Investment memos

Caltagirone SpA – More “Hidden” Value

5th December 2015

We have not posted about one of our core holdings, the Caltagirone complex, for a while. In summary despite the security going up 11.6% since we initiated the position the discount to our fair value has remained broadly the same and the overall quality and certainty of the margin of safety has improved. Below we detail the main changes since our lost post on Caltagirone and we will also be increasing our holdings in CALT IM by another 2.5% to 5.0% at market open.

1. Vianini Lavori Take Private / Grandi Stazoni

On the 15th May 2015 FGC Finanziaria, a company controlled by Francesco Gaetano Caltagirone, made an offer of EUR 6.8 per share ex-div to buy out the 28.1% of Vianini Lavori not controlled by the Caltagirone group which represented a 16.8% premium to the 3 month average trading price immediately preceding the announcement date. In the offer Caltagirone stated that they would delist the entity if their offer was successful and at the a shareholders meeting on the 22 October 2015 it was announced that over 90% of Vianini’s shares were controlled by connected parties and they would be proceeding with a squeeze out and delisting.

We cannot fathom why the minority shareholders tendered their shares into this offer given that, excluding any value for Vianini’s stake in Grandi Stazioni, the offer represented a 48.9% discount to the value of the listed securities and cash net of all obligations that Vianini held. In fact, as we saw with Genterra, the controlling shareholders could fund the entire take out of the minorities with cash on the balance sheet.

Given the discount to a very conservative fair value we didn’t look further into Caltagirone’s motivations at the time or consider whether there was any other value we should have been taking into consideration. However, we know think that a big part of their motivation in this takeover was the upcoming privatisation of the Italian railway assets known as Grandi Stazioni in which Vianini has a stake through its 40% interest in EuroStazioni.

As a quick reminder Grandi Stazioni S.p.A. is a member company of Italy’s Ferrovie dello Stato (English: State Railways) group and was created to rehabilitate and manage the 13 biggest Italian railway stations. The company is 60% controlled by Ferrovie dello Stato and 40% controlled by EuroStazioni which is a consortium of private investors including the Benetton Group, Pirelli, SNCF and Vianini Lavori which has a 32.741% stake.

Interestingly it was reported at the beginning of July by Italy’s equivalent of the FT that the state was looking to sell Grandi Stazioni by the end of 2015 (article can be found: here). Having dug a bit deeper we were able to find a number of articles putting the price tag at EUR 1.0bn which we assume is a TEV not equity value (see example here).

With a bit more moderate sleuthing (and frankly something we should have done in our initial underwrite of the Caltagirone group) we were able to find the 2014 accounts of Grandi Stazioni with a view to trying to test the credibility of the rumoured EUR 1.0bn price take which you can find here.

It turns out that Grandi Stazoni is basically a real estate company which earns rent from commercial tenants located in the stations. Taking the latest annual accounts we stripped out the advertising and other revenue assuming a suitable EBITDA margin to arrive at the “clean” real estate earnings. Assuming a EUR 1.0bn TEV and adjusting out the value of the other businesses you would need to believe a purchaser would be willing to acquire the railway stations for a 5.6% rental yield or better. This would seem fair looking at CBRE data on Italian prime commercial rental yields which range from 4.00 – 5.50% (research can be found here). None of this gives any value to the Czech railway stations which they are currently redeveloping. We have included our workings on Grandi Stazioni valuation below:

Grandi Stazioni Valuation

 

All in all the additional value from Grandi Stazioni adds an additional 17.7% value to the Vianini stake which equates to 18.4% of the current CALT IM market cap.

Finally, in tracing all of this back we also noticed that we goofed up our initial memo by only attributing value from Caltagirone’s 50.045% direct stake in Vianini and missing an additional 6.426% stake that they held indirectly. This is worth an additional 14% of the current CALT IM market cap

So all in all we have “discovered” an additional 30% of value in Vianini when considering the market cap.

2. Caltagirone Editore

When we recommended an investment in the group Caltagirone Editore was EBITDA negative. This has now reversed with the group posting positive LTM EBITDA of EUR 3.2m driven by two things: (i) stabilisation / recovery in advertising revenue, and; (ii) continued effective cost cutting. Depending on the levels of employee and other provisions that get crystallised during 2015 the business will still burn a small amount of cash but not much. Below we have laid out all the quarterly financial and operational KPIs we could find in CED IM’s reporting so you can judge the performance of the company for yourself:

CED IM KPIssee pdf

To be clear CED IM is not out of the woods yet by any means particularly as the online contribution as a % of the total advertising revenue is only 11.6% as of Q3 2015. However, we still continue to hold a small position in CED IM as we believe that a discount of 53% to cash and listed securities represents a dislocation to fair value given the performance of the underlying business.

