptops, networking equipment, and home appliances) as well as its competitive moat. Thanks to its size, the company enjoys low manufacturing costs (economies of scale) and high bargaining power with suppliers. To put its size in perspective, Samsung sells twice as many smartphones as Apple. The company gains additional competitive advantages from its vertical integration, with internal production of many of its own chipsets, memory circuits, and displays.

The consumer electronics space continues to expand, with new product categories emerging that did not even exist a few years ago, such as house cleaning robots, smart watches, virtual reality headsets, personal fitness trackers, personal health monitors, Internet-connected home appliances, and more. Samsung is already leveraging its size and competitive advantages to become a leading supplier in all of these categories. Needless to say, all these devices will also require chipsets and memory components that the company will supply. Over the years Samsung has created tremendous shareholder value and will continue to do so in the future.

Samsung is cheap by any valuation metric. It trades for 9x earnings, 95% of book value, and 3.5x EV-to-EBITDA based on our expected 2017 results. At the current stock price, we are paying fair market value for the non-smartphone businesses and essentially getting the smartphone business for free.

Our main detractors in Q2-2016

The main detractor from performance in the second quarter (and year to date) has been our basket of large-cap US financials. Below is an analysis of this basket.

Basket of large-cap US financials, including TARP warrants

The large-cap US financial companies in our basket declined this year, first in February due to investor concerns about falling oil prices, and then again in June when the UK voted to leave the EU (Brexit). As is always the case with financials, investors are also concerned about slower-than-expected GDP growth, interest rates remaining low for longer than expected, credit losses from economically sensitive borrowers, stricter bank regulations, and further, fines due to actual or perceived past misconduct. While we share all of these concerns, we view them all as transitory in nature.

We have a large investment in financial stocks both in the US and abroad precisely because they are universally hated and cheap. Banking and insurance are critical building blocks of every modern economy and, in our opinion, will continue to generate fair returns for the foreseeable future. Competitive advantages in finance mostly come from size and market share, particularly given ever-increasing regulatory costs that drive out smaller players. For these reasons, we have mostly chosen to invest in the larger financial companies.

The specific details for each bank and insurance company are different, yet the underlying thesis is mostly the same. The large-cap financials in the US were all severely hurt in the financial crisis of 2008. Since then, they have been working to repair their businesses, reduce risks, simplify operations, settle regulatory actions, and restructure bad loans.

Moreover, the banks in our basket will benefit greatly when interest rates finally increase, since they will be able to earn higher returns on assets with only a minor corresponding increase in the cost of their deposit base. For example, if in a few years interest rates are 2-3% higher than today, then Bank of America (NYSE:BAC) could earn a 12-14% ROE, which could justify a 1.6 price-to-tangible book value multiple (currently about 1.0). Combined with 8% annual book value growth over the next 5 years, this scenario could result in Bank of America's stock price more than doubling in the next five years.

Concluding Remarks

We own one of the highest-quality portfolios that we have ever had. We have been increasing our portfolio concentration level, adding on price dips to our highest-conviction ideas and maintaining our cash position to be ready to take advantage of market volatility.

While stock prices in our portfolio have been disappointing recently, the business results of our portfolio companies remain strong. With very few exceptions, all of our portfolio companies continue to generate strong cash flows, grow their businesses, strengthen their balance sheets, and widen their competitive moats. As a result, the companies we own have been getting cheaper relative to their mostly flat stock prices (and from already cheap levels to begin with).

Value investing teaches us that, sooner or later, stock prices reflect the true intrinsic value of the underlying businesses. Therefore, we are optimistic about our expected returns for the rest of 2016 and beyond.

Thank you, our investors and shareholders, for your trust and support of EVCM fund. Please don't hesitate to call with any questions, thoughts or comments.

Sincerely Yours,

Ori Eyal

Managing Partner

Disclosure: None.