Category Archives: Zensar Technologies

WEEKLY COMMENTARY NOV 14 2016 – NOV 20 2016

WEEKLY COMMENTARY NOV 14 2016 – NOV 20 2016

 

Company News

 position-summary-table

PC Jeweller

PC Jeweller’s share price fell by 15.1% during the week bringing the total decline to 31.7% this month as the Indian government demonetized INR500 and INR1,000 notes in an attempt to fight “black money”. On the back of the regulation, the market is speculated that gems and jewelry companies would be one of the most impacted industries as gold and jewelry is thought to be a favorite “black money” asset. The Indian jewelry industry participants speculate a potential import ban on gold is also coming.

 

After the fall in share price, PC Jeweller is now offers a 9.1% NOPAT yield causing us to increase our position to 4.0%. While the company is in an industry with no barriers to entry evident by the thousands of competitors, PC Jeweller and Titan are far more operationally efficient than competitors creating excess profits through strong management. Our initial theory on PC Jeweller’s and Titan’s excess profits was associated with weaker competition from the unorganized sector, but the continued outperformance of PC Jeweller and Titan while listed peers continue to struggle points to operational advantage over organized peers.

indian-jewelry-value-driver-comps

 

The table shows the key value drivers within the industry as well as the financial health of peers. From 2012 to 2016, PC Jeweller has the third highest gross margin with the highest operating margin. Gross margin points directly to the customers’ willingness to pay while the difference between gross margin and operating margin point to the efficiency of management in running operations. In addition to the highest operating margin, PC Jeweller also has the fastest growth in the industry. PC Jeweller has the second highest ROIC leading to the second highest value creation in the form of excess profits. PC Jeweller and Titan are the only competitors that generated any significant excess profits over the period examined. The ability to continually generate excess profits in a period of raw material constraints and weak demand points to the strength of the management teams at PC Jeweller and Titan and an ability for sustained excess profits.

 

To get to an annualized return of 15%, PC Jeweller would have to fight margin pressures through stable operating margin and capital efficiency, while growing at 10% during the forecast period fading to a 0% growth rate in perpetuity. These assumptions do not seem too aggressive given, management ability to continue to create value despite points to sustained excess profits. New store openings and franchising should provide the 10% growth with the fade to 0% growth in year ten potentially being conservative. Our big concern with the above assumptions is competitive pressures lead to ROIC contraction rather than growth. If we change our profitability assumption to marginal excess profits from superior management (ROIC = 15%, Economic Spread = 2.5%), the five year would be 10%. This profitability assumption seems much more conservative and gives us sufficient comfort that if profitability declines there is still ample upside. It seems the risk reward is balanced sufficiently to increase our position size in PC Jeweller to 4.0%. We will be increasing our position size at a price below INR375.

 

Zensar Technologies

On November 17, 2016, Zensar Technologies reported FQ2 2017 results. Revenue grew by 2.7% and operating profit declined by 9.3%. FQ2 2017 was the third straight quarter where operating profit declined as the lack of growth on the top combined with continued growth in employee benefit expense leading to margin compression. The margin compression comes with an increasing average deal size and an increasing number of customers above 1 million, Zensar are unable to grow its top line as rapidly as its employee benefit expense leading to margin contraction. The weak top line growth may be temporary as the company’s backlog is strong at USD700 million up from USD500 million in the last quarter. Zensar is now offering a NOPAT yield of 6.5% despite being a business with no competitive advantage. With very aggressive assumption of a 12.5% discount rate, stable margins and capital efficiency, 10% forecast period growth, and 5% growth into perpetuity, Zensar offers 85% upside over the next five years. Growth in perpetuity is usually only assumed for companies with sustainable competitive advantages, which seems not to be the case for Zensar. Assuming a perpetuity growth rate of 0% decreases the potential upside over the next five years to 47%. Changing the growth assumptions to a 5% growth rate over the next five years, and a 0% terminal growth rate, there is only 19% upside over the next five years. Given the lack of upside, and lack of competitive advantages, we will be selling our Zensar position at prices above INR900.

 

Other Links

 

Why Moats are Essential for Profitability (Restaurant Edition) (25iq)

A fantastic essay at 25iq discussing the importance of moats. It also discusses the amount of research needed to understand the economics of a business. (link)

 

A Narrative Narrative (Polemic’s Pains)

A good blog post discussing how the current narrative on many topics is nothing more than speculation and subject to rapid change (link)

 

Expected Return (Research Affiliates)

Research Affiliates maintains expected real returns of different asset classes including Emerging Market Equities. (link) Given our view that the discount rate is an opportunity cost it may be more appropriate to view expected returns as the discount rate rather than historical returns. The appropriate discount rate for Emerging Markets would be 7.3% expect real return. Adding an additional 2.5% for expected inflation gets to roughly 10% discount rate. Adding an additional 2.5% as a margin of error gets us to 12.5%, our current discount rate. The idea that the discount rate should be tied to expected returns needs to be flushed out, but it seems interesting.

 

Predicting the Long Term is Easier than Predicting the Short Term (Intrinsic Investing)

An interesting article discussing how it is easier to predict the long term than the short term due and why this is one of the reason investing for the long term investing outperforms short term investing. (link)

 

Value Stocks vs. Value Traps (Old School Value)

Old School Value wrote an interesting article by discussing the characteristics of Value Stock and Value Traps. (link)

 

Chris Mayers on 100-Baggers (MicroCapClub)

Chris Mayers wrote 100-Baggers, an update on Thomas Phelps 1972 book 100 to 1 in the Stock Market. In this video, he discusses the key characteristic of 100-Baggers. (link) Below are the summary points.

 

  • Start small
  • Hold for a long time
  • Prefer a low multiple
  • High returns on capital
  • Owner operators

 

Fake News (Stratechery)

A good article by Stratechery on the subject of “fake” news, Facebook’s role in the delivering the news, and the dangers of who decides what news is deemed fake. (link) The discussion of fake news is interesting with the potential to leading us down a scary path. We must not forget the masses still receive their news from a small number of news outlets creating gatekeepers who deem some information to be newsworthy and other information less newsworthy. The existing gatekeepers already create narratives and form opinions among the population.

 

How the Brain Decides Without You (Nautilus)

It may not matter what the facts are, as the brain seems to decide how the world appears based on your existing views. (link) The best way to ensure, you are not missing anything due to pre-existing biases is to seek out the other side of the argument and understand it as well as you understand your side of the argument.

 

How Headlines Change the Way We Think (New Yorker)

Tied to the previous two articles, is an older article from the New Yorker discussing how headlines change the way we think about a story (link)

Weekly Commentary 10/31/2016-11/6/2016

Weekly Commentary 10/31/2016-11/6/2016

We are starting a weekly commentary to provide more consistent updates.  It will contain the news from the companies we cover, random investment thoughts, and the top articles of the week.  Let us know what you think.

 

Company News

 

On November 2, 2016, Zensar Technologies announced the acquisition of Foolproof. Foolproof is one of Europe’s leading experience design agencies, headquartered in London with other offices in Norwich and Singapore. The company helps global brands design better digital products and services for customers based on a deep understanding of consumer behavior, their clients’ business and new technology. It has many Global500 firms amongst its clients. LTM revenue = GBP8.5 million with a mid-single digit GBP million EBITDA with expectations for continued growth rate of 10-15% post acquisition. Zensar’s digital revenue now is 30% of total revenue.

