Inherent Value – January 2019

Inherent Value

We decided to focus this month on going deeper on the performance of our long investment portfolio, which generated a large drawdown at the end of 2018.

While every month we report to you the precise mark-to-market value of your portfolio, that return doesn’t necessarily reflect the inherent value being created by our long investments. While, it is not possible to precisely quantify it1, at Somar we use a few metrics to track each company’s progress in creating value. This month we share with you two of these metrics:

  • Quarterly growth in Trailing Twelve Months (TTM) Earnings per Share (EPS) – a measure of the progress in the company’s underlying profitability
  • Quarterly growth in TTM Sales per Share – a measure of the company’s underlying growth

While neither of these metrics is perfect for measuring inherent value creation, and others may be used elsewhere2, at Somar we believe that a company that consistently and sustainably grows its sales and profitability in a capital efficient way, is creating meaningful value for its shareholders. We believe that over the long term, years as opposed to months, the market value of the company should track the appreciation of its inherent value.

Somar created an index that tracks the growth in EPS for our long investments and another that tracks the growth of sales per share of our long investments3. We plotted these graphs, together with the index of Somar’s net performance on Chart 1 below:

 


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

 

It is interesting to note the steadiness in growth in both sales and profitability of our long book. They are both growing at a high pace and we expect this growth to continue for several years more:

  • Our companies offer a superior value proposition to the consumer, which allows them to steadily win market share year after year
  • The opportunity ahead of them is still quite sizeable. Some of them, like Takeaway.com have not even penetrated 10% of their opportunity
  • They are led by highly capable entrepreneurs who still have a major personal commitment to the company’s success4
  • They operate with capital-efficient, high return on capital business models

We actively track our portfolio companies’ adherence to the points above. It is our belief supported by extensive primary due diligence that the four points above will be valid for our companies for several years to come. However, when that proves not to be the case, we are quick to rotate those companies out of our portfolio. The opportunity set available to us is more than enough to quickly replace any company or group of companies we decide to exit.

Throughout 2017, Somar’s net performance tracked our estimate of inherent value creation. However, in the second half of 2018 we saw a large discrepancy. This seems to be caused from market psychology rather than a deterioration in our company’s fundamentals. We expect the fundamentals to continue to improve at the same pace as they have until now. Therefore, the end of 2018 will prove to have been a very attractive time to invest in our companies. We have positioned the portfolio accordingly to take advantage of this opportunity.

In recent conversations, we heard from some of you that this added transparency into our portfolio is helpful. Therefore, we intend to update this analysis on a quarterly basis.

 

Team

On March 30th I will be speaking at Harvard Business School’s 2019 Investment Conference in Boston. If you are there, please drop me a line so we can meet.

***

[1] An effort that even if possible, would only be current over a short period of time
[2] For example, Warren Buffett uses growth in accounting book value per share
[3] Please see Methodology section below
[4] Please see our letter Alignment of Interests from September 2018

Methodology
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.

Expectations for 2019 – December 2018

Expectations for 2019

The strong market correction of the last months of 2018 was punishing to our reported return in the year. But it didn’t distract us from our mission: to find and buy consumer businesses offering significant upgrades to consumer value propositions at attractive prices and short their competitors with inferior consumer offers that are overpriced and losing market share. On that count, the volatility offered us the opportunity to add to our portfolio at very attractive prices.

Meanwhile, our companies have continued to create value for their consumers and for you. Month after month, our long investments continue to improve their customer offer, take market share and increase their Free Cash Flow. Our businesses are thriving, and time is one our side. The volatility in the market and in our reported returns may give conflicting messages throughout the year, but make no mistake, your businesses are creating value. In the next section, you can see an example of this from our Takeaway.com investments.

An investment in Somar allows you to add to your portfolio attractively priced emerging consumer innovators in the US and Europe. To believe in the success of your investment you must believe that:

  • Companies that have a superior consumer value proposition will continue to take market share and thrive financially.
  • Management alignment with shareholders, in the form of direct stock ownership, ensures that part of the consumer value created flows through to shareholders.
  • Somar’s alignment with you ensures full focus on finding and investing in the most attractive opportunities at the most compelling prices. As the largest LP in Somar, I am fully aligned with you.

This is a time-tested recipe for business and financial success. That doesn’t mean it is easy. Businesses, the macro environment, and the financial markets all have ups and downs. This requires a successful fundamental investor to stay focused on the long-term mission and daily execution. Our team is relentlessly focused on it, on your behalf.

 

Takeaway.com Update

In December, Takeaway.com (“Takeaway”) announced the agreement to acquire the German business of its main competitor in the country, Delivery Hero. If approved, this deal would combine the top 2 players in the market and create the undisputed leader. This news strengthens our investment thesis, increases our expected upside from the investment and reinforces the alignment of interests of management.

In our August 2018 letter we argued that the network economies in the food delivery, make it a winner-take-most business. In our table 1 of the same letter, we showed how the industry recognized this and tended to be consolidated, market by market, by the emerging leader. Rather than embarking in value-destructive price and marketing investment wars, the non-leading players prefer to sell their business to the leader. This deal is further confirmation of this trend.

