2016 ANNUAL PERFORMANCE REVIEW AND NOT QUITE A WEEKLY COMMENTARY 12/19/16-1/8/17
2016 ANNUAL PERFORMANCE REVIEW
While the annual performance review is somewhat arbitrary, it is good to review you investment process on a regular basis to find improvements.
In 2016, the average local currency return of our recommendations was -3.1% with the average US dollar return not far off at -3.0%. Relative performance was -5.3% as the Emerging Market Small Cap Index as measured by iShares MSCI Emerging Market Small Cap ETF (EEMS) was up 2.3% compared to our average US dollar return of -3.0%.
The major drag on the performance of recommendations was Miko International and Universal Health. Universal Health saw a significant decline after its founder and majority took a loan against the company’s shares leading to forced selling in the stock. Subsequently, the company’s operational performance deteriorated drastically leading us to question the validity of the company’s initial financial statements. Miko International saw a number of independent directors resign followed by its auditor resigning due to disagreements over accounts in the company’s financial statements. It hired an auditor of last resort known to work with many Chinese frauds. We also saw poor performance at another Chinese company Honworld as management’s poor capital allocation inhibits its ability to grow without raising external funds. The poor performance of the Chinese small and mid caps leads us to question the financial statements in many Chinese small and mid cap companies. Given the inability to have any conviction, we are taking a smaller position if we invest in Chinese companies. Our other Chinese investments in Peak Sports Products and Anta Sports Products were our second and third best performing stocks in 2017 making us not totally write off investing in Chinese companies. Interestingly, the poorly performing Chinese companies all recently went public and therefore we have implemented a rule of not purchasing any stock that went public in the last three years.
The poor performance of Universal Health and Miko International highlighted the limits to our knowledge leading us to be less aggressive with our position sizing. Our new position sizing philosophy is 1-2% for high quality watch list stocks like Credit Analysis and Research and Anta Sports, 2.0% for deep value, 2.0% for Chinese companies, and from 2.0% to 8.0% for high quality companies depending on the strength of the business and attractiveness of returns. The goal is to get 25-35 holdings. The smaller position sizes do not match with the depth of our research. Our research was deep dive taking up to a month. The depth of research clearly required the ability to take larger position sizes as you can research only 12 ideas in a year. Assuming, half that are fully researched reach our investment standard leads to a maximum of six recommendations per year. There is no way we could ever be fully invested with our new position size philosophy, therefore, we are decreasing the depth of the research so we can hopefully one day get close to fully invested. We will focus on the crucial elements of every investment but not as much in depth. Hopefully, this will also increase the value of the blog for readers as we are trying generating more ideas by researching more companies. As mentioned, we will also be looking at high quality stocks that may be slightly more expensive than our typical investment but meets all other requirements. These will be formally placed on the watch list and placed in the portfolio at a smaller position size. Credit Analysis and Research and Anta Sports fall into this category. The hope is these positions will eventual become more attractive on valuations. The side benefit is highlighting more high quality companies.
Since May 2014, we have made 10 recommendations generating an average outperformance of 30.9%, with three recommendations having negative absolute performance. The average time from recommendation to sale is 459 days with four of the 10 recommendations still being held.
Overall, 2016 was not the best year for stock selection with underperformance of 5.3%. More importantly, we feel the mistakes made have allowed us to strength our process. Despite the bad year, our recommendations are up 30.9% since May 2014.
The table above illustrates position sizes at the end of each half since the end of the first half of 2014.
In 2016, our portfolio fell be 12.8% on the back of poor performance and large positions in Universal Health, Miko International, and Honworld. Despite the poor performance in 2016, our portfolio is up 12.3% in absolute terms since inception and 24.4% relative to EEMS, while averaging 67.9% of the portfolio in cash. The large cash position is a function of our high threshold for investment and the time required in our in depth research process. Hopefully, our shorter reports will allow us to be more efficient at finding ideas allowing us to put the cash to work.
While 2016 was not the best year in terms of performance, the improvements made to our process due to the mistakes made should more than make up for it in the future.
