Dear Investor,

In 2019, Azvalor International and Azvalor Iberia produced 5.5% and 1.9% returns, performing under their respective indexes. Although we are disappointed with the results, we start 2020 with confidence and conviction that our investment principles are still valid, despite the market seemingly not corroborating this premise. We base our decisions on facts and logical reasoning, in order to properly understand cause and effect relationships or, why things happen. Crucially, despite our underperformance, there were many positive facts for our positions in 2019.

From a longer term perspective, we show the accumulated return since the launch of the funds at the end of 2015 and its comparison with its benchmarks:

Executive summary

As we have often mentioned, our investment success in the past was based on sticking with our commitment to buying good value stocks. In a rational environment, this strategy works just fine. However, in the current environment, few investors try to evaluate asset prices according to the profits those assets generate; they prefer stories and narratives about disruptions and future technologies, sometimes bereft of logical reasoning.

In recent history, the market has rewarded this approach of high-grading narrative versus valuation. Therefore, many investors promote ideas and narratives as a central tenet of stock selection more strongly than ever. The consequence is more pressure and frustration for value investors because of their relative underperformance, and there is no guarantee of a sudden change on the horizon. We believe that reason and logic will ultimately prevail, as has happened many times before. Our current portfolio defies many established ideas, which we think is our strength, and despite some occasional mistakes. Nevertheless, our out-of-the-box view requires patience and confidence in our investment process and not everybody is prepared for that kind of commitment. This letter reflects the views of five Azvalor partners – who are all invested in our funds – with the purpose of conveying our trust in our current investments. We believe that patience will be seen in the future as the price to pay in order to achieve our goal of compounding investor capital.

In our correspondence with our investors, we defend the need for a certain resolute psychological predisposition of our investors to not conflate volatility with risk, combined with a limited asset size- remember our commitment with not surpassing €2.5 billion in assets under management.  This has never been truer than in today’s investment market, where patience and volatility tolerance are scarce and valuable.  Many impatient investors looking for low volatility assets create distortions in capital flows: there are industries that continuously get new funding, i.e, Tesla, technology companies or Private Equity, while others are financially constrained such as the coal industry, oil extraction and uranium mining. The result is that, at some moment, this process will end by force majeure: there will be an excess of some goods and inputs and scarcity of others.

Therefore, amidst and despite our tepid performance in 2019, we take comfort that the realities of science, geology and depletion – often reflected in supply-related outcomes coupled with low valuation – cannot last forever. Moreover, as time goes on, with no sign of a reversion, and the frustration of today’s volatility, we feel that the disequilibrium in the situations we analyze and underwrite are perhaps a necessary precondition for tomorrow’s reward. It is in the spirit of taking advantage of these situations that we shape our investment portfolios, so we can monetize and harness market volatility and fads instead of becoming their victims.


Passive investing, ESG criteria and impact on financial markets

Presently, we are looking at an investment universe with widening disparities between popular and unpopular industries. This dissonance is effectively sanctioned by an allocator hierarchy that defines volatility as a risk, one that believes in efficient markets and doubts any edge provided for by active asset management.

This is also a belief system that involves an orthodoxy of hard commitment to perceived positive ESG – Environment, Social and Governance – rules that should be considered in any modern investment process. In our view, the distortions created by these new investment criteria are now predominantly responsible for creating valuation disparities on the market. Ironically, these externalities and biases encumber market efficiencies in capital deployment, although we ought to welcome them as they create investment  opportunities.

The well-known fund flow effect from active to passive instruments continued in 2019, which was not a shining year for active managers. Indeed, nearly a third of the S&P 500 performance stemmed from six stocks alone. Outperforming the index required replicating it with an overweight of overvalued securities, which is an anathema to our investing process and would be considered reckless from the point of view of most allocators. This phenomenon has created a vicious circle of index trumping active manager performance, many of whom are forced to capitulate to protect their franchise to the detriment of preserving their investment discipline. This forced behaviour makes financial flows more important than valuation. When valuation no longer matters in the context of asset allocation, it is inevitable that violent mis-pricings will emerge. Similarly, the hunt for low volatility and duration in an environment of depressed rates leads to justifying inflated valuation multiples.