The deal is highly accretive and will likely lead to more financial upside for Takeaway investors than we anticipated when we made our original investment:

  • Takeaway will almost double its revenues in Germany with no meaningful need for extra fixed costs. It can also significantly reduce its marketing costs, by consolidating the 3 owned brands into one.
  • The emergence of a clear winner in Germany is likely to significantly reduce competitive intensity and allow Takeaway to scale back its pre-deal marketing investment level.
  • Finally, the added market clout may allow Takeaway.com to negotiate better take rates with restaurants.

The deal will lead to increased insider ownership in Takeaway. Prior to the deal, Takeaway’s management owned more than 34% of the company. They do not intend to sell a single share in the deal. Meanwhile, Delivery Hero will take part of the transaction proceeds in the form of an 18% ownership of Takeaway’s stock (which will dilute management’s stake proportionally).

While the deal is too small to fall under the automatic purview of the anti-trust authority, we can’t rule out an in-depth analysis of the deal to be conducted. Once this hurdle gets crossed, we expect the positive impact of the deal to begin to materialize.

Takeaway’s base business has continued to execute well. In further evidence of the different dynamics of secular growers and mature companies, Takeaway accelerated its order year over year growth from 34% in Q2 of 2018 to 40% in Q3 and 37% in Q4 of 2018. This despite a significant slowdown in the German economy which is reported to have declined -0.2% in Q3 and grown only 0.1% in Q4.

We look forward to continuing to update you on Takeaway’s progress throughout 2019.

 

Communication

We are looking to expand the avenues of communication between us and you. Starting in the first half of April we will host quarterly conference calls to provide a live update and answer questions. You can participate live through dial-in or by sending us your questions in advance.

A Tale of Two Cities – October 2018

A Tale of Two Cities

Contrary to what might be a readers’ first reaction, the last month has given us increasing confidence in our portfolio. Most of our long investments have reported and have beat market expectations with few exceptions. A significant portion of our short investments have missed their earnings with some reducing the guidance for the rest of the year. The fundamentals reported are supportive of our theses.

And yet, as you can see from the first paragraph, we had to mark our portfolio down more than 5%. What do we make of this divergence between what the fundamentals are telling us and what the market is pricing? Is the market anticipating a material reduction in the cash flow generating abilities of our companies or has fear severely reduced the market’s appetite for long term winners like the ones we pursue at Somar?

We believe that fear and market sentiment are the major drivers of the moves:
– During this period, we have observed large price swings in the stocks, even in the course of a few hours with limited connection to fundamentals. For example, Takeaway.com reported an acceleration in order growth in Germany strengthening our thesis and the stock opened up 10%. A few hours later, the stock closed down for the day with no additional company or industry related news reported.

– We observed strong rotation away from companies with strong growth prospects into perceived defensive names like utilities and consumer staples. This is a sign of rising fear in the market and not of company by company assessment of opportunities ahead. The market is putting a higher premium on certainty of cash flows over uncertainty of growth potential.

– During this period, the VIX, which measures the S&P 500’s expected volatility, has stayed extremely elevated with some periods above 20% (versus low teens for most of the year). VIX consistently spikes in periods of heightened fear as investor rush to buy market protection, for example in the form of S&P500 put options.

At Somar, we are long-term investors, focused on companies’ execution to capture the abundant
opportunities ahead. Our due diligence process and investment thesis is similar to that of an investor in
private (unlisted) enterprises. However, private equity investors don’t face a daily mark to market. This
provides an opportunity but also a risk:

– The big risk is that you let the daily swings of the stock price inform and influence your views of
the risk/reward of each investment. This can lead you to sell on the lows or cover short positions on
the high. This is a costly mistake that will hurt returns over the long run.

– The opportunity comes from taking advantage of inefficient prices to boost returns. You can buy
more of your long investments at lower prices or short more at higher prices. When you have the
fundamentals supporting your thesis, you can use the market’s volatility to capture a bargain.
Somar’s process positions us very well to take advantage of dislocations like this:

– We value our investments by discounting our views of companies’ cash flows at a normalized
discount rate. This prevents us from overvaluing companies just because the current interest rates
may be lower than the long-term average. It also insulates us from using multiple1 comparisons,
which are moving targets, especially in market volatile times.

– To support our projections, we rely on our own primary and secondary research. We also model the
value under different scenarios to quantify and inform the loss we are assuming if we are proven to
be wrong on our thesis. This research is ongoing and our risk-reward is updated as new information
comes in.

– We invest in companies that create economic value at high rates by gaining market share and
expanding the value offered to the consumer. This means time is on our side on our long investments:
temporary dislocations don’t hamper our eventual rate of return on our investments for the long
positions we hold (Fig. 1). We can even increase the return by buying more when market dislocations
offer that opportunity.


Note: Conceptual graph
Source: Somar Analysis
Fig. 1

Our attitude when the market sells off is humility. We start by assuming the market is right. We go back to
the basics, redo channel checks and talk with the companies and players in the industry to make sure the
incoming data is reflected in our scenarios and risk-reward analysis. We let the incoming data dictate our
actions and decide to add to positions where we are confident our thesis is on-track and the price dislocation
presents an opportunity.

