We are not happy to report these results, as the performance falls short of what we expect from Somar and the businesses we invest in. We have analyzed the causes of this gap and concluded the following:
- Operationally the businesses are performing well, meeting or exceeding our expectations
- There has been no single or small group of positions that caused the underperformance
- Short book has performed well, with a marginal loss in a rising market1
We are therefore very optimistic for the performance ahead for Somar. While it is unfortunate that in the first 7 months, the market performance hasn’t recognized the progress made by our businesses, these periods of gap widening are a normal occurrence in the market. In fact, they open opportunities for investors to capture additional returns and outperform.
Somar recognizes these opportunities and significantly increased our gross exposure during December.
“Don’t judge each day by the harvest you reap but by the seeds that you plant” – Robert Louis Stevenson
Investors, both in managers and in companies, have a very difficult task: make commitments today in the hope of getting a reward in the future, amidst imperfect information. Making matters worse, progress is not linear and therefore, early investment results aren’t necessarily indicative of the ultimate outcome. So the intelligent investor needs to have a clearly defined investment strategy and execute it with intensity and discipline.
At Somar we follow a proven Investment Strategy rooted in 3 key beliefs:
- We believe buying thriving high quality businesses at a fair price is the best foundation for high investment returns.
- We believe the identification and assessment of great businesses and management teams around the
world requires direct observation and tracking and cannot be automated.
- We believe our opportunity set is large and expanding.
Let’s take a look at each of these beliefs in more detail. A thriving high-quality business is able to grow
profits at double digit rates and generate large amounts of free-cash-flow relative to the capital invested.
These businesses tend to have the following characteristics:
- High returns on invested capital
- Strong competitive advantage (e.g. lower cost, differentiation, network economies) that allow it to
maintain or expand its return on invested capital
- Strong secular growth opportunity2 ahead, of which only a small share has been captured
- Ability to leverage its current assets to launch new high-return businesses
- Managed by a highly-capable, shareholder-oriented management team
Owners of high-quality thriving businesses tend to accumulate large amounts of wealth. Consulting Forbes’
richest people list3 reveals several examples of thriving high-quality businesses. Early in his career, Warren
Buffett understood this principle and acquired controlling and fractional shares in high-quality thriving
businesses. Today Somar looks to do the same beyond the well-publicized and owned secular winners4. We
scour the world to create a portfolio of high-quality mostly underfollowed secular winners, and through our
portfolio allow our investors to participate in the future success of these businesses.
We have had success identifying, researching and investing in many high quality businesses over the years
by following a rigorous investment process that includes:
- Screening for companies with fast growth in early stages of penetration of large secular opportunity
- In-depth analysis of financial performance of each company in the industry (public or private)
- Customer experience analysis: e.g. product testing, store visits, customer surveys
- In-depth evaluation of management capabilities through: management interviews, historical
assessment of management delivery against targets and guidance, competitor interviews, interviews
with former employees, analysis of key hires made over time
- Tracking of moat evolution overtime: e.g. price checks, assortment comparison, network growth,
market share evolution
- Scenario analysis taking into account different e.g.macro scenarios, regulatory outcomes, product /
business launches, market penetration, etc.
The above process is very effective in identifying and selecting the most attractive high-quality thriving businesses. It uses both quantitative and qualitative methods and is not bound to be automated or replicated
by an ETF. We believe, the extra research investment produces high quality investment ideas and provides
high conviction that is likely to be rewarded with superior risk/adjusted returns over time.
Fortunately, we live in a period where the opportunity set for this type of investing is large and expanding.
This gives us strong confidence for the current and future prospects of Somar. We see at least two factors
that drive the expansion of the opportunity:
- Growth in number of secular change processes – there is a growing set of secular change processes
occurring today: e.g. e-commerce, electronic payments, social and digital media, smart-phones,
renewable energies, direct lending, rise of artificial intelligence.
- Acceleration in the speed of the secular change processes – the speed at which new technologies
take hold is accelerating (please see Fig. 1 for an illustration). This makes it possible for companies
like Facebook to go from startup to a $300Bn + Market Cap in less than 15 years
Short Position Harvest: Gap (GPS)
Our detailed work on the Fashion and Apparel industries has yielded good investment opportunities. In
December we harvested one of them, our short position in Gap.
Gap is the leading player in the casual fashion and apparel category with sales of about $16 bn spread mainly
over their three core brands: Gap Global, Banana Republic and Old Navy. With more than 3,700 stores
spanning an area of almost 38 mn sqf, Gap is the leading US brick and mortar apparel retailer.
Our work suggests Gap and other traditional apparel retailers are under threat from two secular trends: Fast
Fashion and e-commerce.
Fast Fashion supply-chain models are taking significant wallet share of the fashion-conscious consumer due
to a superior customer proposition: the customer always gets the latest fast-selling designs at the Fast
Fashion store. Fast Fashion’s customer proposition is supported by a different operational model that makes
it very hard for Gap and other traditional apparel retailers to replicate.
Fashion Model Customer Proposition Operational Model Financial Model
- Affordable Prices
- House season design: 4 to 8 collections / year
- Minimize production costs by producing in Asia
- Design to store cycle of up to 9 months
- Stockouts of hot products and high markdowns on remaining
- High working capital requirements
- Volatile Gross Margin
- Latest design (up to 26 collections/year)
- Store inventory turns fully every other week
- Affordable prices
- Design to store cycle in 2 to 4 weeks
- Replenish in-season fast moving products
- Minimize markdowns by initially producing small quantities and reduce price if not sold after 2 weeks
- Negative working capital requirements
- Stable margin
For the consumer looking for classical styles, online apparel retailers offer a wider assortment at lower
prices than traditional apparel retailers like Gap. This has helped online retailers gain market share.
Apparel Model Customer Proposition Operational Model Financial Model
- Pick-up in store – convenient last minute
- Medium assortment
- Full Prices
- Brick and Mortar stores
- Assisted sale
- High Capex requirement per store but scalable
- High working capital requirements
- Shop on website
- Large selection and size availability
- Discount prices
- Ship directly from fulfilment centers
- Ship multiple sizes and receive return of sizes that don’t fit
- Self-service on website
- High upfront platform capex investment
- Lower working capital requirements
Squeezed by both Fast Fashion leaders and online apparel retailers, Gap has been losing market share. This
is mostly apparent in the consistent negative same-store-sales reported despite the closure of underperforming
stores. Given that each store has its own fixed costs, the loss of sales per store negatively
impacts margins and raises questions on the sustainability of the current operational model. Gap’s future
earnings power seems to be getting impaired over time as its fast fashion and online competitors keep taking
Somar shorted the Gap at a valuation that didn’t adequately reflect the business value impairment and
offered an attractive asymmetric risk-reward. In December we harvested our position when it hit our price
1 According to our Risk Manager, Northstar Risk, our short book delivered positive alpha from inception to December 31st.
2 We use the term secular growth opportunity to refer to an opportunity that is driven by a real world change in the customer preferences. This contrasts with a cyclical growth opportunity that is driven by a macro cyclical recovery in the company’s markets.
3 You can find the complete list here: http://www.forbes.com/billionaires/list/#version:realtime
4 Beyond companies like Netflix, Apple, Facebook etc. Somar looks for underfollowed secular winners like HealthEquity, Hargreaves Lansdown, among others.