Category Archives: Anlage Philosophie

EMERGING MARKETS PART 3: JSFC SISTEMA ADRS (ISIN US48122U2042) – IS A RUSSIAN COMPANY INVESTIBLE (2)?

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So this is part 2 of the post about Sistema, the Russian conglomerate, part 1 can be found here…

Sistema offers quite a lot of material for investors on their website, including some nice investor presentations, including a relatively recent one from November 2013. As with Koc Holdings, I found the material surprisingly good for a Russian conglomerate.

Some positive aspects (compared to other Russian companies):

+ clear financial targets in place (Cash flow to HoldCo, ROI above CoC)
+ focus on cash generation and shareholder return
+ compensation of management linked to share price development
+ clear split of corporate center financials esp. debt. Again, this is more transparent than for instance with the Belgian HoldCos I have been looking at

Interestingly they seem to follow a little bit the “Koc playbook” by teaming up with foreign companies and listing their subsidiaries. They do claim that the Sistema Holding company acts as a “private equity” investor, although some of their “Monetization strategies” (dividends) are not really private equity style. Also they can show some significant disposals, such as the Power Generation business last year or their insurance company in 2007, so “empire building” is clearly not their highest priority.

Major businesses:

Sistema has two major businesses which are both listed:

Bashneft, one of the larger Russian oil explorers and refiners active in Bashkortostan (west of the Ural, European part of Russia) & & the Arctic region.

MTS is a large Russian mobile phone company with more than 100 mn clients in Russia and neighbouring countries.

Bashneft is owned 75% by Sistema, MTS 53,4%. Now comes the interesting part: The value of the two stakes (MTS 5,5 bn EUR, Bashneft 5,4 bn EUR) is already significantly higher than Sistemas Market cap plus holding debt. With Holding debt of around 0.6 bn EUR, total Holding EV is 7,7 bn EUR vs 10,9 bn EUR market cap of those two holdings.

Their other participations include Rail cars, a toy retailer, a local power grid, a hospital chain, a retail bank, farmland,and finally a struggling Indian mobile operator. Most of the other stuff made losses at least in the first 6 months in 2013, but even if we attach zero value on that, Sistema trades at a significant discount to its sum of parts.

Most of the other businesses are relatively new, for instance the Rail car business has just been bought and combined in 2013. A very interesting subsidiary is the toy retailer Detsky Mir which seemed to have just more than doubled profits from 14,7 mn USD to 36 mn USD. This proves to a certain extent that they are able to grwo new bussinesses and create value. Assuming a 10X P/E multiple for a fast growing retailer, this would add another 250 mn EUR or so to the valuation. They initially planned to IPO Detsky Mir in March 2014, but I am not sure if they might postpone it for the time being.

The Bashneft acquisition in 2009

The EPS development of Sistema clearly correlates to a large extent with Bashneft and MTS plus any realized gains from disposals. If we look a the last couple of years, we can see that the overall increase in Sistema’s earnings per share correlates mostly with the significant increase in earnings at Bashneft. Bashneft has grown very quickly over the last years with a significant increase in output.

Much more interesting is the timing and the price paid. Sistema acquired the majority in Bashneft in March 2009 for 2,5 bn USD. Remember, this was the time when the Russian Index had lost 2/3 of his value within 15 months or so. In their 2009 annual report, one can clearly see that the transaction was a “bargain” purchase at around 50% of “tangible” book. If we look at Bashnefts financials, we can see that the timing was really good. According to the 2010 Bashneft presentation, Bashneft made around 420 mn USD profit in 2009, so Sistema was buying it around 6x P/E. Already a year later net income was around 1.4 bn, a nice 240% increase, and despite the rouble losses, Bashneft will again earn more than 1 bn USD in 2013. So clearly, this 2.5 bn USD investment has more than paid off for Sistema so far.

One interesting aspect about Bashneft: The reserve replacement ratio, which shows if an oil company is discovering more new oil than it takes out of the ground, is around 800-900% for Bashneft. To put this in perspective: Most major Oil companies have ratios slightly above 100%, BP’s for instance went down to 77% two years ago. So overall, Bashneft seems to be a pretty attractive asset for Sistema. Even Lukoil for instance, another big & cheap Russian oil company has a replacement ratio of only slightly above 100%.

Bashneft got the rights to 2 very promising oil fields in the region in 2010. According to this article, this might be part of a strategy not to allowing any Russian oil company becoming too big.

Although there are clearly risks as well. There seemed to be a rumour, that state controlled Rosneft was “interested” in Bashneft but this was denied by Sistema.

Bashneft itself last year paid significant divdends. The 220 rubles per share would be a dividend yield of more than 12% at current prices. This seems to be a confirmation of Sistema’s strategy to upstream cash into the holding. Unfortunately, Bashneft is only traded very illiquid outside Russia on the German stock exchange, with bid/ask spreads of around 10%. Otherwise, Bashneft would be a very interesting additional investment as well.

Rusneft transaction

Another example for a succesful “private Equity” style transaction ist a smaller Russian oil company, Rusneft. In 2010, Sistema bought 49% of the highly indebted company for 100 mn USD. 3 Years later in June 2013, Sistema sold the very same stake for 1,1 bn USD. An 11-bagger in three years, not that bad. One could consider this as a “proof of concept” regarding their private equity business model.

Comparison Sistema with Koc:

After investing in Koc Holding from Turkey, I think it makes sense to make a quick comparison:

Negatives:
– Sistema doesn’t have the same long-term track record as Koc (20 years against 3 generations)
– the Russian market is clearly even “more dangerous”
– Sistema is less diversified than Koc, mostly Oil and Telco
– until now no proof that they are a “value adding” HoldCo

Positives:
+ they do not have a political problem with the current local leadership
+ no fx issues (oil revenues are in USD anyway), only small exposure to financials
+ Sistema is much much cheaper, both compared to sum of parts and P/E etc.
+ from a true contrarian perspective, Russia is even more interesting than Turkey
+ they seem to be able to pull off really lucrative deals like Rusneft and Bashneft with “eye watering” ROIs

Is a Russian stock really “investible”

This is a big question for me. A couple of months ago, I wrote a post why I would not invest in Greek stocks (mistake !) or German-Chinese companies (score).

Honestly, a Russian stock is clearly in general much more a “speculation” than a German or French one. Compared to Italian stocks however, I am not so sure anymore, as the EMAK and ASTM example clearly showed that Corporate Governance for instance in Italy is not that much developed.

The two most relevant questions in my opinion are:

a) Are the managers fraudsters or thieves ?
b) Can someone else easily interfere and take away assets etc. ?

In the case of Sistema, I do not have the impression that management are explicit fraudsters or thieves. I have certainly no prove for that, but the effort they make with con-calls etc. indicates a certain interest in shareholders and a higher share price. Ron Sommer, the former CEO of Deutsche Telekom is actually the boss of the supervisory board of MTS. They never sold any new shares to the market since the IPO, so the motivation behind the German-Chinese frauds seems not to be relevant here.

The majority owner Vladimir Yevtushenkov is clearly a typical “Russian Oligarch” (but he looks like Bill Gates 😉

However, he seems to be among the more “moderate” Oligarchs, as for instance this NYT article describes.

Another factor “pro” Sisteam is the fact, that both major subsidiaries are listed as well with separate, audited statements which increases transparency a lot and makes it easier to validate the “sum of parts” valuation. On the other hand one could argue: Why don’t they pay higher dividends ? They do have a dividend policy, however they promise to pay out only a minimum of 10% of what they can stream up to the HoldCo. According to this research from Gazprombank, rising dividends can be expected, but still we are talking only about 4-5% if this turns out to be correct. Not much for a company in a country with interest rates above 10%. On the other hand, if they are able to to investments like Bashneft and Rosneft, it doesn’t make a lot of sense to pay out huge dividends but rather to reinvest the money in such “multi baggers”.

The second point is harder to answer. It looks like that Sistema is at least on neutral to good terms with Putin. In the case of the Indian Mobile subsidiary for instance, Putin put the problems of Sistema on the table when he visited India in 2012. From the NYT article linked above, I think this quote from Sistema’s owner is revealing:

And business can only prosper, he added, if the size of business is commensurate with the owner’s political influence. “We didn’t understand it” at first, he said. “Many businessmen grew their portfolios very fast but didn’t understand that one must invest time in connections, human relations, invest in human capital.”