Your opportunity

What is true for Somar and our management of our individual positions, is also true for you and your
management of your investments in Somar and possibly other vehicles. We can use fluctuation in the markto-
market value to add to your positions at attractive valuations and enhance your long-term returns.
This is extremely difficult to do and most people let market concerns detract from their long-term returns
by selling and buying at unattractive times

– Research from Dalbar2 showed that the average fund investor, substantially underperformed the
return of his fund. For example, for the 1994-2013 period the average fund studied returned 8.7%
while the average return for each investor was only 5.0% as investors consistently sold after bad
performance and bought after good performance.

– Follow the crowd behavior is useful and comfortable in most walks of life but is quite costly in
investing where the crowd behavior changes the risk/reward: when the crowd sells and lowers the
prices available, the potential return is higher, and the risk of permanent capital loss reduced.

Our mission at Somar is to help you achieve the highest possible return over the long term. Therefore, we
offer high transparency and write to you monthly to give you as much information as possible to allow you
to make the best decision for yourself. Our phone is always available to answer any questions you may
have. The fundamentals of the companies in our portfolio are supportive of our theses. The market short
term dislocation, while painful, is opening an opportunity to enhance our long-term returns. You have a
similar opportunity as well.

 

 

1 For example, as a multiple of sales or a multiple of earnings – benchmarked against the trading multiples of similar companies

2 Quantitative Analysis of Investor Behavior

 

Alignment of Interests – September 2018

Alignment of Interests

Show me the incentive and I will show you the outcome” – Charlie Munger

Alignment of interests is one of the keys for successful investing. At Somar we evaluate the degree of interest alignment to identify long and short opportunities. We pay extra attention to changes in interest alignment to evaluate the risk reward of existing and potential positions. If interest alignment changes, Somar’s opinion of the risk reward changes.

Conventional wisdom evaluates alignment in a binary way: either interests are aligned, or they are not. Somar looks at alignment in a continuum with different degrees of alignment ranging from perfect alignment to conflict of interests.

* * *

On its long investments, Somar looks for the best possible alignment between consumer value, company profitability, management incentives, stock market performance and Somar investor wealth. (Fig. 1) Every single step of this alignment counts, and there can be losses of alignment at each level.

Source: Somar Analysis

Fig. 1

 

Customer alignment is key for any sustainable business value creation. Somar looks for businesses that offer a material upgrade to existing consumer value proposition either through lower prices, wider choice or superior services[1].

Long investments benefit when we partner with management teams that focus on constantly innovating to expand the value they deliver to customers year after year. This could be in the form of product / service enhancements, price decreases or new adjacent businesses.

Some businesses have this alignment built-in. For example, businesses that benefit from network economies offer expanding value to their consumers as they grow. The value of a telecom network, or social network increases, as more people participate in it. Similarly, the value of a food ordering platform like Takeaway.com increases the more restaurants are available there.

Perfect management alignment with shareholders is difficult to achieve. Conventional wisdom has it, that stock option plans are a good solution. While a step in the right direction, it has a big shortcoming: management has none of its capital at risk. As investors, our first priority is to not lose capital. Stock options are granted with no financial commitment from managers who are left with no incentive to protect capital. They share in the upside but not in the downside. (Fig. 2)

Fig. 2

The best way to align management to investors, is to have managers be shareholders in the business and for those shares be a large portion of their net worth. Somar finds these management teams are extremely entrepreneurial and create significant customer and shareholder value. This happens frequently (but not always) when you partner with the founders of the business. 8 of Somar’s current top 10 long positions still have the founders and their team in place. On average this group averages 15.7% ownership of their respective companies. Ownership in this group ranges from 4.2% to 36.8% of total shares. We are happy to have our entrepreneur managers with skin in the game alongside us.

Conversely, none of our top 10 shorts has an entrepreneur leading it. Management teams consistently have less than 1% ownership of the company. If we add the trusts controlled by the descendants of the founding families (with no management involvement on the day to day operations), the average inside ownership rises to only 4.25%.

As your conduit to these opportunities, we are careful to make sure Somar is as aligned with its limited partners as possible:

  • We have our own capital at risk alongside yours. The Ramos family is the second largest investor in Somar. One other member of our team has also the vast majority of his net worth invested in Somar.
  • Our financial success hinges on us delivering substantial returns to you. Our management fee only covers our basic expenses and we are committed to returning to our founders any economies of scale in the form of reduced fees as our assets scale.

* * *

Alignment changes overtime and needs to be monitored continuously. A prolific source of both long and short ideas for Somar are changes in alignment. We have sold long positions fully when alignment has materially decreased.

Substantial management purchases of stock in the open market are strong sources of new ideas for Somar. Not only do they carry the signal that management believes that their company is undervalued, but they also want to align themselves with shareholders in the value creation opportunity ahead. We follow these movements closely and investigate them immediately.

Conversely, when management sells substantial portions of their shareholdings, we ask ourselves whether we should sell too: either get out of a long position and/or build a short position. This year we had a top 3 position had a major shareholder sell down and we significantly decreased our exposure to it materially: it is now outside of our top 10 positions.