3. Cementir

Quick health warning that this asset represents a meaningful part of the CALT IM value story and we have not done a huge deep dive on it (obvious comment but you should always do your own diligence as this post shows we often make mistakes).

For the first 9months of 2015 Cementir has roughly stayed flat posting 0.7% revenue increase and a (1.9)% decline in EBITDA. Using Cementir’s LTM EBITDA to Sep 2015 the business is trading at a 7.2x multiple which seems inline to slightly cheap to the other albeit larger cement players such as Holcim, HeidelbergCement etc. At a high level the biggest concern that we have about Cementir is that it generates c. 28% of its revenues and c. 32% of its EBITDA in Turkey which is a potentially overheated economy and also has a higher political risk associated with it that we would normally be comfortable with.

CALT IM’s stake in Cementir represents 34% of our total fair value and it you excluded any value for Cementir then CALT would be trading at a 45% discount to our view of fair value.

4. Updated Valuation

See below for our updated valuation of CALT IM, in short we believe that it is trading at a 41.1% discount to fair value based on the current trading value of each listed entity and a 63.9% discount to our view of fair value.

Caltagirone Valuationsee pdf

Our full workings can be found here

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Investment memos

Gencan Capital Inc (GCA CN) – Smash & Grab 1.85x MoM – SELL above CAD$ 0.043

Our relationship with Gencan was even shorter than with it parent and listed predecessor Genterra Capital Inc (original memos can be found here & here). We exited our entire position at CAD$ 0.14 on the 11th November 2015

A quick potted history of the situation as a reminder for those who have not read all the previous posts:

  • Genterra Capital Inc was a Canadian Venture listed company which owned real estate, a solar park and some listed securities
  • On the 10th July 2015 the controlling shareholder made an offer to take Genterra private in the form of cash consideration of CAD$ 1.96 per share and two shares in Gencan Capital Inc an entity being spun out of Genterra which would own the solar asset
  • We exited our Genterra position in the market on the 4th August 2015 at an implied price for Gencan shares of CAD$ 0.195 which implied the market was paying a premium to the undiscounted cash flow streams of the solar park which is mad
  • We then got the opportunity to re-enter Genterra with a view to creating the Gencan spin-off cheap and acquired shares at an all in effective price of CAD$ 0.745 between the 14 & 16th of August 2015
  • The Gencan spin-off became effective on 28th October 2015 and the shares were listed to trade on the Canadian Securities Exchange as of the 30th October 2015

At the time we initiated the trade there was imperfect information on Gencan which had previously been a subsidiary of Genterra and therefore did not have separate reporting as well as having only limited trading history given it only recently started generating electricity as of August 2014. At the time of trade the majority of our information came from the Genterra takeover prospectus and the accompanying valuation report. Since then there has been additional disclosure specific to Gencan Capital Inc on sedar which revealed the following:

  • Rent – confirmed that Gencan has to pay rent to Genterra for the lease of the rooftop which equates to CAD$ 60,000 per year for 20 years (the life of the FiT). They also have a 10 year extension option in their favour (we assume to capture repowering opportunities)
  • Administrative Services Agreement – revealed that on top of the CAD$ 60,000 management fee Gencan would pay to Genterra it would also pay an annual CAD$ 6,000 administrative services fee
  • Overall Operating Expenses – the company is estimating CAD$ 270,000 of annual operating expenses (including interest)
  • Results – on the 5th November 2015 Gencan released its June 2015 9 month results which showed that if Q4 produced a similar amount of electricity as Q3 which would seem sensible given it covers the summer months of July – September then the company would likely hit its revenue target
  • Debt – nasty surprise here that the debt is due on 1st August 2019. Our assumption had come from page E-2 of the Genterra information circular where the independent valuer stated that “A loan from Genterra was used to finance the installation which bears interest at 4% and is assumed to be paid in five instalments of $511,594 on 30 September for the years 2030 to 2034.” On closer examination of the same document on page G-20 they state “Pursuant to an Amending Agreement made on July 16, 2015, the loan has been converted into a 5-year term loan repayable on August 1, 2019, with interest at a rate of 4% per annum calculated and payable monthly in arrears.” Why the valuer was using a different assumption from reality we have no idea but more fool us for not reading the document more carefully

Incorporating all this new information into our model we come to two key conclusions that you need to draw when valuing Gencan today:

  1. The total cumulative net cash flow to equity is likely to be in the range of CAD$ 2,677,286 (depending on your debt repayment assumptions)
  2. Given the 2019 debt maturity it is unlikely that Gencan will make any distributions to the equity until after the maturity as the business looks to build up cash to delever

In terms of valuing Gencan we have changed our base case to reflect the changes above and also show a build-up of cash until 2019 and then a repayment of the debt via a 100% free cash flow sweep. Only once the debt is repaid can you expect equity distributions. This is in-line with project financing agreements for similar solar park ventures that we have seen elsewhere.