 

From a strategic standpoint, the Foolproof acquisition makes sense. Foolproof adds knowledge in a fast growing industry strengthening Zensar’s digital services business. It strengthens Zensar’s client list adding relationship with a number of Global 500 allowing Zensar to cross-sell other services. It is also a smaller bolt on acquisition making it easier to integrate into existing operations. Unfortunately, the lack of price disclosure eliminates the ability to evaluate the transaction fully.

 

We will maintain Zensar’s current 3.5% position in our model portfolio. The company is trading at roughly 6% NOPAT yield with expected growth between 5-15% over the next five years. It continues to generate strong profitability and its executing on its strategy to increase revenue from digital services. It continues to win larger and larger contracts allowing for greater profitability. Zensar’s top 60-65 clients have had a business relationship with company on average over 6 years pointing to a quality product and/or some switching costs. Most smart customers will have multiple vendors allowing the customer to eliminate bargaining power of the suppliers and eliminating their pricing power with it as multiple vendors allows for continuity in case of switching suppliers. The Indian IT services sector is based on low cost labor or price competition. There is no sustainably differentiation on knowledge as employees hold the knowledge of the organization and employees can take this knowledge to another company.

 

Why are we maintaining Zensar Technologies 3.5% position size while decreasing PC Jeweller’s position size to 2.0%? Zensar and PC Jeweller’s both offer a NOPAT yield of roughly 6.0% and both offer growth between 5-15% over the next five years. Zensar’s business seems slightly better to us. Both industry have significant competition, but Zensar’s industry generates much higher average returns on invested capital than PC Jeweller’s, due to the asset light nature of the business. The jewelry business is very working capital intensive. Additionally, Zensar has a long history of steady growth while PC Jeweller has grown rapidly; it is in a much more cyclical industry.

 

On November 3, 2016, Miko International announced the resignation of Mr. Zhu Wenxin, an Independent Director at the company with Mr. Chan Wai Wong replacing him. The resignation is the latest in a series of director resignations. Below is a list of previous resignations.

  • On June 30, 2016, Gu Jishi resigned as Executive Director being replaced by Ms. Ding Lizhen, a member of the founder’s family.
  • On March 14, 2016, Mr. Wong Heng Choon resigned as Independent Director less than a month after being appointed.
  • On February 19, 2016, Mr. Leung Wai Yip resigned as Independent Director.
  • On September 8, 2016, Mr. Ng Cheuk Him resigned as Chief Financial Officer.

 

All the resignations follow the resignation of KPMG on April 21, 2016 and appointment of HLB Hodgson Impey Cheng Limited, an auditor of last resort for many Chinese frauds. The signs of fraud are piling up.

 

On November 4, 2016, Miko announced it signed a Memorandum of Understanding to set up a Joint Venture in the factoring business, an industry far removed from the current operations, which does not make much sense. We are already in the process of selling our position in Miko International.

 

On November 4, 2016, Credit Analysis and Research (CARE) reported first half results. Revenues grew 9% and operating profit grew 20%. The company also grew its client base by 8.5% from June 2016. It also signed a Memorandum of Understanding to start a credit rating agency in Nepal. The company also designated the first “SMART CITY” credit rating. Overall, the earnings report does nothing to move the needle either way. CARE is trading on a NOPAT yield of 3.0% but it is the most profitable company in an oligopolistic industry with significant barriers to entry and a very long runway for growth requiring no capital to grow. We entered with a 2.0% position in hopes that we could increase our position size at a cheaper price. We will maintain the current position given the barriers to entry in the industry, the runway for growth, and the lack of capital required to grow.

 

 

Random Thoughts

 

A recent FT Alphaville article discussed Sanford Berstein’s shift away from valuing companies by discounting cash flows. Bernstein argued in a zero rate world the risk free rate and the over weighted average cost of capital (WACC) is so low the importance of distant cash flows in the intrinsic value is much higher. Given an inability of analysts to forecast cash flows in the distant future, this increasing importance of the terminal value places a significant weight on highly uncertain cash flows. The following exhibits from the FT article illustrate the importance of the terminal value in Berstein’s estimation. Bernstein uses a discounted cash flow model with a five-year forecast period followed by a fade to a terminal value in year 10. Bernstein’s first charts assume a 10% growth rate for the next five years followed by a fade to a terminal growth rate of 3.5% in year 10. The second chart assumes a 5% growth rate for the five-year forecast period followed by a fade to a similar terminal growth rate.

importance-of-terminal-value-ft

 

Under the scenarios mentioned, Bernstein estimates the terminal value accounts for 55% at a 10% WACC increasing to 99% for a 3.6% WACC. WACC or discount rate is one of the many factors determining the importance of terminal value in a discounted cash flow valuation. We believe Bernstein, like many other market participants, is overlooking many other crucial factors in determining the importance of terminal value. We will discuss our view on the discount rate as well as other factors overlooked by Bernstein. We will also discuss another valuation method to overcome the shortfall of increased importance of terminal values in the discounted cash flow valuation. Whenever we value companies at Reperio, we use a similar discounted cash flow model with a five-year forecast period fading to terminal assumptions in year 10.

 

In the article, Bernstein’s main concern was lower interest rates lead to a lower discount rate leading to a lower WACC. Given the value of a corporation is driven by cash flows well into the future, the main assumption in lowering a company’s WACC is interest rates will remain low for a very long period of time. The chart below is the yield on a US 1 year treasury rate since 1953 illustrating the current rate of interest is the lowest on record.

1-yr-treasury-rate

We are bottom up investors but to assume market participants will accept 64 basis points forever in compensation for lending the US government money for one year seems aggressive, particularly, when one-year interest rates were over 1600 basis points in the early 1980s.  .

 

The treasury rate is a key input into the Capital Asset Pricing Model (CAPM) used by Bernstein and many other investors in determining a company’s WACC or discount rate. CAPM like many models in economics and finance is built with assumptions completely detached from reality. The biggest flaw in the CAPM is price equals risk. When calculating the cost of equity to determine the cost of equity, beta is multiplied by the equity risk premium. Beta is the volatility in a stock relative to a stocks benchmark meaning if a company’s share price is more volatile than its benchmark, it is assumed to be a more risky investment and therefore have a higher cost of capital. Putting aside the potential errors in measure a stock beta, a volatile stock does not equate to risk for the investor. This logic would lead you to believe a private business with the exact same characteristics of a public company listed on a stock exchange is a much safer investment, as there is not daily price volatility associated with being listed. At Reperio Capital, we view permanent loss of capital as the true risk of any investment. Permanent loss of capital comes from three risks: business risk, financial risk, and valuation risk. Business risk is the permanent loss of capital due to a permanent impairment of cash flows from competition or mismanagement. Valuation risk comes from overpaying for a security. Financial risk is when a company is has significant financial leverage that may lead to bankruptcy.

 

Another significant problem with CAPM is measuring a stock’s beta. The measurement of beta lends to significant estimation errors. Using Zensar Technologies as an example, if you calculate the company’s beta on a weekly basis since its listed in July 2002, its beta is relative to the SENSEX is -1.19. If you change the time period used in calculating beta to the last 10 years, Zenar’s beta changes to 0.77 illustrating the potential issues calculating beta.

