Dear investor,
The underlying reason for writing a letter to our investors is to illustrate the results obtained. In our ideal world, this letter would be written every five years, as this is our minimum investment horizon. However, we believe that our co-investors should have all the necessary information to judge our work. It is in this spirit that we address these quarterly missives.
The results obtained by our funds are reflected in the tables below. The individual return of each investor depends on the net asset value at which they subscribed:
| Jan–Dec | YTD* | Jan–Dec | YTD* | |||
| Azvalor Internacional FI | 20.3% | 5.7% | Azvalor Iberia FI | 15.6% | 2.5% | |
| MSCI Daily Net TR Europe Euro ** | 2.6% | 3.3% | IGBM Total ** | 2.7% | 2.9% | |
| Return. vs. Index | 17.7% | 2.4% | Return. vs. Index | 12.9% | –0.4% | |
| MSCI World | 5.3% | 5.2% | IGBM | -2.2% | 2.3% | |
| Return. vs. Index | 15.0% | 0.5% | Return. vs. Index | 17.8% | 0.2% | |
| **Includes dividends | *21/02/2017 | **Includes dividends | *21/02/2017 |
We have closed 2016 with a return of 20.3% in Azvalor Internacional and of 15.6% in Azvalor Iberia, comfortably outperforming in both cases their respective benchmarks. Two main factors have contributed to this success:
- Our investment in good companies at very attractive prices.
- The patience shown by you, our clients, to not reimburse the fund when we dropped by almost 20% in mid-January last year.
Our analysis is worth very little without your patience. The combination of both is the reason for the high returns obtained for our investors over so many years: we, as pilots, and you, as co-pilots.
I believe that this association can still conquer higher benchmarks, in light of the evident shortening of our competitors’ investment horizons, and the steady rise of passive management. Indeed, if the bulk of the money invested in markets seeks to replicate an index (massive management) or outperform it quarter over quarter (short-term active management) a niche is carved for those who vouch for the long-term like us. Yet a long-term vision is ONLY possible if you, our co-investors (and we stress “co-investors” because we, managers, invest in the same funds as you do) also consider the long-term.
This is why in Azvalor we have a team of 15 people, led by Beltrán Parages, whose daily mission is to help you focus on the long-term. Let’s remember some of the guidelines of this “manual” that we share every day with those who come to our office:
ONLY invest those quantities that WILL NOT be needed in the next 4-5 years.
Many clients have brought us X to invest and ended up investing half of it… or nothing, following our consultants’ advice of respecting Point nº1. If you invest what you might need, you will not be able to endure the falls that inevitably always occur from time to time in equity markets, and which actually represent OPPORTUNITIES, not to sell “forced by necessity”, but quite the opposite: to invest more if possible.
Trust the management and avoid jumping from co-pilot to pilot.
There is a demolishing fact in the investment fund industry: most clients fail to reach the historical performance of the fund in which they are investing. The reason is simple: they usually purchase the fund when it has already increased significantly, and often reimburse when there are sharp falls. We believe that the best antidote is to rely on managers and on the portfolio of selected companies. The most common errors are:
- “As the fund has already risen considerably, I move out and wait until it corrects to re-enter”: We ALREADY sell those companies that rise in the fund, replacing them by others just as good that have dropped. In fact, this is what our daily work is all about: to keep on looking for cheap companies to replace those that become more expensive.
- “I think the Stock Market is going to rise/fall, so I will try to enter/exit this week”: This is the main reason why investors obtain a lower return than the fund in which they are invested. If our clients trust a method based on an in-depth analysis of companies, there is little point in trying to change that abruptly for a sudden intuition (in general with a large margin for error).
Internalize this identity: “I own very solid businesses which make money in every single part of the word, and I have purchased them at very attractive prices”.
Obviously, the above is only true if we, managers, do not go far wrong, for example, buying bad businesses, or expensive ones. But you, dear co-investor, are reading this letter because you have placed your trust in us. If, beyond this trust in people, in Azvalor we are able to clearly explain to you:
- why we like the businesses we have purchased,
- why they are difficult to replicate by competitors,
- why we rely on the management teams that lead them,
- what factors at stake have enabled us to buy them low,
- why we made mistakes when we did,
…and achieve the above (without giving too many clues to our competitors), then you will be in a position to overcome your inner urge to sell at the worst possible moment. This is the primary objective of letters such as this one and of our annual investors’ conference.