We would sell our position in Gencan at an Equity Free Cash Flow (“EFCF”) yield below 10% (implied price of CAD$ 0.043) and start adding if the EFCF got above 15% (implied price of CAD$ 0.024). As a result we exited our position at a price of CAD$ 0.14 for a 1.85x MoM and a 413,575% IRR.

Updated model below

Gencan Capital Inc Memo (2015.11.15)

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Venture Capital – There is Something Strange in the Neighbourhood

Investing into Venture Capital could not be further away from the focus of this blog. We are aiming to squeeze out returns from unloved and obscure companies that are trading substantially below their liquidation value and do not require growth or other forms of significant outperformance versus their current status quo to drive our return. If we were writing a blog about venture capital investing we would be looking for the next hot ticket and making investments on the basis of blue sky visions often with no expectation of profitable operations in the near or medium term.

Neither strategy is better (in our opinion) and there are some fantastically successful venture capital investors whose track records rival those of great value investors both in terms of returns but also longevity and consistency of performance. So whilst we would be absolutely awful deploying our capital in VC investments there have been a couple of interesting things we have recently been reading around the VC space that we wanted to highlight and discuss.

1. Andreessen Horowitz Presentation on US Tech Funding

Andreessen Horowitz – US Tech Funding.pdf

Whilst Andreessen Horowitz was only founded in 2009 its cofounders Marc Andreessen and Ben Horowitz were very well known VC investors in their own right prior to joining forces and founding this firm. Today it manages $4bn of capital and is known for playing in the mature end of the market at one point owning four of the highest valued privately held social media companies at the time (Facebook, Groupon, Twitter and Zynga).

This is a great thought provoking presentation whose central argument is that all the recent activity and investor interest in technology companies is not comparable to the tech bubble that occurred in the early 2000s. Core to their argument are the following points:

  1. Whilst tech indices are growing in value this is being driven by earnings and not multiple expansion
  2. You have not seen anywhere near the public market listing frenzy that we experienced in the early 2000s
  3. There has been a step change in the size of the market that tech companies are addressing (internet usage and smart phones). To highlight this they provide an interesting metric of tech funding by person online (this does remind us of the Wall Street research analyst folly during the 2000s bubble of inventing new valuation metrics such as “number of eye ball valuation metrics.”)
  4. US ecommerce and online advertising has increased 15x since 1999 and represents a significant addressable market from an economic standpoint
  5. We have not seen the same surge in VC funding that you saw in the 2000s bubble (lower funding also as a % of US tech GDP vs the previous bubble)
  6. The large fundraising rounds get a lot of focus but the majority of the capital deployed is in smaller companies where it has gotten cheaper to start a new venture

Away from the core theme the presenters also focus on trying to explain the “unicorn” phenomenon in VC (a unicorn is a private company with valuation in excess of $1bn). They make an interesting point that the time to IPO for successful tech start-ups is now substantially longer than in the early 2000s. The presentation also makes a compelling case that today tech IPOs have been delayed or even replaced by private funding rounds and imply that the risk of a bubble is lower as these funding rounds are focused on later stage companies. The big gap in the presentation is that they do not prove that there is not a bubble in the privately funded VC companies as they make their argument for why there has been a shift from the public to private market capital as a source of VC funding.

The biggest question the presentation left us with is whether a bubble has occurred in the private capital markets focused solely on the large capital rounds as institutional, sovereign and corporate investors struggle to deploy enough capital into “attractive” opportunities in this low inflation environment. There are two pages that sum up the key part that is missing in their defence of a tech bubble: (i) “Yes there is more funding for larger deals” (p22), and; (ii) “But this is just a rebalancing from IPOs” (p23). The problem with their arguments about tech contribution being flat as a % of GDP and other metrics about the step change in size of the industry is illustrated on p60 where they show that only $212bn out of a total market value of $3,085bn is represented by unicorns, just 6.9%. It is not inconceivable that irrational exuberance has crept into this part of the market.

The one metric we would love to see that would go a long way to evaluating whether we are in fact seeing a bubble in the unicorn VC deals is a comparison of p/e multiples by funding round to the p/e of the listed companies during the early 2000s bubble similar to what is shown on p7 (our guess is this is difficult to compile due to the private nature of all of these unicorns)

This is probably unfair given the quality of presentation and the thought behind it but after reading it we could not help but be reminded of one of our favourite investing quotes:

When people are saying: “this time it is different” grab your wallet and walk carefully toward the door. History never precisely repeats, but it does rhyme.”

Jesse Livermore

2. The Increasingly Crowded Unicorn Club

The Increasingly Crowded Unicorn Club

Not much to say here (particularly as we do not know over half these companies) other that as always a picture tells a thousand words.

