Yoav Zelikovic Investments' Annual Letter, 2018

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About: Exor S.p.a. (EXOSF), Includes: AGO, BAM, EXXRF, FAXXF, FRFHF, IAC
by: Yoav Zelikovic
Summary

I have the privilege to write you this annual letter for the year 2018.

Allocation of the portfolio: 50% deep value micro-cap stocks, rebalanced each month; 25% compounder/outsider-led companies; and 25% special situations.

Despite the gloomy picture depicted, one can make a different analysis of the financial events at the end of 2018 that, with a historical perspective, can surprise and even provide a source of optimism.

We are invested in the Italian conglomerate EXOR (EXO.MI). This family -owned business has compounded shareholder value at a double digit rate for many years via its many holdings including Fiat.

I wish to summarize again and share with you our Ten Commandments, which underlie and direct us in our investment activities.

Dear Investors,

I have the privilege to write you this annual letter for the year 2018.

First, I wish to welcome our new customers who have joined us in the past year as partners in our financial pathway. It is a great honor and privilege for me to manage your capital.

In 1969, Warren Buffett recommended that the partners of his dissolving hedge fund transfer their investment to a new partnership managed by a relatively unknown money manager, Bill Ruane. Many investors accepted Buffett’s advice and were very optimistic about this new partnership that they joined. However, in the first four years, they were utterly disappointed as this new fund significantly trailed behind S&P 500's return every year for the first four years of the fund. Indeed, some of these investors became impatient and redeemed their investment after a short period of time. However, those patient investors who trusted Buffett and Ruane’s judgement, and did not abandon this new fund, were highly rewarded by a return of Ruane's funds that was doubled when compared with that of S&P 500, by the end of that decade (and these outstanding returns continue to characterize Ruan’s funds to this very day). I do not claim to be the next Warren Buffett or Bill Ruane, and returns can never be guaranteed, but the message is clear - investing in equities in general (and small cap stocks, in particular), may be a bumpy ride that can be rewarding (namely, yielding long-term, double digit, yearly returns) only after a long time period.

The message outlined above applies also to the dynamics of our portfolios. After a strong start at the beginning and the middle of 2018, the last quarter arrived (especially the month of December) that caused a loss in the value of our portfolios. You all are aware of the dramatic volatility in the global markets at the end of the last year, which heavily influenced stocks all over the world, and did not skip our portfolios. Our closest benchmark, the Russell 200 Value Index (U.S. small cap value stocks) decreased 12.9% for the year of 2018. The MSCI All-World Stock Index fell 8.71%.

Despite the "gloomy" picture depicted above, one can make a different analysis of the financial events at the end of 2018 that, with a historical perspective, can surprise and even provide a source of optimism. First, the sell off during December 2018 was not as harsh as similar sell offs in the past. Second, historically these "dramatic" sell offs have always been short and lasted only a few months. In the past 53 years, only twice (1973-1974 and 2000-2002) did the U.S. stock market show two consecutive years with negative returns. Careful analysis of the stock market history may encourage us even more. The last four times that the quarterly return of the S&P 500 was below 20%, the returns in the subsequent year were between 17- 38%, in the next three years were 49-73%, and in the following five years were 95-128%.[1] The sceptics among you may be worried about the very insecure world around us (including the unstable European economy, China and Russia becoming more and more powerful, the ever tumultuous Middle East, and, in particular, the very unpredictable American president) and the potential adverse effects of this situation on the stock market. To these skeptics we replay that the U.S economy has already overcome two World Wars, a Cold War with Russia, two major recessions, and the attacks on the World Trade Center, and despite these events the Dow has risen from 62 points at its inception in 1896 up to 26,188 today (a compounded annual growth rate [CAGR] of nearly 10% assuming reinvestment of dividends).

Moreover, if our negative returns in 2018 are placed in the right perspective of our long term investment goals, we can even see this year's negative returns as a positive development. We have already learned from the world's greatest investors, and it has been repeatedly proven, that the best time to invest in stocks is during periods of gloom and depression. These are the best times when a careful inspection of stocks, especially small cap value stocks, and identification of those stocks with potential market beating returns, will yield significant long-term returns to the investor.