The Portfolios
Both Azvalor Iberia and Azvalor Internacional have quality businesses purchased at attractive prices and with a significant upside potential.
The main characteristics of the portfolios are reflected in the table below:
| Iberian Portfolio | International Portfolio | |||
| FCF Yield | 9.1% | FCF Yield | 14.60% | |
| ROCE | 17.70% | ROCE | 49.50% | |
| Potential | 46% | Potential | 5 2% |
With the aim of illustrating how we make investment decisions, we would like to briefly review some of the positions we have already sold. The following examples include successes but also an investment mistake. We believe that error analysis provides just as much, or even more, information than successes.
Técnicas Reunidas
(+65% in 11 months)
Why is it a business that is difficult to replicate?
Although engineering businesses, in general, do no benefit from strong barriers to entry (engineers may leave and become self-employed, in theory), in the large projects segment (niche of TR) clients demand towering technical credentials and, a very high financial strength. Thus, it is not easy for a group of TR engineers to assure that a client from Saudi Arabia commissions a plant just like that. The proof is that in the major projects where TR competes, most of the time it is the same companies tendering for years.
Why do we like its managers?
The Lladó family, founders and main shareholders, manage the company and put their assets “at stake” together with ours. When faced with the temptation of lowering prices in order to compete in bids (something very common when the CEO is not the owner, especially when incentives are on the order book) Juan Lladó and his team have historically demonstrated prudence and discipline in offers, because their incentive is making money, not wining bids.
Those who win bids by lowering prices may temporarily seem “geniuses”. But when the cycle turns and the first complications arise, losses rapidly pile up and can throw years of work and profits overboard. There are abundant cases in the sector such as the one of Saipem, where after subsequent profit warnings the price per share accumulates a decline of 90% since record highs. Likewise, Amec Foster Wheeler, CGG, etc. are companies that are experiencing serious problems of implementation and results and sharp falls in the price of their shares.
This is less likely to occur in companies where there is an “owner”. The year 2011, when the price “war” waged by Korean engineering companies broke out, is a good example of the prudence with which TR is managed. TR sat on the fence although it “cost” her to publish a number of awards that was well below market expectations, assuming the disappointment and criticism of stock market analysts. A posteriori, the problems faced by Korean engineering firms demonstrated that it had been the right strategy. Notwithstanding the above, TR knows how to win contracts and generate profits with them. Thus, in the past 12 years, the order book has grown at a rate of 25% annually. A further sign of prudence is that they have never compromised the balance sheet, which demonstrates their long-term vision.
Why were we able to buy low?
At the beginning of 2016, the company issued a profit warning due to a project in Canada. The source of the problem was one of the subcontractors, the American engineering company KBR. However, TR tacked the problem at its root and responded to the client guaranteeing the best possible delivery without any extra charge. The market reacted violently with a 25% drop in share prices on that very same day. The episode seemed to be the first of a series, as several analysts began to speculate, questioning the quality of the company’s order book. In Azvalor, we took advantage of the situation to buy TR at €21-22 per share, or 6x normalized earnings, with net cash in the balance sheet of almost 40% its stock market value then, and with an order book at all-time highs.
Today, Técnicas Reunidas trades at about €37 per share. In our opinion, it is a good example of how a sound company, with net cash and managed by its owners, can be purchased at a very low price on the stock exchange. The key, as we always say, is not being a genius but being prepared to wait between 3 and 5 years to see any profits. The market took much less, only 11 months, to recognize the value of TR, although this is irrelevant for us: if it had taken 3 years, instead of an IRR of 72%, we would have achieved a satisfactory 18% annually.
Metro Bank
(+60% in 6 months)
Why is it a business that is difficult to replicate?
Metro Bank is a small bank based in London with a simple business model that rests on a quality of service which is far superior to that of larger British banks. Thus, MR attracts deposits at very low cost. For large banks, replicating Metro Bank would require to incur in huge costs and risks, and rebranding so much that they would almost have to “die in order to be born again”.
Why do we like its managers?
Metro Bank was founded in 2010 by an American entrepreneur who had already achieved an enormous success in his home country where he founded, in 1973, a bank with a business model of great customer service and agility in banking operations, and that achieved an annualized return for his shareholders of over 20% in its more than 20 years of existence, before it was sold to a bigger bank. This entrepreneur continues to be the main shareholder and chairman of Metro Bank.
