What to expect in 2018 – December 2017

What to expect in 2018

It’s tough to make predictions, especially about the future” Yogi Berra

I follow the Noah rule: predicting rain doesn’t count; building arks does” Warren Buffett

At Somar we are excited for 2018. Not because we can accurately predict how the year will unfold. But because throughout 2017 we have focused on what we can control.  In 2017, we set out to build an extremely high-quality portfolio for 2018 and beyond. We like our chances under a wide range of scenarios. In 2018, we will continue to relentlessly search for opportunities to upgrade our portfolio. We see a lot of innovation delivering step improvements in customer value propositions.

At this point you are probably inundated with macro-economic predictions. We don’t believe that incremental macro-economic changes will have a material impact in the long-term investment returns for Somar. Macroeconomic growth tends to be a rounding error for the fast-growing companies we tend to invest in. We have seen investors lose very attractive investment opportunities by trying to play the macroeconomic cycle. Throughout our career there has hardly been a year where some pundits didn’t predict an impending recession and cautioned investors to wait. As Paul Samuelson, an economics Nobel laureate said: “Economists have correctly predicted nine of the last five recessions”. Judging for the air time business media give to economic data such as jobs reports or interest rate changes, you would think all great investments spring from tremendous foresight into these variables. But do you remember what the Fed Funds rate and unemployment rate were once you discovered the tremendous business opportunity created by smartphones, online search, e-commerce, ride / home sharing or social media? Did it matter whether the Fed was preparing to raise or decrease rates? Did the economy go into recession after you invested? Do you care?

Rather than fret about the weather or the market, at Somar we spend our energies on the things we can control. We believe we are in the golden age of investing (please see our June 2017 letter) driven by an unprecedented pace of innovation and worldwide consumer adoption. Entrepreneurs are leveraging technical innovations such as the internet, smartphones, cloud computing among others to offer consumers a step change improvement vs. incumbents in the value proposition. The big risk for us is missing investment opportunities. That is why every day we search relentlessly for new investment opportunities under our circle of competence to make sure our portfolio always reflects the best risk-reward we can find. Our 2017 hunt was the most successful in our career. By the end of the year, our portfolio presented a superior risk-reward than it did at the beginning of the year. For 2018 we will continue the same relentless pace. That is what you can expect from us and it is entirely under our control.

Every investment decision stands on assumptions about the business future performance. We strongly prefer to anchor our expectations in assumptions that have proved their validity across time, macroeconomic scenarios and geography. You can build your strategy and portfolio around them. They work for you in most conceivable scenarios. Here are a few illustrations of this:

  • Consumers prefer more choice than less choice
  • For consumers of non-luxury goods, customers prefer lower prices
  • For the same price, consumers prefer more service than less service
  • A good investment occurs when the cash deployed is significantly less than the stream of cash flows generated in the future discounted to the moment of investment

These may seem simplistic or even childish, but they are very powerful. Take the preference for lower prices. It may be consensual that these businesses benefit in recessions as people trade down to save money and extend their budgets. But these businesses also capture share in macro expansions. Sure, some customers will trade up. But a lot of customers who couldn’t afford the product and therefore were “non-consumers” can now start to buy the product. Price competitiveness therefore allows companies to gain market share under different macro-economic scenarios.

So, the time has come for us to make some “predictions” for 2018:

  • strong innovation around the world, including diffusion and adoption of best practices in different geographies
  • continuing execution and roll-out of the innovative companies already in our portfolio
  • relentless search for new investment opportunities by Somar
  • continual upgrading of Somar’s portfolio expected risk-reward

As you can see we are focused on building our Ark. One that takes advantage of the favorable winds we see but also that protects against several different scenarios.

We wish you success in your other businesses and hope you are finding as many opportunities as we are. Feel free to reach out if you want to discuss any opportunities that pique your interest. We are honored that you have enlisted our help in searching for the best opportunities to deploy your financial capital. It is the golden age of investing and we are excited to navigate it with you.

Happy investment hunting in 2018. And above all: Happy New Year!

 

 

 

 

Year in Review – November 2017

Year in Review

The end of a year marks a period of reflection for what has been accomplished, and preparation for what is to come. As we look back at 2017, we feel very good about the progress we have made. We have upgraded our portfolio, developed our team, launched new Data Science projects, reduced fund costs, and built strong constructive relationships with the management teams of our portfolio companies.