Our policy described above is supported by the fact that, despite the short- term volatility of the stock market, the only investment path that displays a long-term upward trend, is the stock market. Various investment paths which are considered "less risky" such as cash, bonds, real estate and commodities are poor long- term investments due to inflationary pressures, changes in demand, and mainly because they do not enjoy the benefits of compound interest which exists in the stock market.

In this regard, I wish to state that our financial concepts and our investment strategy (investing carefully and systematically mainly in small cap value stocks) have been warmly welcomed by our growing number of customers, whose number has doubled in the past year. Furthermore, during the declines in the last quarter of 2018, none of our clients asked to redeem their investment with us. We are very proud of you and see this as a token of good faith that you have all placed in our manner of managing capital. We also wish to provide our clients with some good news in the short term - from the beginning of 2019 up to now our portfolios have re-earned most of the ground lost in the December downturn.

We also wish to remind you in what we invest today and in what we intend to invest in the future. In general, and subject to the investment policy that each one of you has requested, the portfolio of each one of you is divided into three parts (please see your individual periodic reports):

  1. 50% Deep Value Micro-Cap stocks rebalanced each month/quarter/year.
  2. 25% Compounder/Outsider led Companies
  3. 25% Special situations/Mergers & Arbitrage

  1. Micro-Cap Stocks

This investment strategy is based on one of the best strategies in the book, "What Works on Wall Street" by James P. O'Shaughnessy.[2] This strategy selects a basket of 10 stocks (decreased this year from last year’s 25 stocks, in order to limit brokerage costs) the market cap of which is under $ 300 million (stocks which are excluded from the major indexes in the U.S.A.). These stocks are selected only if they fulfill a number of criteria (including value, quality, momentum and financial stability) which have been proven by empirical studies to be a source of alpha.

As we have witnessed in the past two years, all of these stocks and this strategy do not outperform the market every year. Nevertheless, this instability per se (which may cause other investors to abandon the strategy at exactly the wrong time) is the key for its success over time even though it involves "going against the herd". As Prof. Joel Greenblatt, who wrote the book "The Little Book that Beats the Market"), once stated:

"If I wrote a book about a strategy that worked every month, or even every year, everyone would start using it, and it would stop working."

In addition, our implementation of this strategy within an Individual Retirement Account (I.R.A.) at a low cost broker is an especially fruitful way to use this strategy. Within the I.R.A. accounts we can implement this strategy with all of its benefits and also enjoy a tax exemption/deferral.

2. Compounders

Compounders are stocks of holding companies (usually led by Outsider CEO/Owner Operators) and stocks of public insurance companies, around the world. During the year 2018 (in particular, during December 2018’s falls in the stock market) we were able to increase our stakes in these companies at very attractive prices.

Among these companies, we are invested in the Italian conglomerate EXOR (EXO.MI). This family -owned business has compounded shareholder value at a double digit rate for many years via its many holdings including Fiat Chrysler, Ferrari, CNH and the largest insurance company in Europe – Partner Re. The net asset value of this company increased in the first half of 2018 by 4% with a similar rise in its stock price at the same time period. An additional company the stocks of which we plan to hold for many years to come is Brookfield Asset Management (BAM), a Canadian Compounder which owns and manages over $250 billion worth of real assets around the world. Despite the fact that BAM’s stock price has not changed during 2018, the assets under management of the company increased by 23% during the year. We also added to our portfolios a position in InterActiveGroup (IAC), a company in the technology sector that is managed by the renowned investor, Barry Diller. The company has produced double digit annual returns for its shareholders over the past decades.

One of the most promising pathways for investing in the stock market is investing in insurance companies. A well- managed insurance company has two sources of profitability: 1. its basic insurance activity, and 2. the rational long-term investment of its growing "float" (see my article: In Pursuit Of The Next Berkshire Hathaway). Accordingly, we have invested in the Canadian insurance company, Fairfax Financial (FFH.TO), which has compounded book value at an almost 20% rate for the past 30 years. It should be noted that despite a 1% fall in the value of the FFH.TO stock over the first three quarters of 2018, the book value of the company increased by 1% over the same time period, and, in addition, the shareholders have enjoyed a dividend of $10 for each stock. We also increased our position in the American insurance company, Assured Guarantee (AGO). Whereas the stock value of AGO rose over the first three quarters of 2018 by only 4%, the non-GAAP book value of the company increased by 9% during the same time period. We also invested this year in the Norwegian insurance company, Protector Insurance, which is a rising star in the European insurance field.