Often alignment shifts for reasons other than management buying and selling:

  • Strategy shift away from consumer value creation. E.g. slow innovation and start price increases
  • Competitor introduction of a superior product / service
  • Management turnover
  • Change in management incentives
  • Spin-offs
  • Regulatory changes
  • Growth in fund manager AUM
  • Change in fund manager compensation structure

This happened recently to a company we were long. Scout 24 had a star manager in online classifieds: Greg Ellis. Greg is a pioneer in the industry, having built REA into one of the most profitable and faster growing real estate online classified platforms in the world back in his home Australia.  During his tenure he created significant shareholder value with the stock price growing at 62% CAGR for more than 5 years (Fig. 3)

 

Source: Bloomberg

Fig. 3

 

Earlier this year, Scout 24 made a large acquisition in an adjacent market (consumer lending). A few months later, Greg Ellis asked the board to leave the company at the end of 2018 for “personal reasons”. The CFO also asked to leave by September 2019. This loss of alignment with company strategy and management incentives was a sign to us of potential problems with the core business. Given valuation remained close to our upside scenario, we fully sold our position.

* * *

It is an honor to be entrusted with your wealth. We don’t take it for granted any single day. My family and I fully align ourselves with you and work daily to make sure your money is entrusted to aligned management teams that tirelessly work to create and expand the value they offer to their customer.

 

[1] For further detail on our thinking here please read our letter from January 2018

 

Takeaway.com – August 2018

Takeaway.com

This month we will take a deeper look at our investment in Takeaway.com (“Takeaway”). Our thesis provides a good illustration of what Somar looks for in a long investment:

  • Order of magnitude growth opportunity driven by material improvements to the available customer value proposition
  • Highly attractive and defensible business model
  • Capable and strongly aligned management team

Takeaway is a leading food delivery marketplace in Central Europe, with core operations in the Netherlands, Germany, Austria, Belgium and Poland. In these markets, it offers consumers access to large number of local restaurants covering a wide range of cuisine types. Consumers search from each restaurant’s menu and place an order. This order is processed by Takeaway and, if a valid address and payment are behind it, is transmitted to the restaurant that cooks and delivers the meal. For some restaurants that don’t offer delivery, and are important for customers, the company handles the delivery itself for an additional fee[1].

Takeaway has a simple business model, taking a low double digit to mid-teen percentage commission of all the orders through its marketplace.

 

Growth opportunity

We see an opportunity for Takeaway to grow to more than 5x its current size due to its superior value proposition to both consumers and restaurants coupled with its still low penetration of its target markets.

In its markets, Takeaway provides a step-change improvement to the consumer and restaurant value proposition vs. the status quo:

  • Consumers have significantly higher number of restaurant choices and added convenience vs. the alternative of phoning the order in. Prior to the launch of online ordering, most delivery orders came from Pizza chains. Through updated online menus and ratings, Takeaway expanded this into a wide range of cuisine types and restaurants. The marketplace intermediation also saves consumers from repeatedly typing their address and payment credentials, a process both time consuming and prone to errors. Consumers are voting with their wallets and are increasing their order frequency (Fig. 1)
  • Delivery orders are highly accretive for restaurants from a financial point of view. With limited additional investment needed, restaurants benefit from additional revenues with contribution margins ranging from 30% to 60%. Despite the continual addition of new restaurants to the platform, each individual restaurant is seeing increased demand from Takeaway every year (Fig. 2)

Source: Takeaway.com

Fig. 1

 

Source: Takeaway.com

Fig. 2

 

Despite these advantages, and the strong 30%+ annual growth in orders of recent years, only about 12.5% of the food delivery market is intermediated by Takeaway or one of its online competitors providing a vast opportunity for growth for the years ahead.

  • On Takeaway’s core markets[2] we estimate about Eur 12 Bn of restaurant orders are delivered per year. Currently Takeaway delivers only Eur 1.5 Bn of these
  • The delivery market is growing above GDP as more consumers look for the convenience and time savings of not having to cook and do dishes at home
  • Somar’s interview with customers shows that the more cuisine and restaurant options are available and the more convenient (no repeat input of address and payment details) it is to order the more often they tend to order further expanding the overall market potential.
  • These numbers also exclude the corporate catering market, a significant additional opportunity that Takeaway is also pursuing by leveraging its recent acquisition of 10Bis.

 

 

Highly attractive and defensible business model

The food delivery marketplace is a winner-take-most industry making it a very attractive business for leaders

  • Like most marketplace businesses, food delivery benefits from strong network economies (Fig. 3)
  • Competitive behavior is also benevolent: once a clear leader is established in a market, non-leading players prefer to sell their operations and focus on other markets where they can achieve leading positions rather than continue to invest in that market (Table 1)

Fig. 3

 

 

Table 1

 

The business is also very defensible with extremely low churn rates, even for non-leading players. Once a customer has ordered from a food delivery marketplace for at least 3 times, they tend to stick with that marketplace. This means that orders from each cohort of customers tend to accumulate year after year (Fig. 4). Therefore, competition tends to focus on acquiring new customers that previously were using phone for delivery rather than stealing customers from other online competitors.