 

Instead of calculating the weighted average cost of capital, we have used a constant discount rate as we assume there is an opportunity cost associated with making any investment. We are increasing our discount rate to 12.5% discount rate (from 10%) for all companies, roughly the average annualized return generated by the MSCI Emerging Market Index since inception and slightly more than the S&P 500 average annualized return is 9.5% since inception. If we can generate 12.5% annual return elsewhere then cash flows from any potential investment should discounted at that particular rate regardless of what the cost of capital is for each individual company. A constant discount rate also eliminates some of the subjectivity in valuation.

 

Other than lower interest rates and faulty measures of risk, Bernstein’s assumptions seem very optimistic. The FT article only mentioned growth and discount rate assumptions meaning the other important value drivers of operating margin and capital efficiency must have remained constant assuming no competitive pressures over the life of the company. The vast majority of companies succumb to competitive pressures leading to a fall in profitability and/or capital efficiency eliminating any excess returns. If excess returns are eliminated, growth does not add value making it an irrelevant discounted cash flow assumption. A small number of companies can hold off competitive pressures making profitability and capital efficiency irrelevant assumptions. The FT has a great free equity screener. In its universe, there are 13,799 stocks with a market capitalization above USD100 million and a 5-year average return on investment. Of the 13,799 stocks, only 2,001 stocks or 14.5% of the universe averaged a 15% return on investment over the past five years, which a very, very crude approximation of a company with a competitive advantage illustrating the difficulty in fending off competitive pressures and maintaining excess returns. Given the vast majority of companies face competitive pressures the assumption of constant operating margin and capital efficiency and any growth in terminal cash flows is very optimistic. An example is PC Jeweller, the company is operating efficiently generating excess returns but jewelry retailing is a fiercely competitive industry with thousands of competitors with little ability to sustain differentiation. We assume a 10% growth over the first five-year forecast period with growth fading to 0% in year 10 and competition eliminating excess profits.

1-scenario-terminal-value-total-value

 

As illustrated, at a 5% discount rate, the cash flows in the terminal value account for 51.0% total value. At a 15% discount rate, cash flows in the terminal value account for 31.6%. At a 5.0% WACC, Bernstein estimated 91% of a firm’ value is in the terminal value, while our estimate is much lower at 51.0% as we are more conservative on our assumptions for the vast majority of companies. The failure to account for competition makes terminal value a much larger percentage of total value.

 

Changing our initial assumptions to view PC Jeweller as competitive advantaged with sustainable margins and capital efficiency but with no growth in the terminal value, at a 5% discount rate, the cash flows in the terminal value account for 73.6% total firm value. At a 15% discount rate cash flows in the terminal value account for 39.1% of the total firm value still well below Bernstein’s estimates.

3-scenario-terminal-value-total-value

 

Being competitively advantaged and adding terminal value growth of 3.5% similar to Bernstein’s calculations further increases the importance of the terminal value assumptions. Again, growth in the terminal value is aggressive, as the vast majority of companies do not generate excess returns. Assuming a competitive advantage and 3.5% terminal growth, at a 5% discount rate the importance of cash flows in the terminal value increases to 90.5% of total firm value, while at a 15% discount rate 46.1% of the of the total firm value is derived from the cash flows in the terminal value.

 

The assumption of permanent low interest rates, no competitive pressures, and perpetual growth are all flaws in Bernstein’s assumptions that increase the importance of terminal value in a discounted cash flow valuation and probably are over aggressive. Like Bernstein, many investors make the same mistakes in their discount cash flow assumptions, which leads to the question why? The biggest reason is institutional constraints and the focus on asset gathering rather than performance making the vast majority of investors short term oriented and trying to outperform every quarter and every year. This short-term orientation leads to focus on next quarter’s earnings and whether a company will beat earnings estimates rather than focusing on a company’s competitive environment, management, financial health and valuation. The charts below from Andrew Haldane’s Patience and Finance illustrate the short-term orientation of market participants with the average holding period of a stock on the many different stock exchanges decreasing.

nyse-lse-holding-period

other-exchange-holding-periods

 

In the US, the average holding period of equities dropped from 7 years in 1940 to 7 months in 2007. In the UK, the average holding period of equities dropped from 5 years in the mid-1960s to 7.5 months in 2007. Looking at stock exchanges around the world the average holding period of equities has dropped to under 1 year on all exchanges with the exception of the Toronto Stock Exchange and Euronext. It seems evident that equity investors have a shorter and shorter investment horizon leading to focusing on the next few quarters making the discounted cash flow a useless tool for many investors. For long-term investors, a discounted cash flow with conservative assumptions it is still very useful. Another use for a discounted cash flow is to reverse engineer the market’s expectations of key value drivers, which eliminates the need for forecasting and makes judgment of the assumptions of key value drivers, the main determinant of the margin of safety associated with an investment.

 

If the use of a discounted cash flow still concerns you, a residual income model provides the same valuation while eliminating the importance of cash flow forecasts in the distant future. At Reperio Capital Research, we also use a residual income model with a five-year forecast period followed by a fade to the terminal value in year 10, with the current invested capital as the book value and return on invested capital and the discount rate as other key inputs. Residual income = (ROIC – discount rate) * invested capital. The residual income stream is then discounted back and added to the beginning of the year’s invested capital. The theory is every company has an asset base to generated returns. The asset base comes with an opportunity cost as the money invested in the asset base can be allocated elsewhere. If the company cannot generate its discount rate, it is destroying value and the company will be valued at less than its asset base. If the company generates excess profit, it will be valued above its asset base. Revisiting PC Jeweller using a residual income valuation and the same three scenarios illustrated above, we can see the residual income valuation method relies less on the discounted cash flows from the terminal. Under a scenario of no competitive advantage, no excess returns are generated in the terminal value assumptions therefore; the terminal value adds no value. Under the scenario of a competitive advantage but no growth, at a 5% discount rate, the terminal value accounted for 57.1% of the total firm value while a 15% discount rate 14.6% of the total firm value is derived from the terminal value. Finally, under the scenario of competitive advantage and terminal value growth, at a 5% discount rate, the terminal value accounts 83.4% of the terminal value and 21.0% of the total value at a 15% discount rate.

residual-income-terminal-value

 

The residual income method does a much better job at decreasing the reliance on terminal value calculations, but provides the same valuation outcome.

 

Discounting cash flows to value companies is still a valuable for any investor with a long-term orientation. Unfortunately, a model is only as good as its inputs. In a world with increasing short term thinking, garbage in will lead to garbage out.

 

 

Other Interesting Links

 

Jim Chanos’ and Kyle Bass’ views on China (link)

 

Mittleman Brothers Q3 Letter on Valuewalk (link)

  • They talk about a potentially interesting idea within the Emerging Market Small Cap space: ABS CBN in the Philippines.
  • They also discuss other ideas First Pacific Holdings in Hong Kong and Rallye SA in France. Both are based on management track records.

 

Apple Should Buy Netflix (link)

A very interesting post at Stratechery discussing the media value chain.

 

Competitive Advantage of Owner Operators (link)

Base Hit Investing goes into detail into the advantages of owner operators.

 

Missionaries over Mercenaries (link)

Somewhat related to the previous link on owner operators.