Mr. Evtushenkov is not alone in operating along Western lines. One Russian billionaire who also did was Mikhail Khodorkovsky, the oil tycoon arrested in 2003 who has been in jail ever since.

As Mr. Evtushenkov told the Russian Web television station Dozhd recently, he knew Mr. Khodorkovsky when the latter was a young man and worked for him at a Moscow plastics factory. “He was terribly hyper, ambitious,” Mr. Evtushenkov said — and thus, he implied, forgot the rule about operating commensurate with political influence.

This sounds like a guy who knows how to maneuver (so far) within the harsh Russian political and business climate. So the risk should be a lot lower than for instance for Pharmstandard, but clearly, a dispute with government (see Rosneft/Bashneft) or a more powerful oligarch could change this real quickly.

Does Value Investing and investing in countries like Russia contradict each other ?

I want to make one thing clear here: This is no Warren BuffetT “great investment”. It is maybe an “above average” or even “quality” company in a really tough country.

On a pure stand-alone basis, there is clearly no Margin of Safety. As discussed above, certain things outside the perimeter of the company could happen which could impair the value of the stock severely. On the other hand, Value Investing is not only about Warren BuffetT style concentrated portfolio of great companies. There is another style with a more diversified “deep value” approach. I think Sistema clearly fits the “Deep Value” bucket. With this approach however it would be stupid to invest a large portion of the portfolio into a single company. The “Margin of Safety” in those cases comes from investing in a “Bucket” of extremely cheap companies where you can afford that 20-30% will actually turn out worthless, 50-60% are doing Ok and the remaining 10-30% will turn out spectacular.

Sistema in my opinion is a potential stock with a low weight for such a contrarian Emerging Market “bucket”. Yes, a lot of things can happen, but the stock is so cheap that if things turn out positive, the stock could easily tripple or quadruple.

I do have sometimes the impression that especially in the last few years the “BuffetT & Munger” approach is hailed as the ONLY way of value investing. But there are a lot of other succesful investors you had very similar track records with radically different approaches. Among them for instance were John Templeton and Mark Moebius. This ise an excerpt of the 16 investing rules from Sir John Templeton:

3. Remain flexible and open-minded about types of investment.
4. Buy low.
5. When buying stocks, search for bargains among quality stocks.
6. Buy value, not market trends or the economic outlook.
7. Diversify. In stocks and bonds, as in much else, there is safety in numbers.

This is quite different to “buy concentrated and only what you know best”. Just out of interest I have looked into the Templeton Emerging Markets funds. Mark Moebius only owns two Russian stock, Sberbank with a weight of around 3% (7th largest position) and Lukoil (2,7%). Interestingly, Mark Moebius even seems to have a blog with a recent comment to Ukraine. Personally, I would not invest in Sberbank as this could be one of the easier targets for sanctions.

Timing and other considerations

Looking at the 5 year chart one could think that Sistema would have a lot of space to fall further:

But one should not forget that from 2009 to current, Sistema turned a 2.5 bn USD investment in Bashneft into a stake currently worth 7,5 bn USD….Clearly the risk is real that I am much too early.

To give an example: In February 2010 I wrote in my home forum that Public Power Co., the Greek utility looked like a good risk/return situation at around 12 EUR per share (and a P/E of <5). I even said that it looks like that the stock is bottoming out. This is the stock chart:

Although the stock is now back at that level, the stock bottomed out -90% lower at around 1 EUR per share. Luckily I got out pretty soon before disaster struck, but this should be clearly reminder that it can always get worse.

Where is my “edge” ?

Cleary, I do not have any direct “edge” with regard to Russian stocks. I do not speak Russian, I have never been there and I have only access to published reports and research. I am as far from being an insider as one can possibly be. On the other hand, I do have one valuable advantage (as any private invetsor): I do not need to explain this to clients or bosses. I do not have to fear to loose my bonus or even my job if anything goes wrong. Ok, the readers of my blog might think of me as a gambler and my portfolio will suffer but that’s about it.

The biggest risk

A final remark on risk. I have gone through many of the risks related to a Russian stock and I am sure I obly scratched the surface. Nevertheless, I think the biggest risk is not an escalation in the Ukraine. This would be rather a buying opportunity. The biggest risk in my opinion is a hard landing in China. Russia is completely dependent on their natural resources exports. Lower prices for Oil, natural gas etc. will kill the investment case for Sistema. So this is to watch out for.

Summary and what to do

The main attraction of Sistema is clearly the valuation, comparably transparent reporting, professional management and (for a Russian company) shareholder oriented approach. The downside is, on the other hand, that Russia is dangerous for investors which explains the low valuations along the curent political turmoil.

Koc from Turkey is clearly the better company, but Sistema is only half as expensive. In building up my “basket”, I think Sistema has a place, although with a relatively small weight.

Additonally and most important to me, Sistema has shown in the past that they are able to pull of ridicoulusly succesfull deals in tough times as Bashneft and esp. Russneft have shown. So the possibility is high that Sistema again might be actually a winner from the current Russian crisis if they are able to close some more deals at “rock bottom” valuation levels.

The only thing which is really annoying to me is the fact that the spread between the GDRs and the Russian shares has now reached ~13%, a lot higher than a few weeks ago. Still, I am prepared to get my feet wet and will therefore invest into a 1% position for the portfolio as part of my “Emerging Market” basket along Ashmore and Koc holding. The low percentage reflects the (much) higher risk for Russia.

Emerging markets part 3: JSFC Sistema ADRs (ISIN US48122U2042) – Is a Russian company investible (1)?

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This is the third installment of my little “Emerging Markets” series (part 1: Ashmore Plc, part 2: Koc Holding).

As the post got really long, I will divide it into 2 parts. Sorry for the “cliff hanger”….

Investing in Russia

Some readers may recollect that I invested into the Russian pharmaceutical company Pharmstandard last year and was very lucky to get out early before the stock subsequently lost more than 50%. My interpretation of this experience is that an actually relatively well-managed company got bullied into buying a worthless company and thereby shifting a lot of company funds to some shady people.

This should be a reminder that investing in Russia is somehow different. Although one shouldn’t be surprised too much about this. Russia is still at a very early stage in capitalism. It is only 20+ years since privatization started really kicking off. For me, the current state of Russia’s capital markets looks a little bit like the US in the 1910s and 1920s, the age of the famous “Robber Barons”. Bullying other people, “unfriendly” take overs using brute force were quite common in those times as well.

Russia itself is clearly different to any other country as well. In contrast to Turkey for instance, Russia is resource rich, on the other hand it looks like very poorly governed from the outside. Resource rich countries are always at risk to fall for the “resource curse”. This is how Wikipedia defines it:

The resource curse, also known as the paradox of plenty, refers to the paradox that countries and regions with an abundance of natural resources, specifically point-source non-renewable resources like minerals and fuels, tend to have less economic growth and worse development outcomes than countries with fewer natural resources. This is hypothesized to happen for many different reasons, including a decline in the competitiveness of other economic sectors (caused by appreciation of the real exchange rate as resource revenues enter an economy, a phenomenon known as Dutch disease), volatility of revenues from the natural resource sector due to exposure to global commodity market swings, government mismanagement of resources, or weak, ineffectual, unstable or corrupt institutions (possibly due to the easily diverted actual or anticipated revenue stream from extractive activities).

This sounds logical, although further down, Wikipedia cites some other studies which seem to contradict this to a certain extent.

So investing in Russia is clearly an adventure. But again, similar to Turkey, the problems are not a secret. The Russian stock market is currently the cheapest in the world, with a p/E of around 5x, P/B of 0,72 and a dividend yield of 4,3%. In EUR terms, the Russian stock Market lost -34,5% since the end of 2010 compared to +37% for instance for the DAX.

I have a compiled a short table, comparing performance (10 year, 5 Year, 3 Year, 1 Year) and valuation of different Emerging markets:

10 5 3 1   P/E P/B
MICEX 8,26% 18,09% -10,24% -18,12%   5,4 0,7
SENSEX 11,09% 14,26% -3,10% -5,02%   17,1 2,6
IBOV 9,33% 2,89% -20,78% -34,32%   17,1 1,1
SHCOMP 6,54% 2,38% -6,62% -14,04%   10,3 1,4
               
Turkey 8,92% 15,92% -7,31% -37,75%   8,8 1,3
Indonesia 17,87% 30,67% 2,43% -22,43%   21,3 2,6
Philipines 21,00% 32,37% 21,75% -15,48%   19,0 2,8

It is interesting to see that Russia didn’t do so bad over a 10 year horizon, but especially underperformed over the last 3 years. In contrast, the valuation level compared to other EM is really stunning. So one can assume that a lot of bad sentiment seems to be priced in.