Orders per cohort

Source: Takeaway.com

Fig. 4

 

These cumulative orders come at extremely high 50%+ (pre-marketing[3]) operating margins yielding a 100%+ return on invested capital for the business. This is a very low capital-intensive business.

  • Negative working capital: the marketplace collects from customers daily while paying to restaurants 1 to 2 times per month
  • Low capex: the business fixed costs are mostly limited to building and maintaining the marketplace website and app

 

 

Capable and aligned management team

Takeaway is owned[4] and managed by two entrepreneurs and industry pioneers:

  • Jitse Groen founded Takeaway in 2000 and has been its CEO ever since. He is one of the industry pioneers and still owns more than 34% of the company. In its home market of the Netherlands, Jitse built Takeaway into one of the most dominant players in the world with a virtual monopoly and EBITDA margins well over 50% in its home market.
  • Joerg Gerbig founded Lieferando.de in 2009 and built it into a leading player in both Germany and Poland. Upon the sale of the business to Takeaway, Joerg chose to stay as COO and to roll part of the sales proceeds into stock of Takeaway
  • Both Jitse and Joerg are best-in-class operators having developed the “one company” approach for increased efficiency in operations and customer acquisition
    • Dingle global technology platform to be used in all operations around the world
    • Unified brand in each market to maximize efficiency of brand campaigns
    • Centralized back-office functions
    • Simultaneous roll-out of innovation initiatives

 

Attractive Risk-Reward

Upon underwriting this position, Somar assessed the investment to have minimal downside under an adverse scenario while offering at least a 5x potential under our base scenario.

  • Our base scenario represents our best assessment of what the company can deliver. In our judgement there is a 50% probability the company will beat our base scenario and an equal 50% probability it will fall short of it. In general terms we assumed Takeaway keeps its dominance in the Netherlands and achieves half of the penetration and success in both Germany and Poland.
  • Our adverse scenario assumes that Takeaway continues its lead (but not dominance) in the Netherlands and fails to achieve leadership and significant probability in Germany and Poland.
  • The most common path for food marketplaces that don’t achieve leadership is their sale to the local leader (please see Table 1 above). The extremely low customer churn makes these businesses an attractive stream of cash-flows with strong accretive value for the leader[5]. In our adverse scenario we didn’t assume any potential sale of subscale operations in Germany and Poland.

 

There are a lot of risks that we track continuously to make sure our thesis is on track: increase in competitive intensity, change in consumer preferences, change in restaurant preferences, increasing customer acquisition costs, reduced marketplace relevance for consumers (number of orders per consumer) and restaurants (number of orders per restaurant). We use our primary research to confirm our thesis and, so far, have seen increased support for our thesis from the incoming data.

 

 

 

 

[1] Through their subsidiary Scoober. Takeaway believes this part of the business will be breakeven and responsible for up to 5% of total orders.

[2] Netherlands, Germany, Poland, Austria and Belgium

[3] Marketing expense is discretionary and almost entirely to acquire new cohort of customers

[4] Collectively Jitse Groen and Joerg Gerbig own more than 36% of Takeaway.com

[5] A strong data point in support of this is Hungryhouse whose sale to Just Eat took about 1 year to be approved by the UK’s competition authority, and during this time, despite low marketing investment, they barely lost any customers during the period.

 

Keys to Successfully implementing a short idea – July 2018

Keys to Successfully implementing a short idea

On its surface, successful shorting may seem like a simple mirror image from buying a stock: you find a company whose moat and financials are being impaired[1], short it at an unsustainably high valuation, wait and then cover your position at lower price to lock-in your profit.

However, while necessary, the conditions above are not sufficient for success in shorting. Timing and position sizing are also crucial for short profitability. This, together with the fact that over time economies grow and businesses accumulate profits, makes successful shorting much harder than buying stocks.

                                                                      Fig. 1

 

In this letter we will dive deeper into Somar’s shorting method: which we call “The Short Triangle”. (Fig.1) At Somar we believe you need to get these three aspects right at the same time to have a successful short.[2]  Let’s take each of these conditions one by one.

Stock

For a successful short idea, we need to find a company whose futures prospects are being impaired. At Somar we focus mostly on companies being disrupted (see June 2018 letter). When holders of the stock are not pricing in those threats to future profitability and cash generation in the stock we have a potentially good short idea. The question now is how much do we short?

Size

Sizing of a short position is particularly difficult. On the one hand, the larger the initial position, the higher the profits we get when the idea comes to fruition. On the other hand, if the short position moves against you, the size of the short in your portfolio increases automatically, potentially precluding you from increasing your short position at even more attractive prices. In more extreme conditions, you may even be forced to cover your shorts at a loss because you are now violating your own risk controls.

Let’s illustrate this with an example. We want to short stock A. Our risk management rules dictate that no individual short should be larger than 3.00% of AUM. Let’s also assume we initially size stock A into a 3.00% short. Table 1 describes two potential scenarios.[3]

Table 1

Now let’s also assume we initially size stock A into a 2.00% short. Table 2 describes the same two potential scenarios.