 

Value Investing using Enterprise Multiples — Is the Premium Due to Risk and/or Mispricing? (link)

The Alpha Architect discusses the outperformance of Enterprise Multiples.

 

Update of Measuring the Moat (link)

An excellent essay on the analysis of barriers to entry

 

 

Honworld H1 2016 Report Review and Position Sizing October 9, 2016

Honworld H1 2016 Report Review and Position Sizing October 9, 2016

 

Honworld recently released its H1 2016 report.  In the first half of 2016, the company’s revenues increased by only 0.9% and its gross profit and operating profit contracted by 2.5% and 10.2% respectively.

 

Honworld stated the cause of the slowing in sales growth was a slowing of the Chinese condiment industry as well as a shift in its distribution channel strategy from supermarkets to more traditional channels and the catering market. Additionally, the company altered its product mix to better serve the new distribution channels leading higher sales of medium range products, which we estimate as having roughly 50% gross margin compared to gross margin of 65-75% for high end and premium products. The company did not provided a breakdown of sales by product category or gross margins of product categories both of which would be very useful for any analyst trying to understand the business and should be disclosed by the company.

 

The table below illustrates the growth in the H1 2016 of various condiment makers with Honworld performing at the bottom of the pile for growth illustrating company specific issue more than an industry slowdown was the reason for weaker growth.

h1-2016-chinese-condiment-producers-growth

 

Operating margin declined due to an increase in advertising, distribution and research and development expenses. These are all fixed cost that the company should spend significantly on to take advantage of its size advantage over peers making much more difficult for peers to compete.

 

The big concern has been capital allocation of the company. Honworld stated in its annual report that it had reached an optimal inventory level with inventory levels remaining stable in H1 2016 compared to H1 2015. Despite the stable inventory levels, Honworld did not generate strong operating cash flows as both short term and long term prepayments increased significantly. The increase in prepayments could be attributed to growth plans of the company or it could something else.  It is a bit concerning that in the company’s first period to prove its ability to generate cash flow due to minimal inventory investment it was unable due to an increase in a soft account.

 

Overall, it was a disappointing set of results with growth slowing and free cash flow not increasing despite minimal investment in inventory.

 

We are moving to a new approach for position sizing.  There are significant limits to any investor’s knowledge given you cannot now everything inside a company particularly in smaller companies where there is less outside evidence to collaborate one’s ideas. Most investors base much of their analysis on the financial statements provided by the company being researched. For example, the primary driver of the quality of a business is the ability of a company to generate high returns on invested capital. If the financial statements are not an accurate reflection then any investment analysis will be completely off base.  Inaccurate financial statements happen quite frequently with Chinese companies. The lack of trust creates a need for a less aggressive position size therefore all Chinese companies will start at a 2.0% position and increase with evidence that provides credibility of accurate financial statements. Outside investment in Honworld by Lunar Capital improve the credibility of Honworld’s financial statements; unfortunately, an inability to generate free cash flow is a sign of a bad business or bad management decisions. In the case of Honworld, the business seems great with a very strong marginal economics. Unfortunately, management is misallocating capital in a quest to build mammoth inventory levels decreasing returns on invested capital and increasing the need for outside funding if the company keeps growing. The need for outside funding decreases potential returns for investors due to dilutive nature of growth.

 

Additionally during a period of weak growth, when there is minimal investment in inventory the company is unable to generate free cash flow due to a increase in prepayments is concerning. We are decreasing our position size in Honworld to 2.0% and selling at HKD4.50 or above.

 

Deep value investments outside of Hong Kong and Chinese will be 2.0% positions as these are inherent weaker businesses. As you move up the quality spectrum, our maximum position size will increase with the maximum position at 10.0%. Good businesses that are undervalued will start at 2.0% increasing to potentially 6.0% as undervaluation increases. Good businesses generate strong cash flow and profitability and operate in a growing market but may not have competitive advantage. Current examples are PC Jeweller and Zensar Technologies.

 

High quality businesses with competitive advantages that are close to fairly valued will start at 2.0% and increase to potentially 10.0% based on the level of undervaluation.  Current examples are Credit Analysis and Research, ANTA, Turk Tuborg, Grendene.

 

The new position sizing comes with understanding of the limits to our knowledge and the reliance on financial statements published by companies in formulating investment strategies.   Our previous position sizing seems a bit too aggressive. Our goal is to get between 20-30 investment ideas offering sufficient diversity to buffer against any potential  bad investments while still offer enough concentration to take advantage of upside from good investments.

Zensar FY2016 Results Review June 8, 2016

Zensar FY2016 Review June 8, 2016

We are decreasing our position size in Zensar Technologies to 4.0%.  Zensar Technologies continue to performing well with revenues growing by 12.8%, gross margin expanding by 170 basis points and operating profit increasing by 18.4%. The company has been a very consistent in its growth with revenue growing by 21.1% per year over the past five years and 21.3% per annum over the past ten years. Operating income has increased by 20.6% per year over the past five years and 25.3% over the past ten years.

 

The company is shifting its business model from traditional IT services to a digital strategy to drive further growth. Zensar is executing the shift with digital revenues at 27% of total revenues in FY2016 up from only 5% three year ago.  Digitial revenues are expected to continue to grow at over 20% for the next few years.  The company also continues to increase deal size with the number of large deals over 64 clients over USD1 million in FY2016 up from 51 in FY2013.  It also won USD130 million in contracts in FY2016 with expectations for a much higher number in FY2017.

 

Zensar expects margin expansion from increasing significance of digital and decreasing significance of product and license revenue. The company also is decreasing the number of low margin, low revenue accounts with the total number of accounts decreasing from 211 to 194.   Unfortunately, the industry suffers from an inability to grow margins drastically as more business requires more employees.  There are low barriers to entry leading to significant fragmentation within the industry as illustrated by the industry fragmentation.  Zensar’s top 60-65 clients have had a business relationship with company on average over 6 years pointing to a quality product and some switching costs.  Most smart customers will have multiple vendors allowing the customer to eliminate bargaining power of the suppliers and eliminating their pricing power with it as multiple vendors allows for continuity in case of switching suppliers.

 

Our initial investment was due to very cheap valuations along with strong profitability, strong growth, execution, and a strong culture.  The company continues to execute on all fronts but valuations are no longer extremely cheap and therefore we will be taking our profits and nearly halving our position size to around 4.0%.  The company is trading on an NOPAT yield of 6.6% and conservative growth of 10% over the next few years. While the company expected return is over 15%, the lack of barriers to entry leading to fragmentation within the industry and eliminating pricing power increases the risk to earnings.

2015 Reperio Model Portfolio Review 1/4/2016

2015 Reperio Model Portfolio Review 1/4/2016

 

 

2015 Portfolio Review 1 4 2016 Returns

 

Our primary concern is avoiding permanent loss of capital. Our secondary concern is absolute returns with a goal of 15% per annum for each investment.  Our final concern is beating our benchmark ensuring active management adds value.  In 2015, Reperio Capital’s Model Portfolio ended the year up 14.3% while the iShares MSCI Emerging Market Small Cap ETF declined by 9.1%.  We successfully avoided any permanent loss of capital and beat our benchmark by 23.4% but missed our target return of 15.0% as we are building our portfolio and our average cash position 67.5% in 2015.  At the end of 2015, our cash position is at 38.1% but is expected to increase by 15.6%, assuming no price changes as we are reducing our position in Peak Sport Products and Honworld Group.  We are attempting to find one idea per month, which will make us closer to fully invested.  Cash is a residual of opportunities but fully invested assumes a cash position between 10-30%.