Interestingly, I just came across this some recent study, which says that “traditional” value investing, i.e. buying contrarian and cheap, works very well in Emerging Markets, much better than small cap investing or momentum.

Fraud, quality of accounts etc.

Personally, I would not make general distinctions between EM countries, but rather on a company levels. I think fraud and fraudulent accounting is much more probable in those countries than in “developed” markets, although even in developed markets fraud might be more widespread that commonly believed. I think it is more important to look at individual companies and their track record in order to get an idea.

Another aspect is to look out for and avoid systemic fraud. I have written quite often about the so-called “German-Chinese” companies. In this case, Chinese companies sold shares abroad to raise “fresh” money mostly for old shareholders which then got transferred directly to mainland China. In many cases, if you looked at the balance sheet of those companies, there was no need to raise money at ridiculously low valuations as they were supposed to be super profitable and sitting on huge cash piles anyway. So not having a domestic listing and use foreign listings in order to help old shareholders cash out implies a high probability of fraud.

I would however make a distinction for companies which have a local listing and subsequently seek a foreign listing without issuing a ton of new shares or old shareholders cashing out. In many of those cases, companies do so in order to raise their profile and make the company more attractive to foreigners. When they do commit fraud, at least the have to face local law enforcement, no matter how weak that might be. For the German-Chinese companies in contrast, fraud has absolutely no consequences as defrauding Non-Chinese investors is not a crime in China. It looks even that in many Chinese fraud cases, authorities support the fraudulent companies in order to avoid a bad image.

Premium/Discount for Russian ADRs

For some reason, Russian ADRs in general seem to trade in relatively wide bands against local shares. At the time of writing, Sistema ADRs trade around 8-9% higher than local shares. Interestingly, there seems to be no real rule for a premium or discount. This is a list of the most traded Russian ADRs on the London exchange:

Last Px Premium Best
GAZPROM-ADR 0.79%
LSR GROUP – GDR 1.12%
LUKOIL OAO-ADR 0.26%
MAGNIT OJSC-SPON 17.18%
MAGNITOGORSK-GDR 0.24%
MEGAFON-REGS GDR 3.94%
MMC NORILSK ADR 2.14%
NOMOS B-GDR 0.31%
NOVATEK OAO-GDR 11.54%
NOVOLIP-GDR REGS 0.47%
PHOSAGR0-GDR 0.69%
PIK GROUP-GDR -1.37%
ROSNEFT OJSC-GDR 0.35%
RUSHYDRO JSC-ADR -1.70%
SBERBANK-SP ADR 3.17%
SEVERSTAL-GDR 0.45%
SISTEMA JSFC-GDR 8.42%
SURGUTNEFTEG-ADR -0.41%
TATNEFT-ADR 2.77%
TMK-GDR REG S -0.79%
URALKALI-GDR 0.53%
VTB BANK-GDR -2.37%

So Sistema trades at the 3rd largest premium, but honestly I have no idea why this is the case. For some reason, the ADR/local share arbitrage doesn’t seem to work here. The premium compared to the valuation is not huge but still should be kept in mind.

A few thoughts on Ukraine / Crimea

I don’t want to enter any political discussions here but just a few observations from my side:

– Crimea was for long time part of the Russian Empire
– It became part of Ukraine only in 1954 without being asked
– It already has an autonomous status within Ukraine

In my opinion, neither Russia nor Europe have a big interest in escalating this issue. Europe depends on the natural gas, oil and other resources from Russia and Russia depends on the money. For me from the outside this looks rather like a defensive move from the Russians in order not to loose their access to the Black Sea. But of course I could be dead wrong and this could also be the start for a real big crisis. No one knows.

Why not invest in Ukraine ?

I have looked at a couple of Ukrainian companies as well, but with most of them I do not feel comfortable. I don’t think that agricultural businesses are very attractive and for the rest I didn’t find any company which was remotely interesting to me. Ukrainian international Government bonds could be an alternative at some point in time.

Timing considerations

Similar to Turkey, most of the people I asked have a clear opinion on Russia: It will get worse before it gets better and one should just wait a little bit when prices are cheaper and things look better and then make a “safe and cheap” investment. Interestingly, I saw this way of thinking really often but it almost always doesn’t work.

As long as a share,a sector or a market goes up, people are happily buying. As soon as something bad is happening, investors panic , sell into a crash. If they enter at all, they will buy again when prices are much higher, not when prices are low. I actually know very few people who are actually buying when things look bad and assets are cheap.

Something very similar is now happening with PIIGS stock. Two years ago, when the headlines were that the Euro zone will break within a few days, people sold stocks at absurdly low valuations just to get rid of them. Now everyone is happily jumping back into the very same stocks, although they are two or three times more expensive. Why is that so ?

I am not 100% sure but I guess much of that can be explained by the behaviour of “typical” institutional investors with a strong hierarchy. If everything goes well, of course the big boss on the top is responsible for the success. If something goes wrong and clients or analysts are calling, the safest thing to do is to get rid of the exposure as quickly as possible. In many large institutions, the number of controllers, “risk managers”, auditors etc. far outnumber the ranks of the actual risk takers. In order to justify their existence, they will show the boss that they are “on the floor” and will force people to cut risks aggressively irrespective of price level.

As a risk taker in such organisations, it is almost impossible to invest in something with bad headline news and falling prices. You buy something and the probability that it falls further is high. So you will look stupid at the end of the month and your boss and a legion of risk managers will yell at you why you are so stupid. You do this a second time and you will lose your job. So the safest thing to do is nothing, until headline news turns positive and prices are climbing, because then the chances to look good in the short term are much better and your bonus will be higher.

So in my opinion, you can’t have it both. You don’t get super cheap prices and “improving” headline news. Either you accept low prices and bad news or “better” news and (much) higher prices.

JSFC Sistema

As the first company to analyse in Russia, I used Sistema, a major Russian conglomerate. Why so ? Three major reasons from my side:

– Sistema is a conglomerate, so it offers a broader exposure to Russia
– it seems to be a large and relatively well-connected company. So the risk of being bullied like Pharmstandard looks remote
– Shares of the company are listed widely, in the US, London and Germany

This is how Sistema describes itself on its homepage:

Incorporated in 1993, Sistema is now one of Russia’s top-10 companies by revenues and is one of the largest publicly traded diversified holding companies in the world. Sistema was ranked number 315 in the Fortune Global 500 list.

Valuation wise, Sistema looks ridiculously cheap as many Russian companies:

P/E 4,9
P/B 0,9
Div. Yield 2,6%
MArket Cap: 7,1 bn EUR
EV/EBIT ~4,1x

To be continued soon……..

Performance review February 2014 – Comment “Is small still beautiful ?”

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Performance review:

In February, the portfolio performed +2,7%, which is -2,5% lower than the Benchmark (25% Eurostoxx 50, 25% Eurostoxx small, 30% DAX and 20% MDAX). YTD, the portfolio is up +6,5% vs. 3,2% for the Benchmark.

Main contributors for February were G. Perrier with +22,5%, TGS Nopec with +16,9%, SIAS with +10,4% and IGE & XAO +7,1%. Major looser was Cranswick with -5% (in EUR) and Vetropack (-2,8%).

Portfolio transactions

If I look at my transactions in February, I almost feel like a high frequency trader: I sold the final Rhoen Klinikum position as well as EMAK and SOL. I increased positions in MIKO and TGS Nopec and finally I invested in 3 (!!!!) new stocks: Energiedienst, Koc Holding and Ashmore. Cash is now at 13,5%.

The current portfolio can be found here.

Comment: “Is small still beautiful ?”

2014 again showed the usual pattern in the past few years: Small and Midcaps outperform everything else by a wide margin. This is how the constituents of my own benchmark performed YTD:

Perf. YTD
Eurostoxx50 (Perf.Ind) (25%) 1,51%
Eurostoxx small 200 (25) 8,06%
DAX (30%) 1,46%
MDAX (20%) 1,91%

So European small caps seem to be THE hot asset class. A long time ago, when I went to university (early nineties), I still remember when the finance professor talked about efficient markets. He didn’t believe in them and one of the example quoted was the famous “small cap” effect, the “fact” that small caps over the long run perform better than large caps.