Some of the highlights of the year include:

▪ Portfolio: 2017 was the most fertile year for idea generation in our career. We generated many high quality new investment ideas that upgraded our portfolio. Therefore, the expected portfolio risk-reward is currently at the highest it has been throughout the year despite the positive performance delivered so far. This makes us very optimistic for the future.
▪ Team: We have a very senior team at Somar. The team has great rapport and morale is high. Each of us embodies the Somar culture – honest, humble, hungry – and looks for opportunities every day to improve the returns and service to our investors.
▪ Primary Data Research: We are conducting data research projects on 17 companies. Projects include investigative reporting, online engagement analysis, store development tracking, price comparison and SKU range checks. I would like to thank Jason Gans for leading this effort together with two Master’s students from New York University – Jessica Lin and Cheng Bi – who have expanded our Data Science capabilities.
▪ Asset base: Our investor base has been extremely supportive, with many of you sizing up your original investment. We have steadily increased our AUM throughout the year and have recently crossed $40mn in assets under management. In addition, our institutional class (please see the next section) is attracting a lot of interest both from existing and new investors. We see continued progress in the months ahead. I would like to thank Colin Butler for his support in communicating our vision and progress with all of you.
▪ Management Engagement: Throughout the year we have built and deepened constructive relationships with the management teams of a meaningful number of companies in our portfolio. This dialogue has a double benefit for us. First, it allows us to provide value creation suggestions that benefit all of us as owners and second, it allows us to assess each management teams’ ability to execute and adapt against evolving challenges and opportunities.
▪ Risk Management: Our risk has been managed within our tolerance limitations throughout the entire year. Our individual and aggregate exposures have stayed within our limits. There were no breaches of our internal triggers for either an individual position or the portfolio. While we are encouraged with this performance we remain duly vigilant for new sources of risk in the portfolio.
▪ Cost base: We have maintained a rigorous discipline in non-value-added costs which has allowed us to reduce the Fund’s monthly expense ratio by approximately half of what is was at the start of the year. In addition, the management company has operated above breakeven throughout the year. As we say in the office, we are building Somar to be around for decades, not years.
▪ Operations: Joe Yankovich runs a first-class operation. Cash and positions are reconciled daily. We have finalized the NAV 6 days after month end on average. Joe took the lead in executing the launch of our new Institutional Class. Finally, he answers your questions and clarifications in an accurate and timely way, as you may have seen from firsthand experience.
▪ Board: I would like to thank Jennifer Collins and John D’Agostino for their frequent and insightful feedback. Both have made a significant contribution to the firm and helped the Somar team build a best-in-class operation.
Our roadmap for 2018 is very strong. We believe we will continue to improve at a brisk pace throughout the new year on all these areas. We look forward to continuing updating you on our progress and milestones in the new year.
Institutional Class
In response to suggestions from some of our Investors we have decided to launch a new class. We believe this is a unique opportunity that will benefit all our investors.
The Institutional Class is available in two formats1:
A. For Investors that subscribe a minimum of $10.0 mn, we offer a 1.0% management fee and 10.0% incentive allocation.
B. For Investors that subscribe a minimum of $5.0 mn, we offer a 1.5% management fee and 15.0% incentive allocation.
The Institutional Class is open until the earlier of June 2018 or when we reach $100 mn of AUM.

Our existing investors will benefit from the Institutional Class in two ways:
▪ Increased assets will allow us to reduce our expense ratio and therefore reduce the difference between our gross and net returns.
▪ Increased assets will allow us to reach $100 mn of AUM faster, triggering a reduction in the management fee for the Founders’ Class from 2.00% to 1.75%
We are offering our existing investors the opportunity to roll their existing Somar investment into each of the above classes if they reach either of the minimum subscription amounts.
The response to this new class has been extremely positive and we have a good number of ongoing conversations. Please feel free to reach me or Colin (colin.butler@somarcap.com) if you wish to learn more.

 

1 THE FOREGOING SUMMARY IS NOT A COMPLETE LIST OF THE RISKS AND OTHER IMPORTANT DISCLOSURES INVOLVED IN INVESTING IN THE FUNDS AND IS SUBJECT TO THE MORE COMPLETE DISCLOSURES CONTAINED IN EACH FUND’S OFFERING MEMORANDUM, WHICH MUST BE REVIEWED CAREFULLY.