 

 

PC Jeweller

 

PC Jeweller’s (PCJL:IN) share price appreciated by 80.1% with a 1.5% dividend yield, while the Indian Rupee depreciated by 4.5% against the dollar.  PC Jeweller grew its operating income by 25.8% over the past year with the remainder of the share price appreciation coming from multiple expansion with EV/ttm EBIT increasing from 8.5 at the end of 2014 to 10.5 times at the end of 2015.

 

2015 Portfolio Review 1 4 2016 PC Jeweller

 

PC Jeweller opened its first franchise in the previous quarter. Franchising requires little or no capital.  Franchises will be set up in locations where the company has no operations.  In addition, the company is going to open smaller locations to tap the middle/lower class markets, which the company does not serve.

 

The unorganized segment accounts for 80% of the market and in seven to ten years management believes the organized sector will reach 80% of the market with only 15-20 organized players. The company is targeting opening 15 showrooms in FY2016 and plans to add an average 100,000 sq ft per year over the next 5 years.  Assuming PC Jeweller reaches half of its expansion targets over the next five years, with similar profitability per square foot, the company will be trading on a 6.3 times EV/EBIT multiple. This is very conservative as it is half the company’s expansion target, assumes no improvement to profitability, and no franchises.  PC Jeweller is extremely profitable with an average ROIC of 38% since 2008 with stability during an industry downturn.  The company has a very strong financial position with net debt to EBIT of 0.55 times. The company’s management is strong operationally with no capital allocation missteps and there are no corporate governance issues. Despite, the company’s financial health, profitability, growth outlook and management, PC Jeweller is only valued at an EV/EBIT of 10.3 times.  We have sold more than our original investment but continue to hold our current 5.0% position given the company’s profitability, growth outlook, and valuation.

 

 

Zensar Technologies

 

Zensar Technologies’ (ZENT:IN) share price appreciated by 80.6% in Indian Rupee terms. The company paid a 1.8% dividend yield and the rupee depreciated by 4.5% against the US Dollar. Zensar’s FQ2 2016 trailing twelve month sales have increased by 15.9% and trailing month operating income has increased by 26.8%. While the company is growing its intrinsic value, there has also been multiple expansion with the company’s EV/ttm EBIT increasing from 8.4 times at the end of 2015 to 12.7 times at the end of 2016.

 

Zensar continues to execute well with the number of million dollar contracts continuing to increase.  At the end of FY2015, the company’s digital revenues accounted for 13% of revenues up from 5% in at the end of FY2014.  The company expects revenues to reach 20% at the end of FY2016.  The company also continues to increase the number of employees, revenue per employee, and profitability per employee. Since 2011, the company’s employee count grew by 6% per annum, revenue per employee grew by 10% per annum, and operating income per employee grew by 20% per annum.

 

2015 Portfolio Review 1 4 2016 Zensar employees

 

In December 2015, Zensar appointed Sandeep Kishore as the next CEO & MD. He comes from HCL where he is vice president and global head for the life sciences and health care and the public services businesses. He has over 25 years experience in the Indian IT Outsourcing industry and has a very impressive resume.

 

Zensar has one of the highest percentages of digital revenues among the Indian IT Services companies, and has aspirations to be a Tier 1 IT services provider. It continues to generates strong profitability with an average ROIC of 25% since 2005 with little variability.  The company believes it can continue to grow at mid to high teen rates for the foreseeable future.  The company has proven it ability growth with an average revenue growth rate of 23% since 2005. Despite, the company’s strong financial health, profitability, growth outlook, Zensar Technologies is only valued at an EV/EBIT of 12.7 times.

 

 

Peak Sport Products

 

Since our initial purchase in March 2015, Peak Sport Products’ (1968:HK) share price appreciated by 4.2%, paid a 7.7% dividend with no change to the Hong Kong Dollar US Dollar exchange rate.  Peak was initially a 9.1% cost base position. At the time, the company was trading just above its net current asset value and an EV/EBIT of 3.1 times. With the exception of a large cash position on the balance sheet, the company had not made any significant capital allocation mistakes. In July 2015, Peak issued 280 million shares or 11.72% dilution to existing shareholders. Insiders did not sell any of their shares.  The company sold the shares at net price of HKD2.43 representing an EV/EBIT of 4.8 times.  After the placement and during a period of significant stress in the Chinese markets, Peak’s share price fell to a low of HKD1.55 well below the company’s net current asset value of HKD2.15. Our initial position fell from 9.1% to 6.1%.  Given the discount to its net current asset value, we increased our position size by 5.6% to a 15.0% cost position.

 

The company continues to generate consistent profitability with a leading position in the niche segment of the basketball performance market. The company has growth opportunities in both the international and in new segments, tennis and running, where it is bringing its focus on performance and functionality. Despite the company’s strong balance sheet, three year average ROIC of 17%, and mid to high single digit growth, the company is no longer trading at a significant discount to its net current asset value but right above its net current asset value. We are adjusting our position to 5.0% as management credibility and capital allocation skills are in question making the investment a deep value investment rather than a quality value investment.  Our max deep value position is a 5.0% cost position given the inherent weaknesses of deeper value businesses.

 

 

Honworld Group

 

We started purchasing Honworld Group (2226:HK) after our initial recommendation in June 2015. The company’s share price has appreciated by 28.6% from our weighted average purchase price with no dividends and no significant change to the Hong Kong Dollar relative to the US Dollar.  Honworld is the largest cooking wine producer in China. The company is very regional with 88% of its revenues coming from the company’s key regions, which account for roughly 26% of China’s population. The company is still expanding its distribution channel within its key regions.  The combination of the company’s size and ability to garner premium pricing as it is the only one of the top four producers that uses an all natural brewing process for its condiment products gives the company a large gross profit advantage over its closest competitors. Honworld’s gross profit is 2.86 times its largest competitor, 4.81 times is second largest competitor, 8.89 times its third largest competitor, and 16.00 times its fourth largest competitor. This size advantage allows Honworld to significantly outspend competitors on acquiring new customers via marketing and building out its distribution channel and improving the company’s products through research and development. The company has pricing power given the company’s product quality and the low cost of the product.  Unit economics are fantastic with the four year average ROIC per liter is 79%. The company is also growing at 20% rate despite the concerns over the Chinese economy.  Management is passionate, owner operators with integrity although there are some question marks over capital allocation related to building inventories.  Management stated in its H1 2015 interim report that inventory is now sufficient for growth requirements so this may point to decreasing inventory levels. In November 2015, the primary owner charged his shares to receive a loan for his holding company.  Management honesty is evidenced by the donation of the primary shareholder’s cooking wine inventory, valued at RMB7.0 million to the company before its IPO.  Additionally, the primary shareholder sold his family’s cooking wine secret recipe to the company for RMB1.  His family also owned Honworld’s main brand before the communist revolution.  We believe the main shareholder sees the asset as his family’s heritage that he would not put at risk.  Despite the business quality and cheap valuation, EV/EBIT of 9.8 times, the charging of shares for a loan, the lack of few cash flow due to the misallocation of capital, and management unwillingness to have discuss the company all lead to lowering our position to a 5.0% position in our model portfolio.