Looking at most markets today, the history speaks for itself. Just look at the Charts:

S&P 500 vs. Russel 2000

or even more drastic: Dax vs. MDAX

Back to the “old times”: When I started to work for a financial institution in the mid nineties, one of my job was to monitor and explain the performance of a German small/mid cap fund. Every Quarter or so, I had to explain why again the fund had underperformed the DAX by a wide margin and the fund was finally closed end of 1999. Just to give an indication how badly Midcaps performed in this period: From the end of 1994 until end of 1999, the DAX performed ~26,4% p.a. against the MDAX with 10,6%, an underperformance of -16,4% p.a., or in absolute terms +221,96% against 65,55%. No matter what academia would say, the decision makers were tired of looking stupid and pulled the plug.

Consensus at that time was that in the age of globalization, the big international companies would be the stars and the small companies would be crushed. We all know how this story ended.

Let’s look at some more recent numbers: Since the end of 2009, the MDAX has performed 21,5% p.a. vs. 12,4% p.a. for the Dax. The French Small&Mid Cap index has performed 13,9% p.a. vs. 5,95% for the CAC in the same period. So again, many “asset allocators” are faced with a situation, where the logical thing to do is to allocate as much as possible into the much better performing asset class.

However, this past performance is only one side of the medal. Let’s again look back and look at something else this time: Valuation

When my employer at the end of the nineties decided to pull the plug of the small/midcap fund, the DAX was trading at a P/E of 32 vs. the MDAX at 16. Interstingly enough, the situation now is just the inverse: The MDAX now trades at 28 times earnings against the DAX at around 16 times. The situation looks similar in other markets. The Russel 22000 for instance trades at ~50 times 2013 earnings against 17x for the S&P 500. Of course, profits in small and midcaps could continue to grow much faster than in large caps, but at current valuation levels they have to grow much faster than for large caps in order to justify their valuation.

There seems to be so much money flowing into small caps at the moment that even the weak companies enjoy their day in the sun. So what to do now ? Chase the few remaining “cheap” small caps and hope that they get pushed up by the momentum ? Or exit completely ? I don’t know, but for instance European small caps have almost completely disappeared in my BOSS score database from the “attractive” bucket. The few remaining ones are rather “deep value” cases.

In any case, one should be very careful with small caps going forward. Based on current valuations, profits at most small cap companies (Europe and US) would have to increase really strongly in order to be able to produce additional outperformance in the next few years. There might be a few remaining opportunities, but overall “the air is getting thinner”. We will see how this plays out, but experience shows that multiple expanions will stop at some level and then usually reverse quite drastically and for long time periods. So be careful with small caps. Maybe “big is beautiful” might come again….

Emerging Markets series part 2: Koc Holding ADRs (US49989A1097) – the best of Turkey in one stock ?

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As this is a long post, a short summary in the beginning:

– despite the bad headline news, for me Turkey is one of the more attractive Emerging Markets, as valuations are moderate and most problems are clearly visible
– Koc Holding, the holding company of the KOC family offers an interesting opportunity to invest in a portfolio of Turkish companies with dominant market positions
– further, Koc Holding seems to be a professionally managed company with good capital allocation and very good long-term track record
– nevertheless, stand-alone the investment is clearly very risky at least in the short-term and should be part of a broader EM strategy

Turkey background: Lots of problems

Turkey is clearly the Emerging market country with the most obvious issues at the moment. The decline of the Lira triggered a massive interest increase by the Turkish National Bank, which clearly is not really a tailwind for the local economy. When people now speak about emerging markets, they usually distinguish between those who are still OK like China, Mexico and the Philippines and those who have problems (Turkey, Indonesia, India etc.).

Personally, in my experience in such situations, this distinction is most often wrong. Like in the beginning of the Euro crisis, when people for instance thought that Spain is OK, usually all countries in such a “bucket” have problems and the only difference is that the problems surface quicker in some countries than in the other.

That’s why I somehow like Turkey, the current problems are clearly on the table:

– Declining Turkish Lira
– Political issues with Erdogan/Gülen
– Protests and fights in Istanbul
– current account deficit
– war/conflicts in neighbouring countries
– Kurdish minority
– FX loans from companies

Expectations are low, you hardly find anyone who is positive, the consensus view is: “It will get much worse before it gets any better”.

Honestly, I do not have a magic crystal ball to look into the future, but experience shows that once the problems are on the table, the possibility of those issues already being priced in into the stock market are quite high.

From my point of view there are also a lot of positives for Turkey

– strategic well positioned between Europe and Middle East
– no resource course, people have to work in order to get richer
– young, growing population
– main beneficiary if political situation in neighbouring countries improves
– a depreciating currency automatically improves the competitive position. During the Euro crisis, almost everyone said it would be much easier for the “club Med” if they were not in the Euro.

Just as a reminder the map of Turkey and its “friendly neighbours”:

How to invest

There are clearly several aspects to consider. Corporate governance and shareholder rights in Turkey for sure are not at levels as in Anglo-Saxon or Northern European markets. Without a local account in Turkey, it is hard to trade Turkish stocks. So either one invests into a Turkey ETF, which has the disadvantage of a rather high banking exposure (~40 percent of the main indices) or one needs to focus on the stocks traded outside Turkey. To my knowledge, only 3 stocks are traded more or less liquid outside Turkey which are:

– Turkcell (largest Mobile operator)
– Anadolou Efes (Beer)
– KOC Holding, a conglomerate

As I am not so bullish on mobile carriers (see Whatsapp), and Anadolou Efes looked a little bit too hard for me after some merger activities, I looked a little bit more into Koc Holding.

Koc Holding

Koc Holding is the Holding company of the Koc Family of various subsidiaries mostly operating in Turkey. The Koc family directly and indirectly controls ~78% of the shares, leaving a free float of only 22%.

The company looks relatively cheap, but we should not forget that interest rates in Turkey are at around 10% (at 8,10 TRY per share):

P/E 7,7
P/B 1.1
Div. Yield 2.3%
Market Cap ~ 7 bn EUR

The interesting thing about Koc is that almost all subsidiaries are listed subsidiaries. For some reason, a lot of the Koc companies are JVs with foreign companies where Koc “only” owns around 40%. I tried to compile the list of listed subsidiaries. Additionally, I added net cash at holding level and the non-listed companies at book in order to come up with a “sum of part” calculation:

Company Percentage Koc MV EUR mn P/E
Arcelik 40,5% 1.048,0 13,2
Tofas 37,6% 645,5 12,1
Turk Traktor 37,5% 366,7 10,6
aygaz 40,7% 334,6 12,2
Otokar 44,7% 173,4 12,3
Tat gida 43,7% 41,6 106,9
Marmaris 36,8% 7,7 62,0
Altinyunus 30,0% 6,8 282,8
Ford Oto 41,0% 912,7 10,6
Tupras 51,0% 1.623,6 8,1
Yapi Kredi Bank 41,4% 1.536,8 6,1
Yapi Koray 10,7% 1,5 #N/A N/A
Yapi Tipi 4,5% 1,4 #N/A N/A
       
Sum unlisted   602,56  
Net cash Holding   580,00  
       
Sum of part   7.882,81  
Market Cap Koc Holding   6.718,39  
“Discount”   14,8%

We can see, that around 86% of the total value is invested in observable, listed companies. Additionally, we can see that the “discount” is currently ~15% to the sum of part. This is not much compared to other holding companies, but we come to this later. Another important point is that financials (Yapi Bank) are only 20% of the overall value, so a lot less than in the Turkish stock index. The overall low P/E of Koc is clearly driven by Yapi Kredit and Tupras, also something which one should be aware of.

The major businesses:

Tupras is basically a refinery. Normally not a very attractive business, unless you are the ONLY refinery in a country. Tofas and Ford Oto are both car manufacturing JVs, Tofas with Fiat and Ford Oto of course with Ford. Together, they have around 20% market share in Turkey, but much more interesting, around 50% of the production is being exported. So they should make up a lot of lower domestic demand by exporting more.

Arcelik is a “white goods” household manufacturer (among others with the Beko brand) which has also significant export business. Turk tractor has 50% market share in tractors in Turkey plus a 50% export share. Yapi Kredi finally is Turkey’s 4th largest bank and a JV with Unicredit. It has average profitability compared to its peers.