In this context, it is reasonable that we have found our investment ideas in sectors of the market which may be out of the major indexes, and those that may exhibit cyclical or volatile characteristics. Unsurprisingly, those sectors include energy, extractive activities and shipping, which currently represent most of our portfolio. In our opinion, this is the sweet spot of the market, where all the empirical fundamental elements meet psychologically sourced inefficiencies.

Associated with the externalities of passive investing, there is the ESG phenomenon, an acronym for investing while being mindful of Environment, Social and Governance issues. While well intentioned and akin to the original mission of passive investing to champion returns for investors above remuneration for the manager, we strongly feel that many unintended consequences of ESG are similarly parasitic to price discovery.

Firstly, to unpack the Environmental effects: the narrative that mining and energy companies are inherently antagonistic to the environment dissuades investment, effectively naming and shaming would-be providers of capital, thus creating a likely forward shortage. In truth, many mining projects offer jobs and opportunities to deprived regions, and nowadays modern mining includes meticulous remediation and reclamation requirements, such projects become net positive for both regional economies and their inhabitants.

Socially conscious investing raises very murky questions about what constitutes responsible and socially harmonious investment. The energy and extractive industries have already discovered and depleted the obvious and traditional districts, developing the current projects in more remote locations. These regions would find it challenging to attract fixed asset investment otherwise, and industrial investment creates wealth and jobs. Consider Agnico Eagle’s investment in the Nunavut region, which now represents 25% of provincial GDP in the poorest and harshest Canadian province. Or Guyana’s recent bounty in Exxon’s Stabroek and Tullow’s Orinduik field discoveries, which could endow the country that barely achieves of $1,000 GDP per capita in 2004 with more than 10 billion barrels of liquid hydrocarbon resources. We would argue that these prodigious natural resources and their ensuing commercialization are positive for the economic development of regions whose people have had none of the economic (carbon) advantages from which we have all benefited from in the western world.

Finally, Governance. Governance has always been a key consideration for Azvalor, especially at a time when investment in fixed asset intensive industries represent a chief portfolio tilt. Focusing on alignment of shareholders and managers and only investing in businesses with extremely honed compliance programs is critical in industries where graft and corruption have historically been issues.  We value alignment of interests and management teams which invest alongside shareholders with no special warrants or conferred rights. There are plenty of promotional minnows in the resources space that exhibit flagrant abuse of minority shareholder rights, and those will be expeditiously filtered out as part of our investment process.

In conclusion, ESG subjects need to be considered on an idiosyncratic basis taking full account of the impact on societies who are often less well economically positioned than ourselves. Our belief is that many industries today are ignored and starved of capital based on capricious and superficial reasons, while they are important sectors for the local economies and ought to be rewarded.


Our portfolios

Our investments in energy, uranium and coal were challenged in 2019. In the oil sector, where our position Tullow Oil generated a negative contribution of 4.8% to our portfolio, we observe:

  • Crude liquids demand in 2019 is estimated to have grown from7% to 1.0%.
  • Capital spending in upstream oil & gas remains extremely depressed, 50% lower than pre-2014 levels.
  • Despite 2019’s bumper year for discoveries of 12.2bn barrels, including gas finds, supply fell way short of an estimated 35bn barrels of consumption in liquids alone, which testifies to the continued lack of reserve replacement, aggravated by the lack of investment in new exploration projects.
  • The new capacity in global refining has added2m barrels of oil demand, and the imports from China are also growing.
  • Regarding shale oil, doubts about the sustainability of production growth persist. Some reasons are the lack of funding, exhaustion of the best drillings and the deterioration of productivity. The activity of the best drillings has reduced 30% and DUCs – drilled but uncompleted wells – inventories are in the process of exhaustion.