 

Creative Destruction – October 2017

Creative Destruction

Capitalism […] never can be stationary. […] The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers’ goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates. […] The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U.S. Steel illustrate the process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism – Joseph Schumpeter

In September’s letter we looked into some examples of the strong opportunities on the long side created by the current pace of innovation. In this letter we complete that analysis. If some companies are growing at 20% or more per year and the economy is growing at only 2% or 3% per year, some companies must be growing below that or even declining. Therefore, the innovation that spawns creators of value also opens up opportunities to short the companies with inferior customer value propositions.

Innovation can turn established industries upside down. It enables a better and more efficient way to serve customers. Take the newspaper industry. No entrepreneur today would successfully present venture capitalists the following idea: I will hire a lot of journalists. Collect news for 24 hours, chop down some trees, print the news gathered over the last 24 hours in the paper and then distribute to my customers for them to read. The internet allows for instant access to information, and by the time the printed paper arrives to the customer, the stories will be outdated. Therefore, a business model that was extremely profitable for decades became obsolete with the internet and proliferation of smartphones.

At Somar, our work to identify enduring and profound secular change, assists us in identifying short opportunities too. Here is a sample of companies we are or have been short:

  • Fashion retail is undergoing two major secular changes: fast fashion and shift from offline to online. Incumbent fashion retailers that design collections more than 3 months in advance of putting them on their brick-and-mortar stores have a fashion stale offer to consumers much inferior to their fast fashion competitors. The growth of online channel also erodes the historical advantage of a large physical store chain. We have found good short opportunities both in the US and Europe of incumbents who have had trouble transitioning their models into the fast-fashion and online era.
  • The advent of internet TV has offered consumers a wide array of options to watch their favorite shows both live or streaming at their own convenience, with or without commercials. Consumers historically have had only 2 options: subscribe to cable and pay for the full channel bundle or watch only the national broadcast networks. Taking advantage of this, some networks launched many marginal cable channels with sub-par content that customers barely watched and got paid fees per cable subscriber from cable providers for each of them. Internet TV is changing this. Consumers are no longer willing to pay for channels that they don’t watch and are instead signing up for individual channels or for more customized “skinny” bundles with a lower number of core channels. This is eroding customer count and revenues for some TV networks and opening short opportunities for Somar.
  • Fast moving consumer products have applied for decades a tried and true formula for success: develop strong brands with national appeal and recognition, invest strongly in marketing and dominate the shelf space of retailers. This model worked so well and for so long, that most of these companies are perceived to be low-risk and trade at a premium to the market. The market is sanguine about two secular changes that are slowly disrupting this model: retailer consolidation and ecommerce. There is no shelf space limitation on the internet. This allows niche players to be displayed side by side with national brands, thereby erasing a barrier to entry that protected the incumbents in the past. E-commerce is also dominated be less than 5 companies. Mom and pop and local retailers are going out of business given the loss of sales to the internet and the lack of scale to develop an online offer of their own. This is leading to a gradual shift in the power balance from national brands to retailers that is leading to margin erosion and market share losses for incumbents.
  • Grocery retailers are under threat from two secular changes: growth of hard discounters and move of retail online. Both are leading to margin erosion and market share losses for incumbents, opening up short opportunities for Somar. Hard discounters offer significantly lower prices to consumers by lowering the number of products and increasing the percentage of private label offered. This lowers costs in 3 ways: simpler operations; higher bargaining power in a smaller number of products; capture the margin from national brands. E-commerce offers a more convenient and economical way to shop for groceries therefore reducing the foot traffic to brick and mortar stores.
  • The emergence of online commerce is reducing the foot traffic to shopping malls. This erodes the profitability of shopping mall REITs. There is a negative cycle in the shopping mall industry: brick and mortar stores are losing customers to the online channel, this is reducing the profitability of the physical stores and forcing some to be closed [including anchor stores]. This leads to further declines in the foot traffic to the shopping malls and further loss of profitability to brick and mortar stores leading to further closures. Like the newspaper industry example above, the current shopping mall industry structure is a product of historical evolution. Shopping malls wouldn’t be built the same way and in such a large quantity if they were being built today.

As always, we are delighted to expand on our thinking with you in person and phone conversations at your convenience. It is a wonderful time to be an investor and to be able to find opportunities on both the long and the short sides.

 

Upgrading Our Portfolio – September 2017

Upgrading Our Portfolio

Somar’s mission is to support the financial success of our investors by investing their capital in businesses
with both a leading customer-value proposition and a large market opportunity ahead.
We find attractive opportunities in underfollowed companies that have outgrown Venture Capital’s sweet
spot but that are not yet big enough to be ETF-owned.

