2015 Reperio Model Portfolio Review 1/4/2016
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’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.
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’ (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.
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.
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’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’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 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.