In Metro Bank there is deeply-rooted corporate culture of customer service and a major commitment of the team and employees thanks to a good incentive scheme, which includes encouraging the sense of ownership of the entire organization by making employees become shareholders of the bank.
Why were we able to buy low?
Since the bank went public at the beginning of 2016, it seemed to be expensive. After the Brexit announcement, share price dropped which, coupled with a depreciating Pound, made the correction even bigger when measured in Euros. This led us to analyse MR in depth and understand that the capacity of generating profits was “bedimmed” by the strong and rapid growth rate: the vast majority of its offices was far from their level of maturity and, therefore, the margin of contribution to the incremental business was extremely high as expenses are mainly fixed. Adjusted by this aspect, and after the drops caused by the Brexit announcement, the bank’s shares were not as expensive as they had first appeared.
MB is yet another example of a good business with an owner, financially healthy and with high growth prospects, which the market allowed us to exceptionally access at an extraordinary price. In this case, the market did not take very long to rectify “its mistake”, boosting shares by 60% in only 6 months…
Euro Disney (Disneyland Paris)
(+63% in 10 months)
Why is it a business that is difficult to replicate?
There is only one Disneyland Paris: it is Europe’s largest tourist destination, leader among theme parks in the continent. In addition to two theme parks, the company owns hotels, restaurants and 2,230 hectares of buildable land.
The particular situation of the asset
In this case, we didn’t like the management at all: in our opinion, The Walt Disney Company (TWDC) had abused Euro Disney, charging excessive royalties and management fees, which generated major losses and debts that resulted in a 70% drop of securities, a circumstance which TWCD used as an opportunity to increase its stake from less than 40% to more than 76% of capital.
At that point, two attractive circumstances arose: an owner who was “sufficiently” interested now (76% of capital), and a single asset which in our opinion was worth much more. We analyzed in depth the case of its Japanese counterpart, Oriental Land, and realized that slight improvements in attendance produce dramatic improvements in results. Precisely in 2017, the park is preparing for its 25th anniversary, and expects an important boost to the poor attendance figure of the last few years, thanks to the new rides. Moreover, an activist investor urged an independent valuation of the company which gave a result of €3.7 per share, almost three times the price at which we purchased.
Why were we able to buy low?
Euro Disney is a small company with a limited trading volume, without analyst coverage, with poor record of profitability, and all “spiced” with a legal controversy between its main shareholders which adds uncertainty and complicates the situation even further. A company under such circumstances is off the radar of most professional investors who prefer much simpler situations.
A few months after our first investment, The Walt Disney Company made a takeover bid for the entire company at €2 per share, i.e. 65% above our acquisition cost.
Euro Disney is another example of what markets occasionally offer to patient investors: a unique business at a depressed price, in this case due to a series of temporary circumstances. Once again, patience was imperative on this occasion, since TWDC could have made the takeover bid one year later, or never… but the truth is that the acquisition of unique businesses at good prices quite often leads to this type of situations.
Since the purpose of these letters is not to extol our successes but rather to explain our investment process, we feel that it is mandatory to talk about the mistakes we have made.
CTT, Correios de Portugal
(-10% in 4 months)
Why did we like it?
As it occurs in most parts of the world, the business of CTT is a business in decline, with volumes falling between -3% and -5% annually due to the digital replacement of almost all post categories and, in particular, of some major categories such as invoices. These drops in volume are mitigated in revenues by price increases and the growth of other business lines, and end up becoming growth in results owing to the existence of important “levers” to reduce costs.
Moreover, CTT has a very strong net cash position (>30% market capitalization value) which confers it a great resistance capacity and time to address some interesting growth avenues, such as: a) a bank that takes advantage of the densest network of offices of the country and competitors showing signs of serious weakness, and b) an emerging yet promising courier business with the “tailwind” of e-commerce growth. We like the management team and a well-known Portuguese businessman stands out among its shareholders.
After a fall to €6 per share from €10.6 highs (-43%), CTT traded at 8x profits and a dividend yield of over 7.5%, which seemed to us an extremely negative valuation.
