Letters

Inherent Value Update

January 2020

Inherent Value Update

This month we update the analysis of Somar’s Founder’s Class vs the inherent value created by our long portfolio (Fig. 1). The methodology was described in our letter from January 2019[1].

This update shows a continuous and even accelerating growth in the sales per share of our companies. This, however, has come at the expense of profitability as EPS growth has decelerated for the past 9 months. It is
also clear in the chart that the market has taken a less forgiving stance towards companies currently sacrificing profits for faster growth.

While the indexes in the graph aggregate different companies with diverse strategies and their own idiosyncrasies it is important to emphasize that we follow these companies closely and are in communication with the  management teams and competitors. We scrutinize all their investments and make our own judgements of their expected return.

We are confident that the investments being made by our companies are in the long-term interest of all shareholders. We also see our companies keeping and, in some cases, expanding their competitive advantages, which should lead to stable or expanding margins in the future. We are therefore enthusiastic about their prospects for the future. We will continue to update you on this in future letters.

Chart 1
Source: Somar Analysis
Note: Index December 2016 = 100

Sharpening the Saw

One of Somar’s core values is humility. We know we have something to learn every day and from every person we encounter. When our performance falls short of our expectations, we look back and assess what
we could have done differently. These episodes are gems that need to be mined to improve our process and sow the seeds for future outperformance. The drawdown we experienced in late 2018 is a great source of wisdom for us.

While we could easily chalk this period up to the market sudden and apparently indiscriminate sell-off amidst strong execution by our companies, that is not the Somar standard. Yes, our companies executed well, and yes, we recovered those losses. But, what can we learn from that experience? Were there areas that could have been managed better?

I believe in late 2018 Somar would have benefitted from sharper Portfolio Management. Yes, the buck stops with me, and while the work from an analyst point of view was spotless, we fell short in the management of
the portfolio. We have learned from this and strengthened Somar’s portfolio management capabilities going forward. This bodes well for our future performance.

As can be seen from Fig. 1 above, in the summer of 2018 our companies started investing some of their margin into growth initiatives. We were onboard with it, but clearly the market was not. This regime change
in the market was not picked up by me. So, through late 2018, faced with more attractive prices and strong management execution, I did what every good stock analyst does and bought more. This ended up increasing
the losses we suffered in late 2018. While these losses were fully recovered, this portfolio management strategy amplified our drawdown and reduced our dry powder to buy more at more attractive prices later.

A good portfolio manager would have picked up on the regime change, namely the market lack of appetite for faster growth at the expense of short-term profits and adjusted the portfolio accordingly. That means,
increasing our exposure to our favorite investments that were not sacrificing short term margins and holding off on increasing exposure to our investments that were investing short term margin for faster growth until either these investments started to produce higher profits or the market’s appetite for these types of investments started to thaw.

This approach would have allowed us to reduce the drawdown and also enhanced our bounce back performance later. While picking up on regime changes is much more art than science and one can never pick a bottom, being aloof to changes in market appetite is no solution either. We have a wide variety of good investment opportunities in front of us. All at different stages in the investment cycle, from early stage to maturing growth, with margin expansion and strong cash generation opportunities. As a portfolio manager I should use this wide array of options to construct a portfolio that correctly balances them at each stage.

These adjustments have made Somar better. We thank you for your confidence and look forward to continuing to update you on our progress going forward. Our best days lie ahead.

All the best,

Pedro Ramos

***

[1] To calculate the indexes, we calculated the growth in TTM EPS and TTM Sales per share for each quarter since December 2016. We included only long positions that represent at least 1% of our Assets Under Management at the beginning of the quarter. This represents a minimum of 75% of our long portfolio. We then assumed 100% of our long book was composed of these positions. We assumed these positions were held constant until the end of the quarter and multiplied their weight in the portfolio by the growth in TTM EPS (or TTM Sales per Share) of each. Finally, we added the result for every single position, in order to get the composite quarterly growth rate for our Index.

Disclaimer: This website is for general information purposes only and is not intended to be, nor should it be construed as investment advice, nor a solicitation or offer to buy or sell any securities, related financial instruments, or  interests in the Somar Master Fund, LP (the “Fund”) or its feeder funds. The information contained herein is not complete, and does not contain certain material information such as disclosures and risk factors about the Fund or its feeder funds. Opinions expressed are current opinions as of the date of this material only and are subject to change without notice.Hedge funds: (1) often engage in leveraging and other speculative investment practices that may increase the risk of investment loss; (2) can be highly illiquid; (3) are not required to provide periodic pricing or valuation information to investors; (4) may involve complex tax structures and delays in distributing important tax information; (5) are not subject to the same regulatory requirements as mutual funds; and (6) often charge high fees.

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