Mrs. Kusum Jain, a non-Executive Director, resigned from PC Jeweller’s board, with effect December 30, 2016. This is the first director resignation at PC Jeweller for some time, but it is worth monitoring in case there are additional resignations from independent directors.
On December 21, 2016, Zensar Technologies announced it appointed Manoj Jaiswal as Chief Financial Officer. Manoj Jaiswal was Chief Financial Officer for CEAT, another RPG Enterprises company. Before joining CEAT, Manoj had spent 17 years in Wipro in different roles.
Zensar also changed its auditor to Deloitte from PricewaterhouseCooper. Under Section 139(2) of the Companies Act, 2013, all listed companies and certain categories of unlisted public companies and private companies are mandated to rotate their auditors after 10 or more consecutive years.
On January 7, 2017, CARE announced that it was shutting down its Maldives operations after its license expired and decided not to renew. The Maldives operations were insignificant.
Horsehead Holdings (Aquamarine Fund)
Guy Spier, a noted value investor, and portfolio manager of Aquamarine Fund looks back at his investment in Horsehead Holdings. It is a very good template for looking back and learning from your investment mistakes. (link)
Looking For the Easy Game (Credit Suisse)
Credit Suisse’s Michael Mauboussin discusses passive and active investing. (link)
A Bird in Hand is Worth More Than (Forecasted) Eggs in the Future (Latticework)
This is a very good article by Amit Wadhwaney of Moerus Capital Management discussing his investment philosophy. (link)
The Future of Retail 2016 (Business Insider)
Business Insider’s BI Intelligence unit created an interesting slide deck on the future of retail. The slide on the article illustrates the share of digital in different categories. Useful for understanding what segments of retail are most impacted by the internet. (link)
Patagonia’s Philosopher King (New Yorker)
The New Yorker wrote an article on Yvon Chouinard, the co-founder of the outdoor-apparel company Patagonia. (link)
The Irrationality Within Us (Scientific American)
Scientific American discusses our irrationality. (link)
Charlie Munger on the Paradox in Hold vs. Buy Decisions in Long Term Investing (Fundoo Professor)
Professor Sanjay Bakshi discusses Charlie Munger’s thoughts on the decision to continue to hold a stock vs. the decision to buy a stock. (link) The comment section should be read as well as there are many insightful comments. As illustrated by the changing of our positions sizes, we do not subscribe to the buy and hold regardless of valuation. By saying that you would continue to hold an asset at a particular price but you would not buy the same amount if you did not hold it, you are ascribing more value to the asset you hold, which is a bit irrational and is known as the endowment effect. Endowment effect is valuing an item you own more than an identical item you do not own. We try to look at all companies the same way, whether we hold them or not. First, a high percentage of companies can be ruled out as a potential investment due to poor financial health, poor management, or poor business quality. We may compromise on business quality if the company is a deep value investment but there is a limit on this compromise. Once companies pass the first investment hurdle, we assess the attractiveness of the company based on its business quality, management, growth outlook, and risk. Future returns are estimated based on scenarios giving a range of potential returns. If the market values a company so highly that very aggressive assumptions are required to meet the market’s expectations, we would not buy a company or hold a position. If on the other hand, if the market was valuing that same company so cheaply that the most conservative assumptions pointed to significant upside and there was sufficient business quality, we would take our maximum position of 8%. In between the two extremes is a spectrum of potential returns leading to a spectrum of position sizes between 0% and 8%. The decision of the position size is based on the attractiveness of the returns of a business not whether we hold a stock or not.