Aware of the risk of a business in decline, and despite our past successful investments in CTT and its Belgian counterpart, Bpost, we decided to invest only 1% of the Iberian portfolio. In our experience as investors, we already know the damage that a business in decline can cause (the reader may perhaps remember when we invested in American regional newspapers 10 years ago), and we realize, with great sorrow, that if the decline is important enough, any attractive valuation, a priori, ends up being a “value trap”.
What happened?
Earlier this year, CTT published a preview of the results of 2016, reducing the estimate of mail volume (to -4.2% vs. -3%). In addition, the Portuguese government made public its objective of saving postage costs in all public communications, encouraging the use of e-mail. Share price dropped to almost €5.
What was the impact?
Before an even more negative scenario in the evolution of the volume of postal consignments, the attractiveness of investing in CTT depended entirely on the capacity of making significant savings in costs or the success of the new bank. Both situations are probable, but after identifying clearer investment possibilities at that moment we decided to sell, losing only -0.015% in the Iberian portfolio, net after adjusting the dividend received. We do not rule out reinvesting, pending the outcome of further analyzing the two chapters aforementioned, cost savings and the project of the new bank of CTT.
In each of our investments we are exposed to making a mistake. In the past 15 years, we have been wrong in 10-15% of investments. Two thirds of our mistakes were due to excess debt in companies. And the remaining third, to technological disruption. We will continue to err in the future with a probability of 100%, and our challenge will be to make fewer mistakes or different ones (avoid making the same mistakes), and limit the weight of errors in the portfolio.
The environment
There is nothing of significant importance with regard to our previous quarterly letters. As a brief reminder, we are worried about the debt overload in the developed world and the insistence of the Central Bank to patch up the wounds that only the free market can cure. Now that some countries seem to have chosen to change doctors, letting politicians take the lead, it remains to be seen what they will do. Their margin is not very large, and with a few exceptions, their proposals are not the appropriate ones. There may always be brave politicians in the future who apply the correct template with a long-term vision, but the probability is low. We continue to believe that politicians and central bankers will achieve their inflation objective in the end which, in our opinion, is very negative for society at large.
In this environment, we believe that holders of fixed income securities will particularly suffer, and that the best protection is a portfolio of companies which do something that is difficult to replicate, with healthy balance sheets, owners who put their own money at stake, and purchased at attractive prices with a long-term vision.
Azvalor news
As regards participants, we are already more than 13,000 investors who have trusted Azvalor’s investment products, totalling a volume under management of approximately 1.7 billion Euros.
In Investment Funds, we are now 11,800 investors, and over 1,800 in Pension Funds, and with regard to other vehicles, Azvalor Value Selection SICAV has over 300 shareholders and Azvalor Internacionalo SICAV Lux over 500.
One of our funds, Azvalor Internacional, has reached 1 billion Euros of assets under management in just over 14 months of existence. Building on the trust of our investors, this fund joins an exclusive club “unicorn” funds. There are few in the Spanish market and even fewer that are pure equity funds.
Moreover, in February we launched a new fund, Azvalor Blue Chips. This fund follows the same investment philosophy as the existing funds, with the only difference that it is focused on large-caps, limiting most of the investment to companies with over 3 billion Euros of market capitalization. Otherwise, it will follow the same principles and philosophy as the funds Azvalor Internacional and Azvalor Iberia.
At the operational level, we have closed 2016 with over 17,000 transactions processed without any relevant incidents thanks to an increasingly robust operating platform which we continue to work on to enhance its functionalities. In this regard, the new contracting service of second investment fund operations with signature via sms, which allows investors to operate entirely online without needing to print nor sign any physical document.
With regard to Human Resources, we have had 11 incorporations in 2016, closing the year with 36 employees, out of which 5 new partners joined the 4 founding partners at the end of last year. We hope that the number of partners continues to increase in the coming years.
The 4 founding partners have collaborated in drafting this closing letter for the year 2016. It has been a difficult year in many respects and extremely rewarding in others. Let’s hope adversity has helped us grow, and may we always be grateful for all the good things. We can assure you that every day the four of us are thankful for the opportunity of dedicating our lives to what we enjoy most together with the people we want.
As this letter draws to a close, we would like to express our gratitude once again for the trust you have placed in our management. We hope you will join us at our forthcoming conferences in Madrid and Barcelona on 6th and 22nd March. This is the time of year when you can ask us anything you want. Meanwhile, the commercial team, led by Beltrán Parages, will be pleased to answer any questions you may have.