 

 

Miko International

 

Miko International’s (1247:HK) share price has fallen by 27.4% since our initial purchase. The original investment thesis was buying a very profitable, rapidly growing business with a healthy balance sheet run by owner operators. The vast majority of the investment thesis still holds with the exception of the strong growth.  In the first half of 2015, Miko saw negative top line and operating profit growth.  The company put this down to a slowing economy as well as closing of many stores for refurbishment.  The favorable sign of the weaker growth in H1 2015 was Miko’s ability to maintain strong profitability.  Typically, when a retailer is hit by slowing growth working capital balloons and fixed costs become more prominent driving down profitability.  While Miko’s profitability took a slight hit in H1 2015, with ROIC falling to 26%, it was still well above the company’s cost of capital.  Miko is in the process of acquiring distributors and running the retail operations themselves as Miko has been selling products to distributors at 35% of final ASP.  Miko had full control of retail operations but this makes it more formal, allows for better contact with customers and brings the distributors margins in house.  As illustrated in our initiation report, the IRR on taking the retail activity in house is well above the cost of capital.  Despite continued strong returns, management are owner operators with no material corporate governance issues, Miko is trading at 78% of its net cash position and 58% of its net current asset value. It will remain at its current position size given its lack of liquidity.

 

 

Company 9/18/15

 

Company 9/18/15’s share price appreciated by 14.6% from our weighted average purchase price. The company is very strong at acquiring companies very cheaply without taking on debt, and improving their operations.  In all its business segments, the company has shown consistent success generating ROIC well above its peer group average.  The company has multiple unique activities with a tailored value chain that is not easily replicable.  The company’s latest results show it growing at 20% without any acquisitions and over the past five years the company has grow by 50% per annum. Finally, the company’s executives are very strong operators, capital allocators, owner operators, and are increasing their stake in the company. In 2015, the company’s chairman and main shareholder increased his stake from 45.14% to 51.66%.   Despite all the strengths of the company, it trades on an EV/EBIT of 4.9 times.  It is currently our largest and highest conviction position at a 14.5% cost position.

 

 

Company 11/19/15

 

Company 11/19/15 is down 7.0% in US Dollar terms since our purchase in November 2015. The company built multiple competitive advantages in the domestic market and the company is trying to replicate these advantages in the export market.  Within the domestic market, it is a low cost operator with scale advantage due to heavy investments in advertising, product development, automation, and process improvements.  It produces a low priced experienced good that is purchased infrequently combined with heavy spending on advertising the company has built a strong brand allowing for pricing power. In the export market, the company is at the low end of the cost curve ensuring the company stays competitive and profitable.

 

The company is run by owner operators with strong operational skills and an understanding of its competitive position who treat all stakeholders with respect.  It also has consistently generated stable, excess profit even during periods of industry stress and has a net cash balance sheet.

 

Despite the company’s strengths, there is upside to the bear case scenario of no growth and trough margins with the company trading on a 10.5% NOPAT yield and an 8.8% FCF yield. Using conservative assumptions, estimated annualized return over the next five years is 15-17.5%.  It will remain a 5.0% cost base position.

Reperio Capital Research’s Edge 11/6/2015

This is an excerpt from our October 2015 monthly review.

What is Our Edge?

At Reperio, we are firm believers that to produce extraordinary results, you have to do something different from everyone else.  What do we do different in an attempt to produce superior results?

It is something we think about a lot and we believe there are three key differentiating factors for our research.  First, we have a business owner mentality focusing on competitive position, management (not focused on by traditional research providers), corporate governance (not focused on by traditional research providers), absolute intrinsic value (not focused on by traditional research providers more focused on earnings momentum and companies beating expectations), and ensuring there is a margin of safety before recommendation (traditional research providers top picks are what is currently loved by the market due to earnings momentum are their top picks the opposite of our approach.)  We look for high quality stocks with poor sentiment.

 

Second, we have a long term investment horizon.  Jean Marie Eveillard once estimated that 95% of market participants are focused on the short term.  Given 95% of participants are focused on the short term; the vast majority of research providers will be catering to those participants in an effort to win their commission dollars.  Theses traditional research providers are obsessed with the next three to six months and companies with earnings momentum that can beat consensus. Our long term investment horizon coupled with our business owners approach gives us a tremendous advantage.

 

Third, we attempt to play a game where the competition is the weakest, i.e. Emerging Market Small and Mid Cap companies.  Just like any competition, if you play a game against very strong competition, it will be much harder than playing against weaker competition. When you are looking at US large caps you are competing against large buy side, sell-side, and hedge funds.  This is very difficult competition and while there are inefficiencies in these markets they are relatively small.  When looking at small and mid caps in Emerging Markets, competition is from the sell side, the buy side, and the public. Many of the names in the small and mid cap space have very little if any analyst coverage.  Analysts that do cover the names are more likely to be less experienced as most traditional research providers take the approach of trying to gain a small slither of a big pie and therefore put their best analysts on the bigger names.  The combination of short term orientation, and weaker experience leads to little competition. With buy side institutions, the vast majority has 100 or more names in their portfolio and has to know three to four times the number of companies.  This puts little emphasis on in-depth, independent research on smaller companies within Emerging Markets.  Additionally, 95% of buy side institutions are closet benchmark funds (over 100 stocks in the portfolio with big overweights and underweights being 1 to 2%).  This place a greater emphasis on the larger names that are in the index decreasing the importance of small and mid caps even more.  So buy side is very little competition.  The public typically are traders and have very little understanding of business so they are not much competition.

 

Our edge is illustrated by our PC Jeweller recommendation.  At the time of our recommendation in PC Jeweller, no large sell side institution covered the company and the smaller sell-side institutions were focused on the short term regulatory concerns leading to potential weakness in the short term and downside to earnings expectations. Our business owner mentality with a long term view saw a company that showed incredible resilience during an industry downturn (stable and high profitability) with a very strong balance sheet and innovative management with skin in the game.  There was short term looked uncertain due to regulation but the long term growth rate potential was tremendous given limited competition from organized retailers and a store opening target of 15-20% growth per year.  Despite the strengths of the company, it was valued under 5 times EV/EBIT.

 

Zensar Technologies is a similar story. It was a company that was coming off a period of indigestion after a large acquisition, which happens often.  Growth had slowed a bit which potentially put often the very few sell-side institution covered the company with no coverage from any big institutions.  The business owner with a long term investment horizon saw a company with very strong leadership in an industry with incredible profitability due to switching costs with industry low turnover due to a differentiated activity in an industry where the key resource is people and management was guiding 15% top line and operating profit growth for the foreseeable future. Zensar was also trading at under 5 times EV/EBIT eliminating a lot of the risk associated with the investment thesis but in the short term there were concerns putting off the sell-side.