3. The Square IPO

Deal Book – Square, Facing a Chilly Market, Persists in Pursuing I.P.O

In the context of the thought process that the Horowitz piece began we thought this article and process was very interesting for two reasons.

First you are seeing the public markets require a 35% valuation discount to the last private market capital raise valuation in order to get the IPO away.

Second there is another hidden source of losses / potential excess valuation in private VC funding which is the existence of different economic rights for later stage investors such as shares with liquidation preferences or in the case of the square anti-dilution ratchets.

Now a disciple would say that point two is fine as these rights are typically only given to late stage investors and even if there is dilution of early stage investors on a monetisation event they will be making out like bandits regardless. However, given the furious pace of funding rounds we wonder whether there will be some late stage investors who subscribed at similar valuations but get disproportionally hurt in a downdraft as they find themselves sitting on the wrong chair from an anti-dilution perspective when the music stops.

Conclusion

To be clear we are not advocating for the existence of a bubble in late stage / unicorn VC deals, our knowledge and data is simply too skin deep to make any conclusions either way. However, it is always useful to take a critical look at other investment classes as well as your own and ask which offers the best value and risk/return.

Would be great to hear other people’s opinion on VC and any good data they have come across on valuations.

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Investment memos

Gencan Initiation

Recommendation: BUY, target price upto CAD$ 2.17 (including trading costs)

Share Price: CAD$ 2.15

Market Cap: CAD$ 17.9m

Free Float: 28.9%

Ave. Daily Trade Volume: CAD$ 1,288

This investment comes out of our previous involvement in Genterra and is focused on creating the spin-off entity Gencan at a reasonable return on equity over the life of the solar feed in tariff. We have written extensively about Genterra during our hold period and the key post describing the spin-off entity and how we value it is here.

Last week we loaded up on Genterra securities as they represented an excellent return on contracted cash flow. In creating the position we had to factor in the following two considerations:

  1. Position sizing post the demerger dividend – at the top end of our buy range only 10% of capital deployed will remain as the final position in Gencan. Obviously if we achieved better pricing than CAD$ 2.17 our stub position would represent an even smaller % of capital deployed.
  1. Trading fees – when creating the stub position for a maximum price of CAD$ 0.21 you have to be very sensitive to the effective creation price including your trading fees which changes depending on how many shares your purchase per trade (i.e. how spread out your fixed trading costs are). As a result of these factors it made sense for us to acquire 510 shares at CAD$ 2.0 which created the company to a 39.1% IRR in our downside case but if we have acquired 510 shares at our maximum buy price of CAD$ 2.17 our IRR would be only 10.9% which is below our target price of 15.0% IRR

Included below is an overview of how we calculated target trading levels depending on the amount of securities that were offered in the market

Genterra Trade Sizing

On the question of sizing we think this is very good risk as you are acquiring a fixed set of cash flows that have been set by the government with the energy being taken by the government (Ontario Power Authority). The only way for these cash flows to change would be by operation of law as you have seen in Spain which we see as unlikely to occur in Canada. As a result in the rosiest picture you could argue that you are buying a proxy for Canadian sovereign risk significantly wide of where their long dated bonds which trade at a Yield to Worse of 2.27% (unfortunately for what we can see Canada only have 21 sovereign bonds out and the longest maturities are 2021 and 2064 so we chose 2064 as the length of the contract goes to 2034)

We would have liked to have Gencan be a 7.5% position in the portfolio but mathematically we would have had to deploy more cash than we have available in the fund. Instead we took the view that we would deploy all our available cash less 7.5% in case we stumbled across another position we really liked. We expect the spin-off transaction to consummate before year end and to be left with a 5.7% position based on total net portfolio value as of Q3 2015.

In total we completed the following trades last week taking us to a full position size:

Gencan Completed Trades

Our net Genterra creation price of CAD$ 2.109 creates Gencan at a 22.5 – 26.9% IRR to renewable tariff expiry in 2034 and if held to maturity would represent a 3.9 – 4.6x MoM from contracted cash flow.

As with all investments there are risks which we split into pre & post spin off below:

  • Pre Spin-Off – up to consummation of the transaction we will have 80.7% of our fund in Genterra which is scary. We got comfortable with this risk as the transaction is being proposed by the 70% shareholder so the risk of the conditions precedent not being fulfilled is low (our guess is that tax clearance is potentially the only element not in their control). We also get comfortable with this concentration given our view that the controlling shareholder is acquiring Genterra at a significant undervalue vs our CAD $2.90 a share valuation of the enterprise. Finally the nature of the business (real estate and renewables) is very stable so the chance of a material adverse change in the business seems low
  • Post Spin-Off – we are faced with the same risks as we had when we invested in Genterra namely: (i) illiquidity of the security, (ii) controlling shareholder leaking value to themselves, and; (iii) poor capital allocation. Given our approach and focus we are inherently comfortable with risk (i) as it is the main driver of opportunity creation in our universe. We are more comfortable with risk (ii) as the controlling shareholder did conduct a valuation and got court approval for their take private of Genterra, however, we will just have to accept that if this happens at Gencan it will be at an undervalue and that the cost structure of the vehicle will not be optimised (which we reflect in our model). Finally we are probably most concerned with (iii) as the controlling shareholder may decide to use cash generated by the entity to invest in new solar projects at lower equity returns to either help with related party transactions or grow their fee base which would obviously dilute our return