These trends, along with 3 million bopd – barrels of petroleum per day – of natural depletion, will push up oil prices and help players like Tullow, Kosmos and Geopark, as more conventional deepwater oil drillings will be necessary.

In fact, WTI oil prices increased 34.1% in 2019 and outperformed the total return of S&P 500 (including dividends) – 31.5%. However, the whole US energy sector has a market capitalization equivalent to Apple, a clear sign of the undervaluation of the energy sector.

While Tullow stumbled operationally, much of the share price reaction was associated with forced selling by funds looking for regular income, as the company reduced its dividend – a good decision in our view. Tullow should be able to significantly beat its guidance for medium-term production of 70,000 bopd. At the same time, at close to 50% discount to core net asset value, the market is effectively writing off non-producing assets including those in Uganda, Kenya and Guyana, all of which carry potential and realizable value on a pre-production basis.

After the selloff, Tullow had a market capitalization of $975 million and it expects to generate $150 million free cash flow, assuming an oil price of $60 per barrel – which means a P/E of 6.5. In our base scenario of $75 barrel price, we estimate that Tullow would obtain $400 million free cash flow – a P/E of 2.5. Despite the company has failed in its exploratory projects – one of the causes of the selloff -, we think that just its portfolio of production assets would allow for a recovery of our initial investment. Moreover, if the crude price reaches our base scenario of $75 per barrel over the next 2-3 years, then the internal rate of return – IRR – of this investment will be in line with our historical average.

Consol Energy detracted 4.6% of performance. The thermal coal industry underwent a bear market in 2019, which has significantly depreciated export netbacks for US thermal and coal producers. The predominant narrative suggests that lower gas prices and lower emissions will discourage the use of wholesale coal. The IEA suggests that coal production in 2019 was flat compared to 2018 at 5,450 Mtce, fueled by vigorous growth in both India and Southeast Asia, which are expected to grow by a high single digit compound basis. According to Glencore, coal represents 26% of current energy supply and this may shift to 22% by 2030, aggregate tonnage will still likely grow as the production levels move up.

It is true that renewable energy sources will be an important and growing part of the generational mix, but it will be working together with coal-fired plants, as it offers fewer intermittency issues. Solutions involving battery technology to storage renewable generation are fanciful, but according to Mark Mills of the Manhattan Institute “the annual output of Tesla’s Gigafactory would only produce three minutes of annual US electricity demand”. Also, according to Mills, $200,000 worth of batteries weighing over 20,000 lbs would store as much energy as one barrel of oil.

By the same token, we base our investment decisions on a clear assessment of what science and physics currently dictate rather than more fanciful speculation based on hopes and falsehoods. In face of the climate change issue we know that, for some, this is unpopular, though we believe, on analysis, it is a realistic assessment. We therefore consider that the capital shortage – funding costs for coal projects are over 30% – will cause a deficit in coal production. The lack of investment will give birth to the next bull market.

Consol Energy enjoys the lowest unit costs of any US producer due to its unique longwall production capacity in the PAMC. Furthermore, Consol’s marketing strategy insulates it from weak spot markets as nearly all its 2020 and some of its 2021 production is forward sold at elevated prices. Competitor capacity cuts and bankruptcies are fueling a recovery in supply reduction and share will be ceded to survivors of attrition like Consol. These factors should allow the company to weather the cyclical downturn and continue to opportunistically deleverage its balance sheet through selective credit instrument buyback programmes transacted against forced sellers, some of whom are no longer able to own coal as an asset class due to ESG concerns. This is a de facto transfer of value from one type of investors to another one like Azvalor, that approach investing without prejudices and stylistic constraints.

Cameco detracted 1.6% notwithstanding that it was an excellent year for the nuclear power industry which also saw unprecedented primary supply curtailment from chief uranium producers.