Update on Macro concerns August 23 2015

Update on Macro concerns August 23 2015

 

Regarding recent macro concerns, we do not look at macro. While it is very important, it is extremely difficult to forecast due to the complexity of the economic systems. If the Fed and IMF with their armies of PH.D. economists have trouble forecasting the path of economies, we have very little chance particularly when my background is accounting and finance and not economics. Reperio would rather decrease the complexity of investing by focusing on buying high quality companies with good management, strong growth available at cheap valuations. With all that said, we are happy with all the companies mentioned and in our model portfolio as there is little evidence of macroeconomic concerns affecting our companies. The current macro concerns are increasing the number of companies meeting our strict criteria for investment.

 

PC Jeweller recently report Q1 FY2016 earnings. Sales grew by 14.2% with same store sales growth of 5% and profit before tax grew by 17.0%. The company opened four stores in the quarter remaining on target for 20 stores per year.  This illustrates operations are continuing unabated by any macro concerns. The company is also restarting its Jewelry for Less program in August which should increase affordability for customers.  The company agreed a partnership with Blue Nile, a US online jewelry retailer and is currently working on introducing smaller shops with a new brand for value segment of the market, where the company does not participate. In addition financing costs are starting to decline with the re-introduction of gold leases.  PC Jeweller proved its strength as an organization when the company withstood the recent downturn with very strong profitability while all other participants with the exception of Titan saw a significant contraction in profitability.  The market is valuing PC Jeweller on an EV to Profit after tax of 18.7 times. EV to PAT is appropriate given interest costs are such an vital part of the company’s business model. The company is spending significantly on growth depressing current earnings. The company has a huge opportunity to grow for the next five to ten years and maybe more.  The company is very well run and management continues to innovate, find was to maximize the future cash flows of the business and is trustworthy. We have sold more than my initial cost so we are happy to see how the company continues and do not expect selling any of the position any time soon. If we are lucky enough to see a significant fall in the share price, the position size will increase. A position size decrease would require a drastic run up in share price and even that may not do the trick.

 

Zensar Technologies reported Q1 FY2016 results as well. Revenues grew by 16.5% and operating profit by 34%.  Zensar has consistently grown its top line over the years (5 year rev. CAGR = 22%) and with larger and larger deals the companies is growing operating profit faster than revenues. The company is growing digital revenues rapidly and management is doing a good job with all divisions. Application management revenues grew by 19% and IMS continues to be volatile and despite a slight decrease in revenues operating profit grew by 96%.  Product and licenses is a small portion but it turn negative profit in Q1 FY15 to positive profit in Q1 FY2016 with a 3.0% operating margin in Q1 FY2016 from -0.4% in Q1 FY2015.  Overall, Zensar continues to grow at a mid-double digit pace yet the market gives it very little credit for any growth with the market valuing the company on an EV/EBIT of 11 times.

 

Peak Sport also recently reported H1 2015 earnings.  The company grew revenues by 7% and operating profit by 54%.  The company continues to provide highly functional performance products in basketball and is pursuing the same strategy in tennis with some good initial signs.  The company is trading at 1.1 times price to NCAV and 4.5 times EV/EBIT despite a record of continuous and strong profitability. The market is essentially giving the company no credit for its operations.  The position size is roughly 14% and is as large as we would like for a company which is more a deep value investment than a quality value investment.

 

Miko is valued below its liquidation and at the net cash level on its balance sheet, despite the strong growth in the company’s revenues, its industry and its profitability.  (Miko’s share price = HKD0.71, NCAV = HKD1.04, Net Cash = HKD0.68).  It is also trading on a PE of 3.  EV/EBIT is not used given the numerator is near 0. Miko does not seem to have any competitive advantage but is operating in a relatively immature industry allowing for strong growth and low competitive pressures supporting high profitability.  We will continue to increase our position size despite the lack of liquidity as it is a much better alternative to holding cash on a three to five year time period.

 

Honworld Group is a high quality business as it has potential competitive advantage from economies of scale and habit forming behavior.  It also sells a low price product which allows for pricing power.  The company should continue to grow at a rapid pace as the company shifts from a dominant regional business to a dominant national business.  Management is extremely passionate but the insistence on building inventory is a bit perplexing and a major drag on profitability.  Despite growing its revenues above 20%, the company is valued at a 13.7% EBIT/EV yield.  Add a very conservative 5% organic growth rate, the annualized return is around 19%. We will continue to build our position to a as long as prices remain around this level or lower as the company is a better alternative to cash despite management’s insistence on building inventory.

Reperio Capital H1 2015 Review

Reperio Capital H1 2015 Review

 

Reviews on a quarterly basis are too focused on the short term, therefore, going forward; reviews will be made on semi-annual basis.

 

H1 2015 Performance

 

As illustrated above, the second quarter of 2015 saw our model portfolio decline by 0.9% leading to overall first half of 2015 performance of 2.7%. Since inception (5/23/2014), the model portfolio is up 15.6%.

 

 

Holdings

H1 2015 Positions

 

PC Jeweller was the largest position at the end of the first quarter of 2015 and the first half 2015. It remains an extremely strong performer up 76.8% in the first half of 2015 and 199.7% in US dollar terms since recommendation. In the second quarter, we sold 25% of our PC Jeweller position with a goal of selling half our position size and reaching roughly a 5% portfolio position. The company continues to execute very strongly and there is a clear path for growth with new store openings and continued efficiencies, but the level of undervaluation is not as outrageous. We plan to maintain at least a 5% position given the company’s strong operational execution, growth outlook, and reasonable valuations.

 

Peak Sport Products is the second largest position at 7.0% at the end of June 2015. We built a 9.8% position only to see the share price decline due to a share issuance announcement and a general decline in all China related stocks. We will maintain our holding without any increase or decrease. The company has a 5-10% per year growth outlook with a strong ROIC and is trading below its liquidation value but the recent share issuance announcement with the amount of cash on the balance sheet is baffling and dents management’s reputation.

 

Zensar Technologies is the third largest holding at 5.1% at the end of June 2015. The company continues to perform well improving margins after a few weak years following a large acquisition.  In addition, digital as a share of revenues continues to grow. The company expects to grow it top line at a double digit pace with improving margins.  Despite this growth, the company trades on an EV/EBIT of 8.2 times.

 

Honworld Group is a position we are building. The company is the leading cooking wine producer in a market growing at 20% per year. The company has strong management who are leveraging their size advantage to outspend peers on marketing, distribution, and R&D. The company has a high quality product that garners a price premium due to a unique naturally brewed production process. Honworld has traded lower since our initial recommendation as Chinese related stocks are being affected by the fall in Chinese stock markets. The company trades on an EV/EBIT of 9.2 times. Given the growth in the market, the company’s profitability (ROIC = 16%, suppressed due to growth expenditures), and the potential for a sustainable competitive advantage, if the company’s valuation remains below 10 times EV/EBIT, we will continue to build up to a 10% position.

 

Miko International  is our latest recommendation. It is a brand company in the fast growing children’s apparel market. The company’s top line grew by 20% in 2014 and the company is very profitable with an ROIC of 33%. The company’s profitability will probably wane as competitive pressures increase as the market slows but the current valuation is too attractive. The company is trading on an EV/EBIT of 1.21 times and trading at its liquidation value. We will continue to build a 10% position.

 

 

Q1 2015 Reperio Capital Model Portfolio Results

Q1 2015 Reperio Capital Model Portfolio Results

 

In Q1 2015, we found an additional investment opportunity in Peak Sport Products 1968:HK. Peak Sport is an athletic footwear company trading just above its liquidation value (NCAV) with low investment requirements and a good product. The company is increasing its dividend payout ratio. To read more about our investment thesis view our recent research report dated March 23, 2015. We are in the middle of building a 10% position in Peak Sports.