Valuation and Investment Analysis (Bronte Capital)
Bronte Capital wrote an article discussing how they do not use valuations in their investment process. (link) Again, please read the comments as there are some useful comments. Clearly, we do not agree with Bronte Capital’s view. We agree that valuation is difficult and does not provide a point estimate that is why ranges and scenario analysis needs to be used in the valuation process or reverse engineering a DCF or Residual Income model to find out the market’s expectations of key value driver assumptions. These market assumptions can be tested for reasonableness. We believe it is very difficult for anyone to call themselves an investor if they do not have some estimate of what is the value of potential investment. Investing requires understanding the fundamentals of the business, and the valuations of the business. Value investing requires an additional margin of safety to ensure you are not buying a business with sufficiently attractive returns. Not having an estimate of the potential returns of an investment is pure speculation. Bronte Capital focus on operational momentum to ensure the business will continue to grow for a long time. The problem is growth stocks often do not meet the growth expectations of the market and this is precisely why you should have an understanding of what type of growth the market is expecting. Within the Emerging Markets small cap universe, the MSCI Emerging Markets Small Cap Growth Index has underperformed the MSCI Emerging Markets Small Cap Value Index by 141.34% over the past 16 years or 5.66% per annum. Similar to Bronte Capital, growth investors are more concerned with growth than valuation leading to missing a big piece of the puzzle in understanding a business.
Value vs. Growth in Emerging Markets
Given the past two articles, we thought it be interesting to review the performance of various Emerging Market indices to see how each style has performed.
The table above illustrates the performance of MSCI Emerging Market indices across size and style biases. Indices have various inception dates so the longest time period with performance for all indices is 10 years. Over that period, the best performing index is Emerging Markets Quality index followed by Small Cap Value and the Small Cap Index. Over the past 20 years within the large and mid cap universe, value outperformed growth by 1.00% per annum. Quality seems to be the best performing index outperforming the overall index by 1.95% per annum since 06/30/1994 compared to only 0.44% per annum outperformance of value over the past 20 years, and -0.57% underperformance by growth over 20 years. There is a one and a half year difference in the long term performance figures if quality and value and growth, but given the length of the track record there would need to be a drastic underperformance of quality (roughly 35%) over that one and half years for quality’s performance to fall back to the value index’s level of performance. With some confidence, we can say quality has been the best style among the Emerging Markets large and mid cap universe.
Small Cap outperformed the large and mid cap index by 1.24% per annum illustrating a persistence of the size premium in Emerging Markets. Within the Emerging Markets small cap universe, value outperformed growth by 5.66% per annum over the past 16 years. The 5.66% growth translates into 141.34% additional performance over the period. There is no small cap quality index to compare the quality style.
Value outperforms growth in Emerging Markets with significant outperformance vs. the benchmark and growth in the Emerging Market small cap universe. Brandes Institute of Brandes Investment Partners did a study on style bias in Emerging Markets, which can be found here.
Alexa: Amazon’s Operating System (Stratechery)
Ben Thompson always writes great articles on technology therefore is a must read. We tend not to invest in technology as short product life cycles leading to disruption leading to difficulty valuing these companies. Despite the difficulties in technology, Silicon Valley and start-ups are very good at understanding all aspects of business models and therefore reading some of the best writers in the industry helps increase understanding of business models in more investable industries. In this particular article, Mr. Thompson writes the business model of operating systems. (link)
Tren’s Advice for Twitter (25iq)
Like Stratechery, 25iq is a must read. Tren Griffin works in the technology industry but is a value investor. Mr. Griffin gives his advice to Twitter. His advice is relevant for all companies. Understand your competitive advantage and continue to strengthen it while being as operationally efficient as possible. There is not much more to strategy. Understand your competitive advantage. If it is unique advantage, strengthen it as much as possible. If it is a shared competitive advantage, try to cooperate with competitors as much as possible to distribute fairly the benefits of the value created by the shared competitive advantage. If there are no competitive advantages, operational efficiency is the most important thing. Due to institutional imperative, which prevents firms from acting as rational as they can, operational efficiency can allow one firm to persist with excess profits for a long time. The importance to barriers to entry on strategy and profitability illustrates why the identification of competitive advantages, also known as barriers to entry, are so crucial to Reperio’s investment process. (link)
Amazon’s 2004 Shareholder Letter
Amazon’s 2004 Shareholder Letter stresses the importance of free cash flow not earnings the main metric followed by most market participants as earnings does not take into working capital and fixed capital investments required to generate additional earnings, while free cash flow accounts for the necessary investments. (link)