Our model of Gencan can be found below:

Gencan Memo (2015.10.24)

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Track Record

HIPS Performance Track Record (Q3 2015)

HIPS Performance Tracker Q3 2015

We continue to be disappointed with how much time we are actually spending on security selection and the blog which is reflected in the fact that 9 months into the blog we have only deployed 12.5% of our assets.

In the quarter we monetised Genterra Capital Inc after the owners made a combined take private and spin-off bid for the company. Whilst we were very disappointed with the clear undervalue the take private offer represented we were able to exit in the secondary market at an implied valuation of SpinCo that was ludicrously high and generated a profit of 72.8% / 1.72x MoM and an IRR of 162.3%.

Despite only deploying 17.5% of our portfolio at the peak we are up 2.8% net of costs for the first nine months against (1.8)% for the passive portfolio which is 95% invested.

Jubii Europe has reached the buy price we set in our previous article and we intend to revisit that security in the near future. In the meantime we have summarised developments during the quarter for our holdings below

Emerson Radio (MSN US)

We increased our position in Emerson to 7.5% of the portfolio post the late release of their 10K as: (i) the major risk of a negative outcome on the IRS tax investigation had been removed with Emerson achieving a positive outcome vs our case, and; (ii) the stock was trading below our entry price despite this positive news. Emerson’s main issues remain the underperformance of their white goods business and the resolution of the restructuring / liquidation of Emerson’s major shareholder, Grande Holdings, couples with the potential for bad acts by the controlling shareholder.

Since increasing our position Emerson released its June 2015 quarterly results in August which highlighted two areas of concern. The first relates to the profitability of their white goods business post revenue decline of 26.4% in the quarter which was in excess of management’s expected 15.0% decline due to discontinued lines by their customers. We had previously highlighted a concern that with lower customer orders Emerson may not benefit from the same competitive pricing from their suppliers that they were able to achieve on a higher order volume. This concern would appear to be being borne out by the fact that gross margin declined to 7.0% which is the lowest level since Q1 2014.

However, a much larger concern around the white good business is that Emerson management have actually increased their SG&A vs Q2 2014 by 11.2%. This is absolutely staggering and really needs to be addressed as the business is clearly in decline and now EBITDA negative. We remain of the view that the company should sell its white goods business or at the very least cut costs to the bone.

The second issue that is concerning us is that despite a large decrease in revenues trade receivables actually increased by $5m. It is also surprising that inventories have remained flat. We have stated in the past that the Emerson white goods business has a significant positive working capital balance (now $22.1m) and we would expect to see cash released as the white goods business declined. We hope this is just a timing issue as if not it would further point to the poor management of the business by FTI, the board and the executive management team.

Looking at the filings of the Grande Holdings liquidation they are still in the same dance of a perpetually delayed publication of their restructuring circular which is concerning as the restructuring is supposed to be wrapped up by December 2015 (seems very unlikely). As discussed before the process is very opaque and the controlling creditor / shareholder has engaged in questionable dealings both with Emerson and Grande so we will just have to keep close eye on developments.

Our updated fair value range for Emerson is $2.38 to $2.95 which ascribes no value to the white goods business and assumes the full $4.8m of dividend tax liabilities. Acquiring the stock today at $1.23 you are getting the valuable licensing business for free as the estate trades below cash. Furthermore even if you run rate Q2 2015 negative EBITDA from the white goods business and assume no working capital benefit the operating free cash flow yield would be c. 12.5%. We believe the investment thesis remains intact but will closely monitor developments at Grande as well as management actions at Emerson.

Caltagirone SpA (CALT IM)

The only major update in this story is that FCG Finanziaria, a holding company of Francesco Gaetano Caltagirone, made a takeout offer at €6.8 per share for the remaining shares of Vianini Lavori not owned by the connected parties of the Caltagirone Group. It has been recently confirmed that they have got to the 90% threshold in order to delist the company and will proceed to do so.

FCG’s offer represented a 16.5% premium to the last three months trading price but is still a 41.9% discount to our view of fair value (which does not give any value to their construction business).

Included below is our valuation of the Caltagirone complex both at investment date and as of Q3 2015 which shows that the only meaningful moves in valuation have been: (i) the increased market price of Vianini Lavori, and; (ii) the share price of Caltagirone SpA.