Our plan is to hold these, and similar, stocks for many years to come in our portfolios because, typically and despite the short term volatility in the share price of these stocks, patience is rewarding and long-term revenues are significant.

3. Special Situations/Merger & Arbitrage

The role of this category is to serve as a “conservative” element in our portfolios. It is well known that bonds, usually the less volatile portion in portfolios, currently display minimal or, in some instances, even negative yields. As such, we do not consider bonds to be an attractive investment at the present time. In order to diversify our stock-focused portfolios, we use the cash that has accumulated in the investor’s portfolio and invest it in a more “conservative” fashion. To this end, we search the global markets for special situations such as tender offers, re-organizations, delisting, mergers and acquisitions that can provide us with opportunities to make lower risk investments with a target date of return. These investments may yield low returns over short-term periods of time but become very profitable over long term periods.

I wish to use this opportunity to inform you that we have successfully started the year 2019 with a strong momentum. As your portfolio manager, I wish to update you on some of my activities in the year 2018:

  1. By the beginning of 2019 we were able to open our hedge fund, "Tavor Capital", to which I function as an Advisor. The fund is listed in the Cayman Islands, which enables purchasing its units via our IRA portfolios while continuing to enjoy tax exemption/deferral on revenues. By its nature, a hedge fund provides its manager with more flexibility and better diversification of investments. Our hedge fund uses an investment strategy which is similar to the one successfully utilized by Warren Buffett in his original partnership.
  2. I gave lectures on Investments to students at The College of Management, Tel-Hai College and the Ben Gurion University.
  3. I continue to give lectures about Value Investing at various venues in Israel.
  4. As a part of my research/teaching activities and having gained much experience in the subject, I have published over the last three years (2016-2018) twelve articles in leading newspapers and investment portals including Bizportal, Globes, The Marker, Forbes Israel and Seeking Alpha.
  5. I have been invited to regularly contribute of the leading financial portals in Israel- "The Marker" (זירת הניתוחים - הבלוגים הפיננסיים של בכירי שוק ההון באתר TheMarker).
  6. I continue to enjoy the warm environment and cooperative work with the staff of Quantum Capital Markets (and the staff of Interactive Brokers Israel). This cooperation is very beneficial for us and for our clients.

In conclusion of this letter, I wish to summarize again and share with you our "Ten Commandments" which underlie and direct us in our investment activities:

  1. Focus on high quality micro-cap value stocks which have a well-documented track record of achieving alpha and not on high- flying popular stocks.
  2. Identify and analyze the best Compounders in the world, and invest in them as partners for the long-term.
  3. Set a long-term goal of at least a 5 year period to achieve investment returns.
  4. Utilize the powerful effect of compound interest on long-term investments on behalf of our investors.
  5. Refrain from any speculation and short- term trading.
  6. Do not allow “noisy” headlines and catchy newsflashes about the stock market dictate our activity in this market.
  7. Stay away from any investment fads (such as bitcoin), the long-term economic value of which is highly questionable.
  8. Carefully analyze and follow past and present investment strategies of the world’s best investors who are renowned for excellent financial performance.
  9. Continuously read and study professional/academic papers, reports, and research in the area of investments/ finances published around the world.

10. Finally - rehash to our investors the message- "Patience is gold".

We wish to thank our investors, whose number is steadily growing, for the pleasure we have to work with you and manage your hard earned capital, and for the trust you grant us. On our part, we will continue to work on your behalf in a fair, diligent, professional and trustworthy manner, while utilizing our unique investing strategy outlined above.

I use this opportunity also to warmly thank Mr. Matan Guetta, my partner, without whose efforts and contribution none of this operations would have been possible.

Happy Passover!

Sincerely

Yoav Zelikovic

Attorney and Senior Equity Analyst


[1]Thanks to Ben Carlson, from the blog "A Wealth of Common Sense" for the numbers: Buying When Stocks Are Down Big

[2]We must also give credit to Paul Novell and the great work he has posted on these strategies on his website: "Investing for a Living"-

Disclosure: I am/we are long AGO, EXOSF, PSKRF, IAC, FRFHF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.