  • Unlike Venture Capital, most of our companies are profitable and have demonstrated early traction
    with their target market through strong market share gains.
  • Unlike ETF-owned, maturing companies, our companies are in the early stages of capturing their
    overall market opportunity. We believe most of them to be far less than 50% penetrated into their
    overall opportunity.
    This is a thriving and growing universe. This year we have found more opportunities to invest than at any
    time in our career. We believe this is likely to continue due to:
  • The wide range of secular change processes ongoing today: eCommerce, electronic payments,
    electric cars, artificial intelligence, digital media, blockchain, electronic consumer marketplaces,
    cloud computing, fast fashion, sharing economy, internet TV, renewable energy, mobile, augmented
    reality / virtual reality, autonomous driving, genome sequencing and editing, social media, robotics
    and drones, crowdsourcing and crowdfunding, among others.
  • The acceleration in the adoption of the above mentioned secular changes.
  • The reduced amount of capital available to invest in our target universe compared to the growth in
    funds dedicated to investing in ETFs and Venture Capital.

Here is a sample of the opportunities we are excited about:

  • Healthequity is a leading provider of Health Savings Accounts1. They are only ~1% penetrated into
    what we assess to be their ultimate opportunity.
  • Zooplus, which we wrote to you about in our letter from May 2017, is only 4% penetrated into their
    ultimate opportunity. They offer lower prices, wider assortment and fast delivery. We believe
    Zooplus to be worth far more than its current value.
  • We are invested in the first global outsourcer for game studios. They are world leaders touching 500
    games per year compared to about 12 for a leading game studio. Their current market share is only
    2% of their estimated $5 Bn opportunity, but it is growing fast. They offer lower costs and faster
    time-to-market to their game studio clients. They offer their employees job security and exposure to
    more games. We expect to make multiples of our original investment.
  • As we reported to you in last months’ letter we have a very profitable investment in food delivery
    aggregators. They offer customers wider choice, fast and reliable delivery at no extra charge. We
    expect to make multiples of our original investment.
  • An on-line disruptive travel leader in Europe has about 25% market share of its home market. It is
    taking market share at a strong clip. They offer travelers cheaper travel options with more flexibility
    around dates and places of stay. We believe the business is worth at least double what we paid.
    This is only a subset of the wide array of opportunities we are seeing. Please call us if you want to discuss
    any of these or other opportunities in more depth.
    It is important to note that these businesses bring superior value to their customers. This could be either in
    the form of lower prices, wider assortment, better quality or better service. Innovations like these tend to
    expand the existing market. Conservatively speaking, we are probably underestimating the ultimate size of
    the opportunity.

Every day we scour the world on your behalf, for opportunities better than the ones described above. If we
find them, we upgrade our portfolio and substitute a great idea by an even better one. Fortunately for all of
us we found a lot of them in the first three quarters of this year. Currently we don’t see this pace decelerating.
We will keep updating you on our progress.

 

1 For more details, please read our letter of November 2016

Fact-based vs. Opinion-based Investing – August 2017

Fact-based vs. opinion-based investing

“When my information changes, I alter my conclusions. What do you do, sir?” – John Maynard Keynes

One of the hardest and most profitable skills to develop as an investor is the ability to be open to new information and to change one’s mind when new information alters one’s previous conclusions. At Somar we have improved our returns by leveraging new information to change long positions into shorts and short positions into longs. To develop this skill, we had to overcome 3 barriers:

  • Confirmation bias
  • Commitment and consistency bias
  • Ego

Confirmation bias is the tendency to look only for information that confirms one’s conclusion and to ignore other information as “noise”. Confirmation bias closes our mind to alternative explanations for the available facts. This effect gets stronger for emotionally charged issues and for deeply entrenched beliefs1.

  • To avoid this, at Somar we proactively use our primary research and data science projects to look for any information that might disprove our investment thesis. Somar also proactively looks to understand in depth the investment thesis of investors with opinions contrary to our own.
    Commitment and consistency bias is our desire to be (and appear) consistent with our previous choices and actions. After taking a public action or stand, we face very strong personal and social pressure to stay the course even in the face of new and adverse facts and information2. This bias makes it extremely hard for investors who have publicly written about a position or presented an investment thesis to change their minds in the face of new information.

At Somar we avoid writing and presenting about existing positions. We wait until we harvest our investments to go public about them.