Caltagirone SpA Value Evolution

Caltagirone Editore SpA (CED IM)

Since our investment the CED IM’s discount to fair value has increased by 3.3% despite the underlying performance of the business significantly improving. In Q2 2015 the business posted positive EBITDA of €1.3m vs a loss of €0.4m in Q2 2014 representing an overall profitability improvement of €1.7m vs a similar improvement of €1.2m in Q1 2015. These improvements have meant that the business has moved from a €3.7m cash burn in H1 2014 to a €1.9m cash generation in H1 2015 which is a sterling effort.

The negative is clearly that revenues continue to decline with the positive performance in EBITDA being driven by continued cost cutting. Whilst CED IM’s online revenues are increasing strongly (11.5% increase in the quarter) we expect the need to see revenue stabilisation to see a real re-rating in the stock.

Hopefully the Caltagirone family will look to take advantage of the clear mispricing of CED IM in a similar way to Vianini Lavori although obviously we would hope it is at a price which more closely reflects fair market value.

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12 Things We Have Learned From Reading The 25iq Blog

If you have not read Tren Griffin’s 25iq Blog we would highly highly recommend it. The highlight of the 25iq Blog is a series of articles entitled “A Dozen Things I’ve Learned from …” which covers a whole host of value and VC investors as well as some leading entrepreneurs past and present.

Having read the blog cover to cover we thought it would be good to highlight the twelve things we have learned (or at least have had reinforced) from great men and women in a chapeau to a great blog. Thanks Tren

[the lessons below are in no particular order of importance and should be viewed in the round]

 

1. Keep Things Simple!

“Listen, business is easy. If you’ve got a low downside and a big upside, you go do it. If you’ve got a big downside and a small upside, you run away. The only time you have any work to do is when you have a big downside and a big upside.” Sam Zell

This is an absolutely brilliant quote. Drawing on our limited experience since starting this blog the securities we have spent most of our time agonising over have been related to Sam’s third category (e.g. Unitech Corporate Parks). We are continuously left with the feeling that a good investor really needs to size their best longs aggressively given good ideas are so rare.

 

2. Don’t agonise over forecasts and recognise the limitations you are working with

“We deal in probabilities, not predictions.” Marty Whitman

“In both economic forecasting and investment management, it’s worth noting that there’s usually someone who gets it exactly right… but it’s rarely the same person twice. The most successful investors get things ‘about right’ most of the time, and that’s much better than the rest.” Howard Marks

Investing is a probabilistic exercise where the frequency of an investor’s correctness should not be the focus but rather the magnitude of correctness. We all need to recognise that there is risk, uncertainty and ignorance involved in investing and diligently focus in on an approach that minimises the risk inherent in uncertainty.

 

3. Investing is physiologically though, the temptation to lapse into bad habits is ever present

“The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.” Howard Marks

Psychological mistakes are at the same time the biggest source of danger for an investor and the biggest source of opportunity when other people succumb to those mistakes. Staying apart from the maddening crowds, having stable capital and a long term outlook will put you in a very small club that can exploit the psychological flaws of others.

25iq has an absolutely fantastic post about the 12 most common human psychological flaws. We would encourage everyone to read it and identify past examples of your biases (link

 

4. Stay within your “Circle of Competence”

People seem more comfortable investing in something about which they are entirely ignorant.” Peter Lynch
We have found it particularly hard not to fall into this trap when we are looking at seemly attractive value opportunities in either technology or financial companies which are both areas where we lack a great deal of knowledge compared to “real world” industries. It is likely that we will post an investment memo in the coming weeks about a financial company that looks incredibly cheap but the biggest risk is that we are not 100% on top of their business model and think it is difficult to be as an amateur investor.

 

5. The key determinant of a business value is current and future cash generation

“If you don‘t have the free cash flow, you don‘t have anything.” Leon Cooperman

The only unforgivable sin is to run out of cash. At HIPS when we screen for deep value opportunities positive operating free cash flow (or in a few cases a very small burn rate vs the margin of safety) is an absolute must.

Away from investing our other hobby is collecting art and friends often ask if we are doing it is an investment to which the answer is always no. Art’s only inherent value is what at least one person is willing to pay for it. We have picked up cracking pieces at auction because we were the only buyer, similarly we have paid over the odds for rare items because there was one other buyer in the room. Compare this to cash which is globally fungible and can be used to buy anything, particularly other assets that generate more cash. As a value investor should always be looking to acquire the asset that generates the most cash over a long period of time at the lowest risk which is selling for the cheapest price. As usual Warren Buffet put it best in his excellent article extolling the dangers of investing in gold particularly this quote: “if you own an ounce of gold for an eternity, you will still own an ounce at its end.”