The WNA conference in London last September produced the latest Nuclear Fuel Report which clearly showed that the Fukushima demand “pothole” has been filled. In a variety of scenarios, nuclear power generation is in a positive demand situation. This is a growing industry and critical to maintain healthy, carbon free, and reliable clean energy for the world. Nuclear power generation is now likely to grow by 2% compound rate, bringing the nuclear fleet to 569 GW by 2040 or 50% increase from current levels. Nuclear power is the second largest worldwide source of emission-free generation at 10% behind hydroelectric power at 18%. Crucially, it is also the essential non-intermittent energy source that conveys grid stability and facilitates the transition to a fully electrified society.

Historically, human development has been based on higher energy density. According to Vimy Resources, a single nuclear fuel pellet carries the same energy content as 564 liters of oil, 1000 kg of coal and 481 cubic meters of natural gas. As a competition to renewable energy, putting aside its continuous and stable generation, an equivalent production base would require an unfeasible number of wind turbine installations. According to NexGen, the largest wind farm in the world covering 375 square km generates 1.75Mw per square km, whereas the largest nuclear plant in the world is able to produce around 2Gw per square km; an improvement in energy generation efficiency of 1100x. Nuclear power plants consume approximately 170 million lbs of U3O8 per annum, currently provided by a primary supply of 120 lbs and a secondary supply of 20 lbs; the rest of the production deficit is covered with inventories.

Secondary supply availability continues to be under pressure as supplies are exhausted; the discipline of producers like Cameco and Kazatomprom forces down inventories, thus eliminating the illusion of commodity abundance. The amount of mobile uranium inventories is a point of contention, but it is very likely that the amount of realistic and mobile inventories available on the market is substantially less than expected. This may create a precondition for a shortage on the market. With 70% of the global primary production sold below its costs and incentive prices for new investment at least 3x spot prices, a reversion is likely in the mining companies stock prices.

Cameco is one of the biggest uranium mining companies and owns the best properties in North America. We feel it is highly undervalued as a Western producer on a market where provenance may matter more than ever. We eagerly await the conclusion of the US task force regarding US policy, but 2020 should also adjudicate the outcome of the Russian suspension agreement and whether the West will continue to overlook Iran’s uranium programme through waiver roll-overs.


The sector weighing in our portfolio contrasts with the established consensus and the major indexes. These established views are that oil, gas, maritime transport, coal and uranium are very risky. We believe that they are nonetheless necessary and, as they are not quite popular, there is less room to disappoint. The companies will suffer fewer expected setbacks, and therefore, they become less risky than the rest of the stock indexes.

We saw these trends before the 2019 rally, and now we perceive these risks as more dangerous. It is ironic that investors consider passive investing less risky in a moment when major indexes are traded with the highest premium for a long time, guaranteeing a zero return in the long-term. Overpaying for stocks is clearly a mistake. In other words, and against popular opinion, we think that the whole market – understood as indexing to the major indexes – has never been so risky. Meanwhile, other unpopular sectors, punished by passive investing and ESG, are the most attractive opportunity after a risk-reward analysis.

Thinking differently from the crowd forces us to accept volatility episodes, which is the price we pay on behalf of a significant return. Again, the facts ratify our portfolio construction and our investment philosophy, while the stock prices differ. It already happened in the dot-com bubble and the housing bubble in Spain. Now, the reversion is lasting longer and the need for patience is even more critical. This need for patience is backed by the next facts:

Firstly, comparable assets to those that we own are traded at a premium according to market valuations, the purest representation of their intrinsic value.

Secondly, the pessimism reflected in the shares – for instance, Tullow or Consol – does not match the implied default probabilities of the debt instruments of those companies.

We continue to question the validity of our own views over time. But we feel the opportunities are so attractive that we do not need to be totally right, it will suffice not to be totally wrong to achieve great results.

Finally, we have one of the most liquid portfolios of our career. This is very important in the current situation, as the patient investor would not be affected in case other investors decide to exit our funds. We remain wholly invested in our funds on a personal basis, aligning our incentives with the investors.


Administration and Business Area. News from Azvalor.

In 2019, we continued strengthening our operating platform from the point of view of technology, with improvements in infrastructure and security. Now, we can give more information to investors in the private area of the website thanks to these new functions, which also allow us to improve our operational process.