 

Table 2

 

By comparing Tables 1 and 2 we can highlight the inherent tension between profit and risk management inherent in sizing up a short trade:

  • A larger initial size for the short provides a higher potential profit (+0.60% vs. +0.40%)
  • But that comes with additional potential costs: not only the potential loss is higher (-0.60% vs. – 0.40%) and more importantly the option to short at higher prices is lost and we may even be forced to cover at an unattractive price, realizing the losses in the portfolio

It is important to note that the risk management limits are important to prevent escalating losses on shorts whose investment thesis proves out to be wrong. For example, on Scenario 2 in Table 1, if the PM would keep the short at 3.60% (thereby ignoring the risk management rule of reducing it to 3.00%) and the stock went up a further 20%, the losses would now be an additional -0.72% (20.00% x 3.60%) rather than –0.60%.

When you buy a stock, this sizing dilemma doesn’t occur. Let’s say you buy stock S up to 3.00%[4] of the fund’s AUM. If the stock initially declines 20%, you now lost -0.60% of AUM and are sitting on an investment that is now only 2.40% of AUM. We now have the option of buying more stock at a more attractive price. If the stock is kept at the same level and then declines another 20% we will lose -0.48% (20% x 2.40%). So, the loss on the second adverse event (0.48%) is smaller than on the first (0.60%).

The risk on the long (buy stock) positions declines when they move against us, opening up the option to reinforce the position at more attractive prices. In short positions, the risk increases when the stock moves against us, reducing the opportunity to reinforce the position and potentially forcing the closing of the position at a loss. Sizing is a critical skill on the short positions.

Timing

The previous section made it clear that a short investment doesn’t tolerate dramatic adverse movements in the stock price until the thesis fruition. Therefore, timing the entry and exit points are very important to minimize the potential for forced transactions at unattractive prices for risk management.

There is a strong propensity to be “too early” in a short trade. Long investors tend to be sanguine to early indications of trouble and discount it as normal bumps in the road while bidding the share price higher. For a successful short, exercise of good judgement on the potential impact to the company fundamentals of incoming news. Then we need to decide where the tipping point lies, which will start to sow the worry among the company investors that its future profitability may not be as high as they had anticipated.

Being too early in shorts is costly and may lead to losing money on a short, even though the original thesis is proven correct in the fullness of time.

To illustrate this let’s analyze Trivago. The company went public in December of 2016. It is a travel price comparison engine mostly focused on hotels. It is a challenger, following TripAdvisor which through its rich content and unmatched review content is the market leader. To compensate for this, Trivago embarked on a massive TV advertising campaign to acquire traffic. It would then sell this traffic onto online travel agencies and hotels. Their financials showed that overall the company’s customers were paying as much for the traffic provided by Trivago as it cost Trivago to acquire. To put it simply: Trivago’s revenue matched its spend on TV Advertising. Given its lack of additional differentiated features (reviews, social engagement, unique content) we didn’t see this as a sustainable business model. In fact, the market was saying that it didn’t see any value added by Trivago but just merely a low (or zero) margin reseller of traffic.

Fig. 2

Soon after its IPO Somar took a short position on Trivago. As can be seen from Fig. 2 we proceeded to experience steep losses on the trade as the stock doubled in the first 6 months of the trade. Investors were attracted to the company’s high growth rates and were convinced the company could continue to grow fast by adding a growing number of new users at lower average prices to eventual turn profitable. The first two quarters of 2017 showed progress on growth but not on margin. In the third quarter of 2017 the first cracks started to appear when growth faltered, and margins failed to improve.

While we recovered some of our losses in the second half of 2017 we ended up losing money on the trade overall by being too early. We were forced to reduce risk prior to our thesis being proven right.

* * *

Somar’s culture stresses the value of being honest, humble and hungry. No part of our business keeps us humbler than the short book. This is a massive opportunity ahead for us. It adds tremendous value to our investors and to our return profile. It requires flawless execution, emotional balance and strong judgement. We are heads down focused on capturing it and improving every week. We are excited by the roadmap ahead and look forward to reporting that back to you.

 

[1] We wrote about this in last month’s letter

[2] By contrast, the same is not necessarily true in long investments. If you buy a large position and it initially declines, its new lower size, provides you additional space to add on weakness. Also, if your initial investment is small, and the stock goes up, the new size in your portfolio is larger at the higher valuation.

[3] In all the described scenarios in this section we are assuming constant overall fund AUM throughout the period.

[4] To be clear we are able, and have, bought single long positions that are larger than 3.00% of AUM in our fund

 

Incumbents, Disruption, and Short Opportunities – June 2018

Incumbents, Disruption and Short Opportunities

“We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten. Don’t let yourself be lulled into inaction”
Bill Gates

“You can resist an invading army; you cannot resist an idea whose time has come”
Victor Hugo

“Your margin is my opportunity”
Jeff Bezos

This past month, General Electric (GE) was dropped from the Dow Jones Industrial Average after more than 110 years in the Index. GE was the last founding member of the index in its current format. This watershed moment calls our attention to the fragility of business success, constantly under attack by competitors, technological innovation and regulation.