 

6. Spend as much time learning from your mistakes as your successes

“It is fine to celebrate success, but it is more important to heed the lessons of failure.” and “There are many lessons about the dangers of success, and Henry [Ford] is one of them.” Bill Gates

Failure is an opportunity to learn. The more you learn in life the more you learn that there is even more you don’t know and that some things are unknowable.  What you may attribute to success may be luck and vice versa.  Success in one domain does not equate to success in all domains.  Success may cause you to succumb to “man with a hammer syndrome (everything looks like a nail).”

 

7. Nothing good or bad goes on forever. Don’t extrapolate something indefinitely

“Rule No. 1:  Most things will prove to be cyclical. – Rule No. 2:  Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1.” Howard Marks

“Whatever happens in the stock market today has happened before and will happen again.” Jesse Livermore

When people are saying: “this time it is different” grab your wallet and walk carefully toward the door. History never precisely repeats, but it does rhyme.” That markets will fluctuate in cycles is inevitable; predicting the timing and extent of the cycles is impossible.  Value investing is about putting yourself in position to benefit when the inevitable happens.  Price, don’t predict!

 

8. “Unless you’re running scared all the time, you’re gone”

“Unless you’re running scared all the time, you’re gone.” Bill Gates

“A steel company might think it is competing with other steel companies. But we are competing with all other companies.” Henry Singleton 

In our opinion Bill’s quote applies to life away from investing. Being paranoid, self-reflective and constantly in search of improvement is the hallmark of the most successful people we have encountered. Given we are apt to buying business that are mispriced due to a structural change in their market Henry Singleton’s quote resonates a lot with us. We have found it difficult to find a moat that we can really underwrite for 100years particularly in the age of disruptive technology. Businesses tend to fail not from a frontal attack, but when they are eclipsed or enveloped.

 

9. Don’t buy anything that doesn’t have a substantial margin of safety

Most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose.” Seth Klarman

“A lot of people talk about risk in the stock market as the risk of stock prices moving up and down every day.  We don’t think that’s the risk that you should be focused on.  The risk you should be focused on is if you invest in a business, what are the chances that you’re going to lose your money, that there is going to be a permanent loss.” “[The] key here is not just shooting for the fences, but avoiding losses.” Bill Ackman

As Buffett says Rule No.1 is “not to lose money,’ and Rule No. 2 is “not to forget Rule No. 1.” The second point to bear in mind is to only care about permanent capital loss and not market to market movements. Permeant loss of capital can only occur if your underwriting of a business was incorrect and something occurs that fundamentally and permanently changes the cash flow generation profile of the assets (think yellow pages when google thundered onto the scene). We are also constantly reminded that the volatility of a stock, known as beta, has absolutely no bearing on the securities inherent risk of a security and anyone trying to tell you otherwise should be rounded ignored.

 

10. Don’t let your first purchase price anchor your subsequent buying if Mr. Market presents more paper substantially lower

“Your profit is the difference between your average purchase price and your average selling price. Bernard Baruch [a great investor in the 1920s] said nobody buys at the bottom and sells at the top except liars. Your stock will go down after you buy it, and it will go up after you sell it. Being willing to lower your average cost [by buying more when a stock drops] is a great strategy. But it’s difficult.” Ben Miller

Every purchase we made in the HIPS portfolio (albeit we have not made many) has gone down after we purchased it. Probably our biggest asset allocation sin to date has not been adding to Caltagirone Editore when it was in the 0.80s despite the fact that the business had turned EBITDA positive compared to when we initiated the position at EUR 1.00. There are reasons for this and hindsight is always 20:20 but it illustrates Ben’s point. You should not be adding a position to your portfolio that you would not be comfortable buying if it was 50% down without any fundamental change in the facts driving value.

 

11. Hold a concentrated portfolio of high conviction stocks that represent your best ideas

“Owning stocks is like having children — don’t get involved with more than you can handle. The part-time stock picker probably has time to follow 8-12 companies.” Peter Lynch

“An investor is better off knowing a lot about a few investments than knowing only a little about each of a great many holdings…. you diversify most of the diversifiable risk away from a portfolio by owning 20 or 25 positions.” Seth Klarman

“…for an individual investor you want to own at least 10 and probably 15 and as many as 20 different securities.  Many people would consider that to be a relatively highly concentrated portfolio.  In our view you want to own the best 10 or 15 businesses you can find, and if you invest in low leverage / high quality companies, that’s a comfortable degree of diversification.” Bill Ackman

There are a lot of different opinions amongst proven value investors about diversification. Investors like Walter Schloss and Joel Greenblatt have high 10s to hundreds of securities in their portfolios whilst the giants quoted above are all comfortable with less than 20. Marty Whitman once argued that once your portfolio exceeds 40 names the risk of closet indexing is high. What is clear to us is that you need to find your own style as an investor and just because we gravitate to a concentrated high conviction strategy doesn’t mean you should.