All in all, Koc claims to generate 10% of Turkey’s GDP, which at least in my opinion is the highest concentration I am aware of in any country for a single Group.

So at a first glance, Koc Holding seems to be a very good way to invest into the Turkish economy with an underweight in financials and an overweight in market leading companies with a significant export share.

Qualitative assessment / other considerations:

When I looked into the 2012 annual report and also into the available investor information , I was genuinely surprised how good the material is.

Koc 2012 annual report is a must read for anyone interested in the Turkish economy although Koc clearly is subjectively maybe more optimistic. At the time of writing, Koc just issued their preliminary 2013 earnings and the results look surprisingly robust (+15% including gain on Insurance co sale, unchanged excluding)

In my opinion, Koc has many aspects which are lacking even in most developed markets companies:

– Clear targets: Grow above Turkish GDP and create shareholder value, IRR hurdle of 15%
– clear dividend policy (20% of Earnings)
– Some businesses profit from Lira weakness (50% of cars and tractors are exported, Beko white goods etc.)

I also liked how they explained their strategy: Expand into other sectors only in the home market, expand internationally only in sectors where they have significant experience int he home market

What kind of Holding company is Koc ?

I do think that Koc is actually a value adding Holdco. I make this subjective assessment on 3 major observations based on their excellent, regularly updated investor information :

First, they are not shying away from selling subsidiaries if the consider them as not good enough, such as the very well-timed sale of their insurance subsidiary at the peak in 2013 and several other subsidiaries in the last years

Secondly, especially for a Turkish company, I was very surprised how clearly they formulate their strategy. They have clear IRR target and also a clear strategy where and when to invest.

And thirdly, their track record is surprisingly good. Over the last 20 years, total return for Koc Holding was 33.8% p.a. in local currency. This translates into 7.9% p.a. in EUR or 8.6% in USD. It is slightly lower than the S&P 500 (9.5% USD) and DAX (8,4% EUR), but we need to consider that:

– Koc is currently trading 50% below their peak valuation in June 2013 (whereas both, DAX and S&P trade at all-time-highs
– in the last 20 years, Koc had to withstand, among other issues a hyperinflationary environment which culminated in a new currency in 2005 which had exactly 6 zeros less than the old one

For me, this is a quite convincing track record in generating and maintaining shareholder value in the long run. much better than anything I have seen in other “Club Med” countries.

Koc and Erdogan:

Following the protests in Istanbul, there were some stories that the Koc family took position against Erdogan. As a kind of revenge, then Erdogan sent special tax auditors to Tupras. However, as this very nuanced article points out, this could have been it already.

I am clearly no expert here, but the fact that the Koc family, among others, survived 3 military coups, the second world war and hyperinflation, the probability is maybe relatively high that they survive the current episode, but risks are clearly there.

Stock Price

Looking at the stock price, one has to look at the stock price in hard currency:

We are clearly not at the lowest level but still around -50% off the peak from June last year. Funny, how optimistic people seem to have been only 8 months ago…..

Valuation:

Koc currently trades at an P/E of around 7,7x 2013 earnings. Without the insurance sale, this would rather be like 9 times but still cheap.

In my opinion, under normal circumstances, a company like Koc with a lot of market leading subsidiaries and a great track record could trade easily at 10-15 times P/E. If we assume that the Lira will make back at least some of its decline (maybe 10-15%), we could see a potential upside without assuming any growth over 3 years 35%-100%. If we assume some growth, Koc could be more than a double, especially compared to current valuations elsewhere in Southern Europe.

Summary:

In total, I think KoC Holding is clearly a risky but interesting stock in an interesting market. The combination of a good long term track record and a diversified group of well positiioned local companies reduces the individual risk to a certain extent, although the political issues between the Koc family and Erdogan have to be kept in mind.

At the current valuation, the upside is large enough so I do not need to try to time the market and will establish a 2.5% position in KOC Holding ADRs at current prices (USD 18,20 per ADR) for the portfolio.

Short term, the stock price could (and most likely will) go lower than the current level, when “risk off” mentality returns to the market.

A final warning: This stock is clearly more volatile than my average stock picks and should be seen as part of a more diversified “excursion” into Emerging markets. I plan to invest at least into 4-6 different EM companies with a total portfolio weight of 10-15%, the start was already made with a first Ashmore position earlier this week.

In parallel, I am also selling down most of my last Italian positions in order to derisk this part of the portfolio, as the valuations (and risk return relationships) for Italian stocks have become mediocre at best as people have become very optimistic.

My five (Value) cents on Whatsapp: Network effect meets Lollapalooza

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No breaking news here, the acquisition of Whatsapp by Facebook for 19 bn USD has been widely commented already many times.

Some of the more notable comments were:

Damodaran looks at it from a value and trading perspective and sees only merit as a trade

John Hempton feels “out of tune with the time” about the deal becasue the Facebook stock didn’t fall after the announcement

Henry Blodget has a slightly more positive take on the deal

What those comments have in common is that they all look at Whatsapp as another social media app like Twitter, Tumblr etc. In my opinion and my experience, Whatsapp IS NOT a social media app, at least not intentionally.

Whatsapp is so successful because it offers two big advantages for users:

– its cheaper than traditional SMS
– it is also much easier to use (nicer smileys, you can look if someone is online, easily send pictures etc.)

In my opinion, Whatsapp only “accidentally” became something like a “social media” platform as it allowed group communication more easily und unobserved compared to Facebook. If you use facebook nowerdays, efficient communication among friends is not that easy any more with all those crappy “likes”, advertising etc.

Back to Whatsapp “roots” as an SMS killer: There was an interesting article on Bloomberg.com about the amounts lost by mobile carriers due to Whatsapp & Co with the following estimates:

Free social-messaging applications like WhatsApp cost phone providers around the world — from Vodafone Group Plc (VOD) to America Movil SAB (AMXL) and Verizon Communications Corp. — $32.5 billion in texting fees in 2013, according to research from Ovum Ltd. That figure is projected to reach $54 billion by 2016.

So instead of thinking about a “social media app” one could also think of Whatsapp as a “Mobile communication company” which concentrates on a very specific part of the value chain of mobile phone carriers.

After the initial euphoria, mobile telecommunication has not turned out as such a great business as one would have thought. The high capital required for licences, tower infrastructure, retail outlets etc. plus the regulation has turned the business pretty much into a commodity business. As in many commodity business like car insurance etc., the carriers tried to discount their main offer as low as possible and then charge all different extra stuff, especially SMS. There was for instance a “scandal” in Germany, when providers let people especially kids, send SMS although the prepaid money was already used up. Many parents then were surprised when they then got extra bills or had to load unexpected high amounts in order to get the phone working again.

So one can imagine how quickly especially kids or poorer people with limited prepaid budgets (but a data plan included) adopted a free service like Whatsapp. This also applies to generally poorer countries where mobile phone expenses use up significantly higher shares of total budgets than for instance in Germany or the US.

Compared to the full value chain of mobile carriers, a texting app requires almost no infrastructure, no retail outlets etc. You can easily rent cloud processing capacity for very small money from Amazon on a variable basis and scale up if you need more.

Similar cases: Mobile phone contract resellers

A very similar business model is that of the classical mobile phone contract “reseller”. Freenet AG for instance, a German mobile phone “reseller” managed to get a 3 bn market cap just by reselling plans from existing mobile phone Providers.

Compared to moble phone carriers, this business is clearly attractive as one doesn’t need to buy the licences ec. Compared to Whatsapp however, the business model looks rather shitty as you need to advertise constantly, prefund the phones, maintain a retail outlet etc. And remember: This 3 bn market cap has been achieved with “only” 8.5 mn clients in one country. If Whatsapp for instance would decide to go into reselling, they could make live difficult for those guys as well.

No cashburn

What I found also very interesting is the fact, that Whatsapp didn’t burn a lot of cash. According to some articles, Sequoia capital only injected 58 mn UD in total “outside” capital. So this is another big difference to many other internet or social media companies: very little “cash burn”. I guess one reason is that they didn’t need to make a lot of advertising. As the reputation of mobile phone companies is bad enough, their service was just such a “No brainer” or “killer app” for many that it went “viral” without spending any money on advertising. I am not sure if they have to pay to Google or Apple for the app stores, but overall, distribution cost seemed to have been quasi non-existent.