Somar is relentlessly searching for short opportunities created by the abundant innovation we see in the world right now. We look for incumbents with high market shares and inferior consumer offers. The current strong and accelerating pace of innovation creates a fertile environment to find such opportunities. We are excited and believe that the Somar investment method positions us well to take advantage of them.
We have seen a larger number of former leaders go through hard financial times in the past few years. The accelerating disruption of large incumbents can be seen for example by analyzing the number of companies dropped from the Dow Jones Industrial Average index (composed of 30 companies). As Fig. 1 illustrates there has been a growing trend over the past few decades.

Fig. 1

Technological innovation and entrepreneurial prowess are allowing new innovative challengers to offer a
vastly superior value proposition to consumers: in the form of significantly lower prices, wider assortment
or better service. This leaves incumbent companies with the difficult task of sustaining their high market
share with an inferior consumer offering. If they can match the challenger’s offering this normally entails
lower margins. Frequently, challengers possess advantages that incumbents can’t even match (e.g. network
economies, superior customer information / customization, embedded in business processes).

To appreciate the impact that innovation has on the value of companies and their contribution to the overall
economy at any point in time it is instructive to look at the Dow Industrials components for different periods
of time. In 1884, Dow’s predecessor index was mostly composed of Railway companies1. By 1905 it was
composed mostly of Basic Materials and Utility companies2 After the Great Depression, in 1939 the
components were more diversified (see Fig. 2).

However, a lot of these companies no longer exist, others have gone through bankruptcy proceedings (e.g.
Bethlehem Steel, Chrysler, GM, National Steel) and others are under significant pressure to survive today
like Sears Holdings Corp. for example. This analysis is a clear reminder that size and leadership alone are
not guarantees of future financial success in the face of innovative competitors.

 

Fig. 2

Successful disrupters succeed by changing the source of competitive advantage. For example, for many
years, leaders in mass fashion leveraged large scale, good designers and strong marketing capabilities
through both media campaigns and capilar store fronts to offer affordable fashion to the masses.
With the advent of fast communication networks and large data processing capacity, large scale was no
longer critical to lower production costs: fast fashion players lowered costs by significantly reducing costly
mark-downs through virtually eliminating fashion risk. This new model shifted the basis of competition
from scale to responsiveness of supply chain. Challengers like Boohoo and Missguided succeeded by
offering consumers a significant upgrade to the value offered:
– More adequate and appealing designs in touch with current trends
– Lower prices (funded by lower markdown and marketing costs)
– Wider assortment
– Convenient home delivery
– Stronger community engagement through social media interaction with like-minded customers
This was possible by designing a different supply chain and distribution strategy
– Reducing lead times from 3 months to 2 weeks
– Making small initial runs, testing them online (for only a few hours) and producing larger batches
of the products the consumers liked
– Using customer and celebrity endorsement on social media to generate buzz and demand
– Home delivery from central warehouse with larger inventory and deeper size offer

DJIA Components on March 4, 1939
Allied Chemical and Dye Corporation General Electric Company The Procter & Gamble Company
American Can Company General Foods Corporation Sears Roebuck & Company
American Smelting & Refining Company General Motors Corporation Standard Oil Co. of California
American Telephone and Telegraph Goodyear Tire and Rubber Company Standard Oil Co. of New Jersey
American Tobacco Company (B shares) International Harvester Company The Texas Company
Bethlehem Steel Corporation International Nickel Company, Ltd. Union Carbide Corporation
Chrysler Corporation Johns-Manville Corporation United Aircraft Corporation
Corn Products Refining Company Loew’s Theatres Incorporated United States Steel Corporation
E.I. du Pont de Nemours & Company National Distillers Products Corporation Westinghouse Electric Corporation
Eastman Kodak Company National Steel Corporation F. W. Woolworth Company

For years, incumbents like The Gap Inc or H&M relied on their large scale and numerous store network as
a competitive weapon to keep expanding and taking market share against smaller mom and pop chains.
Today, however, these stores and large scale are a hindrance to their ability to move online faster and
efficiently and to move to a fast-fashion production schedule. This change of the source of competitive
advantage in the fashion industry has opened several short opportunities for Somar.
Somar believes that the process of disruption today is evolving faster for two reasons:
– Customers have instant and convenient access to information through the internet and their
smartphones. Therefore, they are quicker to find superior offers when available
– Easier access to capital through both venture capital and public markets, allows disrupters to scale
faster and mount a more robust challenge to incumbents3
With many disruption processes in place and faster scalability of challengers, Somar believes there are
plenty of attractive short opportunities in the markets today. Your team at Somar is heads down focused in
finding them and making them work for you. We will continue to report to you on our progress.

 

Source: Wikipedia; Somar Analysis

1 Chicago & North Western Railway Company; Delaware, Lackawanna & Western Railroad Company; Lake Shore Railway Company; Louisville & Nashville Railroad Company; Missouri Pacific Railroad Company; New York Central Railroad Company; Northern Pacific Railroad Company; Pacific Mail Steamship Company; Chicago, Milwaukee & St. Paul Rail Road Company; Union Pacific Railroad Company; The Western Union Telegraph Company.
2 Amalgamated Copper Mining Company; American Car and Foundry Company; American Smelting & Refining Company; The American Sugar Refining Company; Colorado Fuel and Iron Company; National Lead Company; The Peoples Gas Light and Coke Company; Tenessee Coal, Iron and Railroad Company; United States Rubber Company; United States Steel Corporation.