 

12. Remember the importance of having an “edge”

“To make money, you must find something that nobody else knows, or do something that others won’t do because they have rigid mind-sets.” Peter Lynch

“[At a horse racing track people make] bets and the odds change based on what’s bet. That’s what happens in the stock market.” Charlie Munger

We debated whether to include this as having an information edge is very difficult for the amateur investor. The quote from Munger puts this best as it highlights that betting on a favourite or long shot may or may not be a good bet. What matters is whether it is “mispriced” in your favour because the market is missing something. We believe that the market is efficient most of the time and therefore you need wait for the right pitch and look in areas where market inefficiency is likely to occur more often.

We decided to include it as we believe the amateur can generate edge by digging in the illiquid, obscure backwaters of the stock market where the professional money manager doesn’t tread. When reading other investment websites where both amateur and professional investors pitch their top ideas we are always surprised to see that the majority of the recommendations are large cap stocks that are very well covered by the street research analysts, money managers and newswires. It seems to us that your statistical probability of finding something that gives you confidence that you will outperform on an absolute basis seems very remote compared to less well covered parts of the market. Remember it is mathematically certain that you can’t beat the market if you *are* the market.

 

We hope this was as helpful as the content on the 25iq blog; it is certainly no match for it. The only thing we did not add as we thought it was too obvious but is definitely something you need to focus on if you do not already is to remember that “A share of a stock is not a lottery ticket. It’s part ownership of a business.” Peter Lynch. The right thing for an investor to love is the process of investing, not the bet itself.  The right process for an investor is to understand the value generated by the underlying business.

Happy hunting

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Investment memos

Genterra Capital Inc (GIC CN) – From an Irrational Price to an Irrational Price

God the market is weird. For over 4 years Genterra traded at a totally irrational price (see my original investment memo). Immediately after the company announced a share buyback and spin off worth CAD$ 2.25 (CAD$ 1.96 in cash and $0.29 of value in a new security) there were two trades at $1.91 and $1.97 allowing you to create Genterra Energy for free (see my update article). Now the security trades at $2.45 valuing Genterra Energy (“GEI”) at an equity return as low as c. 2.6% for a yield stock with no growth prospects.

In addition to the valuation of GEI I was also going to comment on independent valuation included in the management information circular as I think it is flawed in a number of places but have decided against it as my time is probably better spent searching for the next Genterra as opposed to railing against being short changed vs fair value.

To be clear I am selling my Genterra stock tomorrow as soon as there is a bid in the market.

Genterra Energy

You can find the management information circular here which provides all the detailed background on the transaction and GEI.

Appendix E deals with the valuation of GEI and provides you with the following key inputs:

  • The annual energy output is 812,495KWh
  • The Feed In Tariff (FiT) has a 20year life expiring in 2014 and is set at CAD$ 0.635 per KWh
  • To reflect the decline rate in the solar panels over time you should reduce the energy output but 0.7% per year
  • GEI has a $60k per year management agreement with Highroad (related party owned by the Letwin family)
  • There is a loan of $2,557,970 which bears a 4% interest rate and amortises in equal instalments of $511,594 in years 2030 to 3034

There is no mention of rent payable by GEI to Genterra but in previous reports of Genterra they have mentioned that $50k per year of rent was payable by GEI for use of the roof of their properties. It is also worth noting that Highroad was previously happy to manage the solar park for $30k per year as per the last Genterra reporting.

I built a rough and ready model for GEI the output of which you can find here: Genterra Energy Valuation (2015.08.02).

My model shows equity free cash flow without ongoing rental payments from GEI to Genterra and also net as it is not clear from the circular. It is worth noting that operating and administrative expenses for GEI for the first 6 months equated to c. $67k which might point to rent being paid going forward. It also does not ascribe any value to the solar equipment at the end of its 20 year life. From the little I know there is value to the “repowering” of solar parks at the end of their life but given GEI doesn’t own the land on which its solar assets are on I don’t think you can assume that any benefits would accrue to GEI in this case.

The market is currently valuing GEI at CAD$ 0.49 vs my view of fair value at CAD$ 0.21 which is derived from wanting a 15% equity return over the life of the FiT whilst assuming no repowering and also that Genterra charges you rent.

Put another way the current price indicates that investors are willing to earn a 2.57 – 4.55% equity return over the 18 years depending on the answer to the rental question. On top of this the security will be very illiquid as the free float will remain at 28% of total shares. In addition you will still have the risk of related party transactions as you did owning Genterra, namely that Genterra related entities are providing: all management services for GEI, are the landlord for the site your park is on, and; are your lender.

It feels great to take advantage of Mr Market’s irrationality both on the way in and the on the way out as my track record is much closer to both buying and selling too early.

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