Moat /network effect

In another comment on Slate about the Whatsapp deal, the author says the following:

The different pricing schemes they come up with are just different ways of trying to maximize the value they extract from consumers. In a world without WhatsApp, selling SMS separately from data is the best way to do that. Then along comes WhatsApp to exploit a hole in the pricing system. But if WhatsApp gets big enough, then carrier strategy is going to change. You stop selling separate SMS plans and just have a take-it-or-leave-it overall package. And then suddenly WhatsApp isn’t doing anything.

I can clearly not look into the future but there are some obvious mistakes in that argument for instance:

1. Big companies hate to cannibalize itself. Whatsapp is already big enough but they haven’t done anything because more often than not, it is “easier” being cannibalized by someone else than by a guy or a division within the own organization
2. Anyone using Whatsapp will not go back using SMS again. Only few people prefer to live in the stone age if they have a choice
3. Although it was easy and cheap for Whatsapp to get to this stage, it is not as cheap and easy for any potential competitor to achieve critical mass. Absent any further technological break through, the “network effect” of the established leader will make it extremely expensive for any competitor to “scale up” in this business. In a sector where the network effect is so string, the “barrier to entry” increases tremendously if there is a dominating player with a large market share.

Especially the last point is important in my opinion. As long as this segment is growing, it makes a lot of sense for Whatsapp to provide this service as cheap as possible in order to avoid making it attractive for other competitors. Especially as it doesn’t seem to cost a lot of money to run it for a couple of hundred million people, they have a lot of time to actually increase profits.

Oh, and by the way, forget about that shitty Blackberry messenger app, this won’t save them (see number 3 above).

Lollapalooza effect

Warren BuffetT‘s “sidekick” Charlie Munger has coined this term. I copy the definition from this blog post:

The lollapalooza effect is what happens when you have more than one bias/incentive acting at the same time. It means the confluence of several themes heading in the same direction to produce a given result which can either be positive or negative. And, as it becomes hugely powerful, it also becomes a major driver of human misjudgment.

The current confluence of at least 4 important “streams” that are mobile communicication, faster internet, smartphones and Mobile micro payment is a good example of such an effect. On a single basis, a “product” like Whatsapp would not even exist. With my old Nokia 6110, I could only send sms and take calls. With my first “multimedia” phone (a Siemens Benq…what was that again ?) I could only surf some specialised web sites chosen by the mobile carrier at a horrendous cost and slow spead. But now, with full and fast internet access, easy to navigate touch screens, app stores and a cheap internet data plans, a couple of guys in SFC can create a product at a cost of 60 mn USD which is used by 450 mn people globally after only 5 years.

Valuing companies in such an environment is indeed very difficult as anything could happen, both to the positive and the negative side. I think we should prepare for much more “killer apps” coming out of this Lollapalooza environment which have the capacity to challenge or even destroy other established business models. And I do not mean only print magazines, Nintendo DS or alarm clocks.

What about the 19 bn USD paid ?

If we look at the Bloomberg article above and i we consider Whatsapp as a mobile communication company, one could make the following calculation:

If messaging really lowers mobile carriers revenues by 56 bn uSD globally in 2016, one could argue (among many other scenarios) in the following way:

– if Whatsapp is responsible for 20% of this, then their “damage” or cost saved for the mobile client is 10.8 bn annual
– if Whatsapp manages to charge 25% of the saved amount at some time, this would mean around 2.7 bn USD p.a.
– as the costs seem to be low (they don’t need to buy licences etc.), a net profit margin of 60% might not be unreasonable

So all in all we would expect under those (maybe too optimistic assumptions) around 1.6 bn in profits. Going back to professor Damodaran, this would be still lower than to justify the paid value:

Whatever the model, though, you would still have to generate at least $2.2 billion in after-tax income from advertising to Whatsapp users to break even.

but still, Whatsapp could turn out to be quite a valuable asset. This does not even include the possibility that Whatsapp moves further along the mobile communciation value chain, like actually handling all communication including calls and “degrading” carriers to exchangeable capacity providers which would be one option.

Now how about Facebook ?

First a short disclosure: I have never owned and will never own Facebook shares, that is on my “too hard pile”.

But overall, I am not sure that Facebook is the best fit for Whatsapp. Facebook didn’t get mobile unless a few months ago and I am not sure if they will get it now. For me, Google would have been a much better fit or even Microsoft or Apple. But again, who knows ? The biggest danger for Whatsapp in my opinion would be indeed if facebook would force a connection with their services or something similar as, in my opinion, Whatsapp IS NOT a social media app but a mobile communication platform with the potential to take out an even larger share of mobile carrier’s revenue in the future.

Summary:

Many people see the 19 bn Whatsapp purchase as a sure sign for a top in the social media hype. Although it might turnout as such, in my opinion Whatsapp itself is a very interesting mobile communication business with the potential to further shaka up this business.

Due to the network effect, Whatsapp has created a huge barrier to entry for any competitor, supported by the fact that they still offer this at basically no cost. The pricing power of Whatsapp in my opinion is much bigger than “social media” as customers clearly understand the savings against traditional mobile carrier charges. Going forward, Whatsapp seems to be well positioned to move even further into the territory of mobile carriers, resellers etc.

The price paid by Facebook clearly looks very rich, but looking at mobile carriers and the implied profit potential rather that social media businesses, it might not be unreasonable. It remains to be seen however what Facebook is doing with this acquisition.

If Whatsapp would be a listed company, I might even forget my traditional value metrics and buy it, maybe not at 19 bn but still, at a “non-value” valuation.

Portfolio Management: EMAK, Sol SpA, Rhoen & Concentrating ideas

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As many other investors, I think it is currently much more difficult to find new convincing ideas. On the other hand, many of my portfolio stocks performed very well and are now near or past my inititial target. Let’s look first at some of the portfolio stocks:

Rhoen Klinikum

As I have said before, once the share price of Rhoen approaches the initial bid price of 22,50 EUR, I will sell this “special situation” investment which I did last week with an overall return of +32%. Clearly, it would be tempting to “ride” the current momentum, but honestly, I do not know why investors are suddenly so “hot” about the stock.

Fundemantally, at least in my opinion, Rhoen is now fairly valued. Compared to the initial deal, the “rest Rhoen” has to prove if they are a valid company. Sure, it looks like that the party is just getting started but still, the risk/return profile was a lot better at 15 EUR ……

EMAK

I also sold out the remaining EMAK stake. Unfortunately, EMAK did not profit so much from the “January effect” as much as I hoped. As with Rhoen, the “special situation” status has now expired somewhat and long term, EMAK is for me only an “average” company at an “average” price, so no reason to hold it further. I sold yesterday at around 0.85 EUR per share with a total profit of +89% for the whole position.

Sol Spa

Finally, I sold out of Sol Spa last week at well at a price of ~6,10 EUR per share, netting a 55% gain over a holding period of around 14 months. Sol Spa was a hard stock for me to hold. Although I really like the company, the stock price advanced much qicker than the business. Since I looked at them back in April 2012, clealry the health care business continued to grow, but the traditional gas business has to struggle much harder than i thought. The profit declined both, in 2012 and 9m 2013, but the share price still increased by 50%.

At a current P/E of 19, P/B of 1.5 and EV/EBIT of 14, I think the risk/return relationship is not exciting any more. Again, I will most likely regret this in the short term, but mid- to longterm, I cannot justify the investment.

What now ?

The above mentioned transactions generate ~9% additional cash. As I do not have any investible new ideas available, should I just let the cash lie around until I find something better ? Well, thankfully I still have room in my already existing portfolio positions. For two of the stocks I do have a very positive opinion:

TGS Nopec

TGS Nopex has issued surprisingly good Q4 numbers plus they announced a new stock buy back. So a good opportunity to upgrade this to a full (5%) position which I did at around 177,5 NOK per share

MIKO

As I have written before, I expect MIKO to significantly improve profitability for 2013. Therefore I increased the stake in February at a price of around 68,20 EUR per share to increase the stake from around 3.5% to 4.2% of the portfolio. Unfortunetly, there is not enough trading to make it a full position yet.

That still leaves me, even after the new Energiedienst position, with around 19% in cash which suspicously looks like market timing but is not or only indirectly. It is just hard these days to find good stocks at cheap prices. But I am working hard on new (or old) ideas. Further candidates for a potential postion increases are Van Lanschott and Trilogiq.

Energiedienst Holding (CH0039651184) revisited

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Almost exactly one year ago, I looked at Energiedienst Holding, the Swiss/German Hydropower utility.