Ego exacerbates the two previous biases. The larger the ego, the more entrenched the investor will be in his
opinions and public standing and therefore the more resistant he will be to change his mind. Paraphrasing
Max Planck: “Science advances one funeral at a time”3.

  • At Somar we take a mission approach to investing. Our mission is to scour the world for the most
    compelling risk-reward opportunities to put your capital to work. We don’t let anything get in the
    way of us achieving that mission, including each team member’s ego. Humility is a core value at
    Somar4.
    Over the past months, we have found thesis-disproving information for a few of our positions and acted
    accordingly. On some of them, the implication of the new information was large enough to make us switch
    sides between long and short.
    To illustrate, we had a short position on a food restaurant delivery aggregator5. Our thesis included the
    following points:
  • Increasing competition – our talent flow analysis identified Amazon and Uber building teams to enter
    the market. Other VC funded new ventures were entering the space.
  • High margins that appeared to be unsustainable given the growing competition.
  • Valuation that didn’t reflect either margin erosion or loss of market share.
    We put the short position on and new competition did materialize as expected. However, our primary
    research on its effects, including competitor and customer interviews, uncovered the following facts:
  • New competitors were unsuccessful in stealing existing customers from the incumbent. Once a
    customer is using an app to order food from his favorite restaurants, he has no incentive to switch
    provided there are no service glitches.
  • Competition also had no impact on the rates that restaurants paid to the incumbent aggregator.
  • The incumbent, being the larger player, benefits from strong network economies: the more
    customers it gets, the more orders it sells for restaurants which in turn attracts new restaurants to
    join the marketplace; and the more restaurants join the marketplace, the more attractive it becomes
    to customers, leading existing customers to order more frequently (given wider range of food
    options) and new customers to join the platform.
  • The incumbent also benefitted from scale economies in advertising which significantly lowered its
    customer acquisition cost and creates an additional barrier to success of the new competitors.

We reassessed the cash generation potential of the company and concluded that its current valuation was actually quite attractive. We covered our short and then we built a long position.

 

1 For more information please start at https://en.wikipedia.org/wiki/Confirmation_bias

For a deeper analysis of this bias please read “Influence: The Psychology of Persuasion” by Robert Cialdini

3 The original quote from Max Planck is: “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it.”

4 Our three core values are: Honesty, Humility and Hunger. For a copy of our culture statement please e-mail Colin at
colin.butler@somarcap.com

5 You will notice we don’t reveal the names here to avoid commitment and consistency bias.

Mistakes… I’ve Had a Few – July 2017

Mistakes… I’ve had a few

At Somar we strive daily for continuous improvement to make sure the portfolio at market close is more compelling and has more upside than the portfolio at the start of the day. We use several tools for this: talking with management, direct observation, data science, reading, observing other people’s mistakes and analyzing our own mistakes.
This month we will share what we learned from some of the mistakes we’ve made since inception. After reading this letter you may be surprised how we have been able to deliver returns despite so many mistakes. That speaks to the quality and upside of the opportunities we are finding. We have found more attractive opportunities in the last 3 months that at any time in the life of the fund. That is a topic for another letter…

Mistake number 1: Outrageous Valuation is not protection enough for a short
We had a short position in a consumer technology company. It had an early lead in a growth market but not a defensible moat in our opinion. Leading competitors were developing alternative approaches and our short was losing market share. We expected market share losses to continue in the foreseeable future. Channel checks with customers and competitors corroborated these findings.

At 20x forward revenue we felt we had a very attractive short opportunity. The market was assuming the company would grow to serve substantially all of the market at maturity. While possible, we felt that was an extremely unlikely scenario: there are many additional competitors entering the market with superior offers. In H1 2017 a larger, growth-challenged technology company acquired our short at 30 x forward revenues and we had a very unprofitable position on our hands.

Our detailed post-mortem taught us important lessons. First, while financial considerations tend to rule investment decisions in the markets, they are not absolute. A CEO and a board struggling with growth issues and an unattractive equity story may be willing to overpay for an acquisition in the hopes of changing the narrative and buying more time to attempt a turnaround. Irrational financial decisions are easier to make for management teams and boards with other people’s money. Second, growth disappointment stories can take longer to play out and open themselves to acquisition outcomes. Third, valuation is a weak provider of margin of safety in short investments.