 

At the end of Q1 2015, cash still represents 84.7% of our portfolio. It will take some time to deploy the cash as our research process is very detailed and takes a significant amount of time to complete. We will build our portfolio as ideas come along and will remain disciplined in our research process.

 

Our portfolio at the beginning and the end of Q1 2015 is illustrated below.

Q1 2015 Position Sizes

 

PC Jeweller

 

PC Jeweller performed well in Q1 2015 as the company continues to execute its store expansion plans. At the time of initiation, our expectations was for a doubling its showroom count over the next five years. PC Jeweller since announced it plans to triple its showroom count with some expansion coming through franchising.

 

PC Jeweller continues to be one of the most efficient operators with the Indian Jewelry Retail industry. During the recent downturn due to restrictions in supply most Indian Jewelry Retailers had a very difficult time remaining profitable while PC Jeweller remained very profitable. Government restrictions have eased and PC Jeweller continues to report strong numbers with earnings starting to normalize.   FQ3 2015 (Sept-Dec 2014) saw showroom count increase to 48 from 40 in FQ3 2015 and retail square feet grow to 279,000 from 238,388, representing growth of 20% and 17% respectively.  PC Jeweller’s top line grew by 40% and operating profit grew by 62% while total capital employed only grew by 7%. This was during a period when gold leases where still not being used as a financing tool as restrictions on gold leases where just lifted. Gold leases drastically decrease the upfront working capital requirements and interest costs (12% to 4%).

 

The company also announced innovative partnerships with Flipkart, an Indian online retailer, and Blue Nile, a US online jewelry retailer. These partnerships give PC Jeweller additional distribution channels with minimal investment requirements. The true extent of the additional earnings power from this channel is not yet known but it is good to see management always thinking of innovative ways to improve the business.

 

The strength in PC Jeweller’s operating business lead to a 48.6% increase in the price in CQ1 2015 and 152% return since we first recommended the company. In May 2014, we were able to purchase an extremely profitable business in an industry with huge variability of profitability at 4.27 times EV/EBIT. The company is going to triple over its store count over the next five years, yet still only trades at roughly 9.4 times EV/EBIT. Its largest competitor but closest in terms of profitability is Titan Company, which trades on an EV/EBIT multiple of 30 times. Titan generated much better profitability but PC Jeweller is growing much faster. Titan’s profitability advantage will diminish, as Titan was aggressive in selling installment plans to customers, which decreased its working capital requirements. The installment plans have now been outlawed. Given PC Jeweller’s growth outlook, profitability and Titan’s valuation, PC Jeweller should be trading closer to an EV/EBIT of 20 times.

 

PC Jeweller FQ3 2015

 

Our initial investment was $12.3 million. We sold $16.4 million of PC Jeweller’s shares as the share price rose. Despite our sales at the end of Q1 2015, PC Jeweller was 9.2% of our portfolio. Given we have sold more than our initial investment, we do not foresee any sales and will see how PC Jeweller progresses over the next five to ten years.

 

 

Zensar Technologies

 

Zensar Technologies appreciated by 8.1% in Q1 2015 and 62.8% since the initial recommendation. We purchased Zensar when it was trading on an EV/EBIT of 4.65 times despite steady top line growth and very strong management team. The company’s share price was depressed as margins were depressed across all business lines. Despite the depressed margins, the company remained very profitable. The company continues to grow at a mid to high teens with expanding margins and is valued like a no growth company currently trading on an EV/EBIT of roughly 8.5 times.

 

Zensar Technologies Quarterly Performance

 

Overall Performance

 

Reperio’s Model Portfolio increased by 3.5% in Q1 2015 and has increased by 16.6% since inception. The Reperio Model Portfolio outperformed iShares MSCI Emerging Markets (EEM) by 1.4% and underperformed the iShares MSCI Emerging Markets Small-Cap (EEMS) by 1.5%.  Emerging Market ETFs are used as they are probably the lowest cost vehicle to accessing Emerging Markets with EEM and EEMS both having an expense ratio of 0.69% for 2014.

 

USD Returns Q1 2015

Q1 2015 Relative Performance Chart

 

 

Q3 2014 Reperio Capital Model Portfolio Performance

Q3 2014 Reperio Capital Model Portfolio Performance

In Q3 2014, only two positions met our strict criteria for recommendation and portfolio inclusion. PC Jeweller and Zensar Technologies were recommended and initial position sizes of 12.293% and 4.105%, respectively, were built. The remainder of the portfolio is allocated to cash until additional investment opportunities meeting our strict criteria are identified.

Despite a starting and ending cash position above 80%, our model portfolio appreciated by 12.97% USD return in the third quarter of 2014 equating to an 16.88% excess return relative to the iShares MSCI Emerging Market Index (EEM) and 14.05% excess return relative to the iShares MSCI Emerging Market Small Cap Index (EEMS).  Both positions performed well with the equity portion of the portfolio appreciating by 69.21% in the quarter.

Q3 2014 Model Portfolio Performance

PC Jeweller’s share price appreciated by 91.8% in rupee terms. The strength of PC Jeweller’s performance lead to a sale of roughly 40% of the position at a weighted average price of ₹247.86 representing a 109% gain on sold shares. After the sale, PC Jeweller’s ending position size was 12.7%. PC Jeweller is still undervalued on an EV/Owner’s Earnings of 8.52. The company had weak quarterly numbers, touched on here, but should double its showroom count over the next 5 years with high probability of further margin (higher diamond sales) and multiple expansion (peers trade at an unjustified premium to PC Jeweller).

 PC Jeweller Target Price Assumptions

On September 30, 2014, PC Jeweller announced a partnership with Flipkart to create a platform for online jewelry shopping. PC Jeweller’s hope it to create a seamless online-offline shopping experience where purchases can be made online and returned at anyone of PC Jeweller’s 46 showrooms. Flipkart is a leading ecommerce site and one of the ten most visited sites in India. It reached USD 1 billion in sales in 2014, a year ahead of the company’s target. This partnership illustrates PC Jeweller’s management strength and gives the company a huge opportunity to create a leading Omni-channel presence.

Zensar’s share price appreciated by 40.7% in rupee terms leading to an ending position size of 5.0% position. In the quarter, among other things, Zensar reported weak margins in its latest quarterly report, acquired a company and announced a partnership. The quarter’s earnings were already discussed in an earlier post. Zensar first entered into a definitive agreement to acquire Professional Access. Professional Access is one of the largest Oracle ATG and Endeca partner in the world with USD38 million in revenues. It strengthens Zensar’s e-commerce solutions. It is a key strategic area and a good acquisition. Zensar also announced a partnership with Agile Financial Technologies. This greatly strengthens Zensar’s financial vertical business as well as strengthens its presence in Middle East.

Zensar should continue to grow revenues at a low to mid-teens rate for the near future, yet the company is trading at a no growth valuation. If management is able to reach its revenue and margin targets over the next two to three years, the company’s intrinsic value is more than double the current share price. The company would have a higher position in the portfolio but liquidity is an issue.

 Zensar Target Price Sensitivity Table 9222014