That was my summary from last time:

The current system for renewable energy in Germany (selling renewable electricity into the market at any price with the consumer paying the difference) is hell for “traditional” utilities including hydro power.

The German utilities have maybe underestimated the extent of renewable production, otherwise they could have done the exactly same thing themselves. Now however, the are in a kind of “death grip” between having to run their expensive black coal and gas plants for peaks and the artificially low electricity prices. Combined with unfavourable natural gas delivery contracts, especially for E.on the air will remain quite thin.

So unless something changes significantly, German utilities (including Energiedienst) will need a long long time to adjust capacity and change their business models.

So the first questions is of course: Did something change ?

Well, firstly, the stock price of Energiedienst dropped a further -25% form around 38 CHF to currently around 29 CHF. So just from the pure valuation point of view, the stock clearly looks cheaper:

P/B 0.86
P/E 12
EV/EBIT 12
EV/EBITDA 7
Div. Yield 5.1%.

Energiedienst released preliminary numbers for 2013 today. At a first look, it doesn’t look pretty. EPS came in at 1.99 EUR per share, the third consecutive decline since the peak at 2.70 EUR in 2010.

Looking further into their preliminary numbers, I was especially surprised by this:

  2013 2012 change in %
EBIT in Mio. € 79 99 -20%
EBIT Segment Deutschland in Mio. € 53 56 -6%
EBIT Segment Schweiz in Mio. € 27 43 -38%

Profit in Germany was only slightly lower, but we see a big drop in Switzerland which is surprising. In the text they mention that they took a special charge for long-term electricity purchases in the first half-year so one can assume that this has to do with the Swiss business. So not surprisingly, Free Cash Flow looks better than earning:

  2013 2012 change in %
Free Cash Flow in Mio € 79 83 -5%
Bruttoinvestitionen in Mio. € 44 57 -23%

This results in a total net cash balance of 146 mn EUR at year-end or 4.40 EUR per share which is almost 20% of the current market cap. So “cash adjusted” P/E is around 10. Additionally, they announced some kind of strategy change and review, however without any real details

OK, so we do have a relatively cheap but declining business, why bother ?

First, at least to me it looks that Electricity prices have at least for now stopped their free fall as those two charts show:

I am clearly not an expert on electricity prices, but with the currently mild winter (or no winter at all), I would have expected a further drop but that doesn’t seem to happen at least for now.

Political environment

Since last year, again some things have changed. We have now the “GroKo” in Germany, the coalition between the two large parties, conservative (CDU) and Social democrats (SPD). Interestingly, the boss of the junior party SPD, Sigmar Gabriel, has taken over the responsibility for Energy.

As I described a year ago, under the current system, mostly retail clients have to pay a surcharge in order subsidize above-market prices offered to the owners of solar and wind power plants. Many large companies are not subject to this “tax”.

The surcharge is increasing every year, both because of lower wholesale prices and additional capacity. However, pressure is building up against this system from many sides. Clearly, the established utilities are fighting against this as hard as they can and threaten to switch of expensive gas-fired power plants which are essential for net stability. But now, also the EU commission started to look into the exceptions for large companies already in December.

Also the core voters of the SPD are mostly lower-income recipients which are most effected by increasing electricity prices along rising rents. So Sigmar Gabriel, the SPD energy minister has to do something in order to stop further retail price increases or he will have no chance of winning the next election. Some ideas were already floated, mostly a limitation of future renewable capacity and lower rebates in the future. The concept drew a lot of critic from all side, although some parts, especially the requirement for direct marketing of renewable power doesn’t seem to be that bad.

In parallel, the bankruptcy of wind energy “pioneers” like Prokon shows that even under current high transfer payments, the big boom in new renewable energy seems to be mostly over and I guess investors will be much more careful in the future.

On top of that, the big utilities are taking out a lot of conventional capacity in Germany, party also in order to increase the pressure on the politicians.

So without being an expert in those issues, it looks like that the “tide might be turning” at some point in time in the future with regard to electricity prices or at least that they are not falling that much more. But this is clearly my own opinion and cannot be supported by a stringent theory or facts.

But why Energiedienst ?

As I have written before, the big traditional utilities like RWE, EON etc. have a lot of other problems, like too much debt, nuclear liabilities, pensions, problematic foreign subsidiaries etc. Even Verbund, thy Austrian Hydro Power utility has a lot of issues with Italian and other foreign investments. Energiedienst, on the other hand does not have those additional issues.

Energiedienst still looks more expensive than its peers:

Name P/E EV/T12M EBIT EV/EBITDA T12M P/B Dvd 12M Yld – Net Net D/E LF
             
ENERGIEDIENST HOLDING AG-REG 11,8 10,2 5,9 0,8 5,2 -7,8
VERBUND AG 9,4 9,8 4,8 1,1 3,8 70,5
RWE AG 108,3 7,2 3,0 1,5 7,4 77,9
MAINOVA AG 15,4 50,5 23,3 2,3 2,4 76,4
E.ON SE 12,2 8,2   0,7 8,3 45,2
ENBW ENERGIE BADEN-WUERTTEMB 51,0 13,0 6,1 1,4 3,1 43,0
LECHWERKE AG 21,7 21,6 14,7 3,1 2,8 -55,8

They do not jump out of this comparison table as the “super cheap” utility. But if we look at Lechwerke in comparison, a comparable, regional, Hydropower utility in Bavaria owned by RWE, sometimes quality is honored with very rich valuations.

In my opinion, the quality of Energiedienst, especially in comparison to EON, RWE & Co is not reflected in the share price. Clearly they suffer as well from current electricity prices and they are not a growth stock, on the other hand, as a hydropower generator without variable input cost, they will benefit the most from increasing prices.

The downside at the current level is in my opinion relatively protected, unless they do something really stupid with their net cash. This is in my opinion the key issue to watch going forward. Energiedienst will generate a lot of cash as reinvestment requirements will be rather limited. If they owuld actually start ti buy back shares, this couldbe a nice surprise but there is no indication that they willdo so.

I am aware that buying a German utility stock now is a pretty contrarian play and many people will say EON and RWE are cheaper and could more speculative upside or not to invest in utilities at all. My focus however is more on the downside, where I think Energiedienst is much better protected than the big, indebted players. So overall, I think the “full” risk/return relationship of Energiedienst is better.

Summary:

An investment into Energiedienst is clearly a bet on constant or higher electricity prices based on potential political changes, so it is rather a “special situation” investment with regard to potential regulatory changes from the current, unsustainable status quo. What I like about this bet is that to a large extent this will be driven by political actions which will be either uncorrelated or even negatively correlated to the overall economic situation and hence, to the rest of my portfolio.

My return target over 3 years would be the annual dividend of currently 5% plus a stock price increase of ~30% which would indicate a target P/E of 13-14 at current Earnings (ex then cumulated cash).

So for the portfolio, I will initiate a 2.5% position for the “special situation” bucket at ~29.50 CHF / 24.50 EUR per share.

Compagnie Du Bois Sauvage & Ackermans Van Haaren update

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A friendly reader has sent me a recent research report from KBC about Belgian holding companies, including “sum of parts” valuations for both holdings I looked at, Cie Bois Sauvage and Ackermans & Van Haaren. Just for fun, I wanted to compare my valuations with those valuation:

Cie Bois Sauvage

Here is the comparison table:

Prt Value Comment KBC Valuation
Neuhaus Chocolate 100,00% 300,0 PE 25 265,0
Behrenberg 12,00% 54,0 at 1.5 times book 63,0
Umicore 1,56% 60,5 At market 59,0
Recticel 28,89% 53,4 at market 51,0
Noel Group 29,37% 4,6 PE 10 12,8
Other   20,0 as disclosed 26,7
         
Codic Real Estate 23,81% 24,5 at book 23,1
other reals estate   60,0 as disclosed 66,8
cash etc.   20,0   11,5
         
Sum   597,1   578,9
Net debt   -80,0   -61
NAV   517,1   517,9
         
shares our   1,6   1,6
NAV per share   323,2   323,7

Strangely enoungh, the final valuation per share differs only marginally, despite some divergences, most notably did they value Neuhaus 40 mn lower than I did. Interestingly they have a target price of “only” 235 EUR and consider it as a “hold” position.