 

Somar Turns 2 Years Old – May 2018

Somar turns 2 years old!

The first two years have been an exciting journey for Somar. As we start our 3rd year we are very excited to continue to improve the quality of our portfolio, taking advantage of the large opportunities in front of us.

This month, we thought it would be good to hear from the team directly through a video. You can find it at: https://youtu.be/SyWZsbcJ6iU

Our Process to Evaluate Investment Opportunities – April 2018

Our Process to Evaluate Investment Opportunities

“You should never take more than you give
In the circle of life”

Elton John – Circle of Life, Lion King Soundtrack

 

The focus on creating more value than that which you capture is core to Somar. We believe we can deliver our investors a level of excess return vs. the risk they are taking that far exceeds the amount they pay us in fees. As an organization, we are focused on elevating and growing our employees to accelerate and upgrade their careers. As an investor, we partner with businesses that are creating more value for their customers than their competitors.

In this letter, I want to show you why I believe this is a very powerful approach to building a sustainable long-term investment portfolio. In addition, it is also a great framework for identifying great short opportunities. As an investor, Somar believes that we will thrive and achieve great returns, when the customers of the businesses we own thrive. And when the customers of the businesses we short are not receiving the best value for their money. We believe in full alignment with the fate and satisfaction of the end customers.

What does Somar mean by consumer value? We mean the difference between the maximum price the consumer would be willing to pay for a product or service and the price he pays for it. Let’s use an example: as a family man, I always look forward to spending Christmas with my family back in Portugal. It is something I dream about throughout the year and one of the highlights of my vacation. Therefore, I would be willing to pay quite a large amount for a plane ticket that would deliver me home. Let’s say I was willing to pay $10,000 for the trip (please don’t tell the airlines). If you book in advance, you can get a coach seat for no more than $1,000. Therefore, the difference between what I’m willing to pay ($10,000) and what I actually pay ($1,000), is my consumer value. In this case, $9,000.

Now, as an investor I don’t need to precisely quantify the consumer value. I just need to know whether a new product or service is going to increase it significantly or not. Continuing with our example: if an airline starts a low-cost service to Porto and charges $500 per ticket, as an investor I know that the consumer value for most, if not all of the consumers is superior. Incidentally, this is what companies like Ryanair and Wizz Air are doing in Europe. Therefore, as an investor I would be curious to learn more about this company.

Price is probably the easiest to understand improvement to consumer value but far from the only one. Others include choice, service and quality of product. In the airline industry:
– an airline could significantly increase choice by adding the number of destinations to which it flies directly (anyone likes to make connections?);
– an airline could improve service by offering more leg space, priority boarding, and better onboard food and entertainment options;
– an airline could improve the quality of the product by flying faster and getting you to your destination sooner. I know some of the readers of this letter have flown the Concord in the past.

Once a company offering a step function improvement in the consumer value is identified, Somar needs to answer two additional questions:
– Can the company provide the product while earning an attractive return?
– Can these returns be sustained over the long run? That is, can competitors copy the company’s offer?

If the company can sustainably offer the superior product, we need to understand how much of the market they could ultimately serve. To answer this, Somar tests the product, interviews existing and prospective customers and makes an estimation of how many additional customers would benefit from adopting the superior product. Based on our own scenarios for market share capture we will estimate the value of the company. We are attracted to situations where what we pay is significantly less than our estimation of the value. The risk-reward is attractive when the amount we can win if we are right is much larger than the amount we could lose if we are wrong.

This process is very effective in identifying attractive short opportunities as well. The thought process here is inverted. We are looking for companies whose consumer value proposition is inferior to that offered by another competitor. In addition, the company is either unable to offer the superior product offered by its competitor or can only offer it assuming a strong negative impact to its margins and returns. We will take a position when the valuation of the company doesn’t account for the negative scenario of ongoing market share erosion. The risk-reward is attractive when what we can lose if we are wrong is a fraction of what we can win if the market share loss materializes.

It is important to note that these market share dynamics are independent of the macroeconomic environment. What matters is whether a company has a sustainable superior consumer offer to its competitors. This doesn’t change whether the macro is favorable or we are entering a recession.

Now macro fluctuations, or even macro news will lead to sharp swings in share prices and create opportunities for long term investors. While any recession would certainly not be beneficial for our long investments, it would also likely hurt our shorts too which would offset some of the potential losses from our long book. Therefore, volatility normally tends to bring very attractive opportunities for Somar. We have been taking advantage of this since inception, more so in the last few months and will continue to do so in the future.

* * *

There are several ways to be a successful investor. Other investors have had success with more leveraged strategies, financial engineering, macro analysis or even technical analysis. At Somar, we see ourselves as businessmen. We believe the best way to build wealth is to take care of your customers, add a lot of them every year by offering a superior product and let the operations drive our financial value. My background including several years working with leading companies as a consultant both at McKinsey and BCG has proven very helpful in our endeavor.