The improved systems have reduced the operational risks. For instance, in 2019, we managed 12,000 operations and had only one incident that led to a Customer Service complaint.

The digitalization of the operations has been key to achieve that level of efficiency. At present, we are processing more than 90% of additional operations on digital channels through SMS authentication.

Loyal to our objective of encouraging long-term savings, we have significantly increased periodic contributions to our mutual funds, surpassing 1,000 transactions. The process to execute those transactions is simple and requires just two authorizations – firstly, Azvalor’s and, secondly, the investor’s bank -, activating automatically the periodic contribution. We think this strategy is very appropriate to increase savings over time.

We would like to highlight the 2.2 million visits of our website over the year with a user base of just 600,000. This high level of traffic has also been extended to our Youtube channel – AzvalorYou. Our videos received more than 235,000 views, adding to a total 3.5 million viewed minutes.

In 2020, we will continue to improve our systems and processes. We expect to communicate some new functions soon, making engagement with Azvalor even easier.

In the business area, we appreciate the support of our investors. In a difficult year, regarding the relative underperformance of our funds, we gained the confidence of more than 1,100 new investors. As we have experienced before, the moments of worse performance have generated more activity from investors, confirming their support. However, for the first time since our beginning, we have also experienced the loss of a significant number of investors. We are very thankful to all of them and we reiterate our commitment of hard work to increase investors’ savings, which are jointly invested with ours in the funds.

The raison d’être of Azvalor is a combination of investors’ trust and a meticulous investment process, which we have applied for more than 24 years. And although this good work is not always reflected in the results temporarily, we are sure that this approach is still valid and profitable.

Analyzing the current portfolio of Azvalor International, more than 50 positions in the portfolio – currently and in the past – gave an aggregate positive result of 20% in 2019. More than 20 stocks returned over 40% and 9 of them more than 60% – some of them were already sold after a good performance. On the other hand, 22 positions were in negative during this period – and caused a 15-point drop for the funds – but only 4 of them represented 80% of the total negative return. These positions are still on the portfolio because, in our opinion, they will not be a permanent loss – still an attractive opportunity. Despite these declines – that we consider temporary – we still remain confident that the initial investment will be recovered with gains.

This data confirms that the process works and the expected return according to our estimations is not properly reflected in the actual performance. We learnt from recent research, i.e, the study by Tweedy Browne Company LLC ‘What Has Worked in Investing’, that 80-90% of the fund returns is generated at between 2% and 7% of the investment duration. What we do not know is when. That is why we need patience and confidence in the process.

Furthermore, our commitment with long-term savings is growing over time, as is our interest in the sustainability of retirement plans in Spain. This topic has been largely discussed in public debates, but it remains relatively unknown for many savers. For this reason, we have started a survey among our investors to obtain and publish the key information concerning our retirement plans, in order to raise awareness about the need of accumulating capital. We will show the conclusions of this investigation this year.

We remain committed with other educational projects on finance and investments. Some of them are the 2nd Summer Course managed by Azvalor at the Universidad Complutense de Madrid (UCM), the translation of books on finance and the recent agreement with the association Madrid Invest – Argent Spain – to promote knowledge and importance of investment in universities.

Finally, we are proud to support the most disfavored sectors of our society, through our Davalor platform in collaboration with África Directo. In 2019, we contributed €509,000 to projects managed by Davalor and África Directo. 23 projects in 10 different countries shared the whole contribution, which involved construction and reconditioning of schools, refurbishing of hospitals, deployment of solar installations and purchase of educational material and medical care. In total, more than 92,000 people and their families have benefitted from the welfare initiatives of the fund. We would like to thank all the participants and the team África Directo.

We encourage all our investors to attend our 5th Investors Annual Meeting in Barcelona and Madrid, which will take place at the beginning of March. We will soon get back to you with the details.

Thank you for trusting us and remaining our partners in the most literal sense of the word.