Ackermans & Van Haaren

Value Method KBC  
DEME 550 Implicit val. Takeover 995  
Van Laere 26 0.75 book 44  
rent-a-port 5 at book 9  
Maatschappi 20 At book 28  
Sipef 130 market cap 482 137  
Delen 522 1.5 book 970  
van Breda 336 1.2 book 470  
Extensa 80 0.8 book 187 Extensa + Leasinnv
Leaseinvest 108 Traded 0  
Financiere duval 40 at book 45  
AnimaCare 40 2x book 21  
MAx Green 70 10x Earnings 10  
Telemanod 30 10x Earnings 9  
Sofinim 255 75% of NAV minus cash 362  
GIB     41  
Other     39 Belfimas
         
Net cash holding 148 Q3 -93  
         
         
Total 2360   3274

Here we can see that they came out clearly much higher than I did. Especially the private banks were valued much more richly at 1.44 bn vs my 850 mn. I think that this could be a little bit aggressive. The other big difference is DEME/CFE. Where I used the initial valuation before the merger, they use the current market value, which is clearly better. This is partly off set by the lower cash balance where I used the balance before the transaction.

Interestingly again, they apply a discount to the NAV, however in Ackerman’s case only -20% vs the -30% at Cie Bois Sauvage. Their target price is 86 EUR and they rate the stock surprisingly as a buy despite an upside of less than 10%.

Overall it is interesting to see their valuation, but honestly I am not overly impressed and it does not change anything in my conclusions.

Performance review January 2014 – “Taking responsibility”

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Performance:

January was a very good month for the portfolio. The portfolio gained 3.68% vs. -1.86% for the benchmark (New benchmark since 1.1.2014: Eurostoxx 200 Small 25%, Eurostoxx50 25%, Dax 30% MDAX 20%).
Major positive contributors were April SA (+12,8%), Cranswick (+10.2%), Installux (+9.6%), Draeger Genußscheine (+8,0%) and Hornbach (+7.1%). Overall, the portfolio benefited from a January small cap effect more than anything else.

Portfolio transactions:

As discussed, I sold the entire Celesio position. Additionally, I started to sell down a quarter of Rhoen at around 21.95 Eur. On the sell list as well is the remaining stake in EMAK. Unfortunately the January effect did not help the EMAK share a lot.

Cash is currently at 15.6% of the portfolio. The portfolio as of January 31st can be found here.

Comment: Taking responsibility

Currently, two complete former management boards of two infamous German banks are standing trial. In both cases, HypoReal Estate and BayernLB, the boards made large acquisitions just before the financial crisis (Depfa, Hypo Alpe Adria) which turned out to be disastrous and sank both banks.

Of course, both boards and CEOs do not see themselves responsible for what happened. Hypo Real Estate’s former boss Funke blames the former German Finacne Minister Steinbrück for everything, the BayernLB CEO Kemmer blames of course the financial crisis for everything.

Taking credit personally for success and blaming others for failure seems to be common today in most management boards. As an investor however this kind of behaviour is very dangerous in many ways. In order to compound wealth long-term, investors need to avoid mistakes much more than trying to pick the next Apple or Google.

Blaming others for bad investments is in my opinion a sure way NOT to compound well in the long run. Blaming others and not oneself increase the risk that the same mistakes are made over and over again. Clearly, luck plays a big role in investing as well, but in the long run skill and especially the avoidance of “Unforced error” will dominate luck.

A good example is the current Prokon “scandal”. Many people now are blaming the German authorities that they didn’t step in and closed the scheme long ago. No, it was not the fault of the investors, which ignored all the warnings, it was the fault of others. Thinking like this leaves the door wide open for the next Ponzi scheme and then the next and the next etc.

If I make a (big) loss with an investment, my first question always is: What did I do wrong ? What did I miss ? Did I ignore facts or did a fall into a behavioural trap ? Unlike a CEO, the only person I can possibly fool is myself, so no need to blame the financial crisis, incompetent politicians, bad weather etc.

The same goes for greate investments. One should also ask oneself: What part was luck and what was skill ? History is full of failed investors which made one lucky trade and then lost it all because the thought that they actually knew what they were doing. The Celesio trade is a good example. Yes, I made a quick nice profit, but my initial assumptions were wrong. So instead of thinking: Hey, merger arbitrage is easy, I should ask myself if this is really a game I should play in the future as I do not seem to have better insights than anyone else.

So to make the long story short: For long term investment success, it is far better to take the opposite strategy of a typical Bank CEO: Take full personal responsibility for failures and only partial credit for success. I will almost guarantee that this will lead to a much better outcome than the typical “Bank CEO” approach for your personal portfolio.

Random thoughts on Emerging Markets, Contrarian investing and Circle of competence

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Since I have started the blog, I have been actively avoiding (or even shorting) anything which has significant Emerging markets exposure. This was quite a controversial strategy as for the last few years, investing in Emerging markets or companies with high Emerging market exposure was considered to be one of “THE” no-brainers in investing, along with commodities and residential real estate. Who doesn’t remember the famous “cleanest dirty shirt” slogan from Pimco’s El Erian ?

The momentum of Emerging markets carried them over the Eurozone crisis up until the end of 2012. Interestingly, even after first warning signs emerged like falling commodity prices, free-falling orders for companies like Caterpilar, the Batista bankruptcy etc. last year, the story of the “Emerging market consumer” and the swift transformation from investment led economies into happy consumer countries seemed to be still alive.

Now however, at least in the public perception, people are surprised that the infamous “decoupling” of the BRICs & Co was (as always) more wishful thinking than anything else. Interestingly again, the mood quickly turns from “no brainer” to “full panic”. On the other hand, European stocks, which 2 years ago were seen as total disaster, are touted as the most promising asset class despite being now much more expensive than 2 years ago.

As a contrarian investor, this is the time when one should pay attention and prepare oneself. On the one side, current sentiment tells me that I should become more careful with my high percentage of European stocks, on the other hand, I think it will be a good time trying to expand my circle of competence and start to look more into stocks with Emerging Markets exposure.

However, as a contrarian investor, one should be aware that one is always too early, both in the way in and the way out. This is basically the opposite side of the momentum investor. Psychologically, in my experience, most stock investors seek “instant” gratification. If you buy a new stock, you want the stock go up directly in order to have positive feedback on your thesis. Very few people can stomach declining share prices especially for new investments. In institutional environments there is a very high implicit pressure to invest into stocks with positive momentum as this increases the likelihood to look good in the short-term and this is all that counts, even in many so-called “value investing” outfits.

Back to Emerging markets: The truth is, I know very little about Emerging markets. I have documented one attempt with Pharmstandard as a special situation, where I was clearly luck to get out in time. So one clearly needs to have some sort of strategy.

In principal, there are various ways to gain exposure to Emerging markets:

1. diversified funds/ETFs of Emerging market stocks
2. single emerging markets stocks which are traded on accessible stock exchanges
3. Companies in developed markets with significant EM exposure

Personally, I think it makes most sense to extend the circle of competence in little steps. So investing in a company based for instance in China, where I have no clue how the market works and which is active in an industry where I don not have a lot of experience might be a very bad idea or the equivalent of pure gambling. One should also avoid obvious “compromised” sectors like German listed Chinese companies as the likelihood of systematic fraud is too high in my opinion.

The diversified approach has also big problems. In many markets, for instance Turkey, banks have a huge weight in the indices. As banks are the most vulnerable companies in a real crisis, index investing often turns out to be a suboptimal approach.

This leaves in my opinion two alternatives:

A) Invest in EM companies where I know the sector / business very well
B) Invest in developed market companies with significant EM exposure

Strategy B) in the current stage is relatively difficult, as especially in the consumer and automobile sector, people seem not to believe in any crisis or downturn. Yes, companies like Adidas, Yum or Volkswagen have underperformed the DAX this year, but they are not cheap.

Strategy A) has the drawback that often only a few companies are easily available to invest. In Turkey for instance, there is only a handful companies traded outside Turkey and one might not easily find traded ones in the prefered sectors.

One important caveat: In my experience, both booms and busts take longer to play out as everyone thinks. So there is absolutely no hurry to fully jump into EM stocks now. On the other hand it is very unrealistic to actually identify the low point. So once a certain investment is identified which is attractive, one should buy without trying to time the market.

In any case, for the rest 2014 I will try to look at the one or another company with significant EM exposure instead of chasing the few remaining undervalued European or American stocks. I might even start positions in some and prepare for a lot of pain, both for missing a continuing rally in Europe and for losses in new investments. But that is what contrarian investing is all about.

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