Mistake number 2: Larger operations have a higher probability for hiccups
Last year we built a position in Chipotle Mexican Grill. Our analysis showed a compelling risk reward as
they recovered from the e-coli and norovirus outbreaks from 2015. Our thesis was:

  • Chipotle will be able to fully recover its customers as it revamped their operations and team (incl.
    hiring Jim Marsden a top Food Safety expert) to prevent additional episodes in the future
  • Superior customer value proposition, serving fresh wholesome food at low prices
  • Still a lot of opportunity to expand its operations in both the US (to more than five thousand
    restaurants from currently about two thousand) and International markets (where basically there are
    no restaurants today)
  • Industry leading unit economics with store ROIC of about 70% prior to the incident and about 30%
    at current volumes
  • Our Data science project tracks daily visits to restaurants and showed customers slowly returning to
    the store and accepting a 5% price increase
    On July 2017, an additional Norovirus incident occurred at a Virginia store. This led to a strong sell-off in
    the stock and put in question the company’s ability to recover lost customers. In Chipotle’s defense, it
    appears that the incident was caused by an employee not following the company’s protocol and coming to
    work sick. That said, it affected the customers’ confidence in the company and slowed the traffic recovery.
    Somar lost money and our returns suffered from it.
    We didn’t appreciate how difficult it is for an operation with more than 2,000 stores to operate a flawless
    operation that prevents all employees from breaching the protocol. Given the national exposure of a big
    chain like Chipotle that makes it a very slow and bumpy recovery of confidence and traffic. Ultimately, this
    makes it unlikely that Chipotle can fully recover its previous peak traffic. Our investment thesis didn’t
    appropriately account for this.

Mistake number 3: Investment thesis can be wrong
Last year we invested in TripAdvisor which, we believed, provided a very compelling risk/reward based on
the following investment thesis:

  • TripAdvisor will increase the monetization of its industry-leading traffic by assisting hotel shoppers
    book their hotels [Instant Book] instead of just charging Cost per Click to its advertisers
  • TripAdvisor can defend and expand its industry leading traffic moat: largest amount of reviews
    offers fresher and more relevant information which attracts more traffic and reviewers in a virtuous
    circle.
  • Online travel is a growth industry offering mid-teens growth. TripAdvisor will continue to take
    market share and grow faster than the industry
    TripAdvisor’s management had been very deliberate and slow in the roll-out of Instant Book. Through our
    data science checks we picked up on an acceleration of the roll-out to substantially all of the bookable hotels,
    coupled with agreement with the largest hotel chains and online travel agencies. When TripAdvisor reported
    its earnings, their hotel shopper growth had decelerated to a yearly rate of only 3%, not only lagging the
    online travel market pace of mid-teens but also the overall travel market of mid-single digits. This put in
    question our investment thesis and we could think of no good explanation. We were left with the conclusion
    that TripAdvisor’s consumer proposition was not as compelling as we had judged it to be.
    In the after-market the shares were trading down about mid to high single digits and we took that
    opportunity to substantially sell our position. This served us well, as the stock fell even more the following
    days. We lost money but we took comfort in being clear minded about identifying a problem with the thesis
    and being quick to react to it. That saved Somar investors further losses.

As you can gather from these three examples we analyze in-depth our mistakes and learn from them. This
makes us better investors year after year. We are deep believers in continuous learning and the growth
mindset so well explored by Carol Dweck in the book we gave you last Christmas.

Golden Age of Investing – June 2017

Golden Age of Investing

Over the first half of 2017 we added several new secular winners to our portfolio. The pace at which we
have been doing that has been accelerating which speaks to the quality of the opportunity set ahead of us.
Our estimation of the portfolio’s risk-reward now stands at an all-time high [please read our April 2017
letter for a description of this internal metric].

Without sharing the “secret sauce”, I would like to provide you a little taste of what drives our excitement.
Please reach out to us if you want more details.
The invention and dissemination of the internet and the massification of its accessibility through
smartphones is transforming the way people live and creating new sources of wealth and competitive
advantage. This change opens up a wide array of business opportunities. A good share of these opportunities
come from businesses with a strong and growing competitive position and extremely attractive business
models.

Such a massive change in the economy, business and society has happened before and give a hint to what
we have ahead in our lifetimes. In the Agricultural society, wealth and power were mostly driven by how
much land you had and how productive it was. To preserve its power, families passed it from generation to
generation to the oldest male offspring. By concentrating it on one heir they prevented power and wealth
from being diluted. Each family county fell under the protection of a King. Social mobility was quite low.
The only opportunity to increase the wealth and power was to conquer other kingdoms and take their lands
leading to the creation of empires.

The emergence of the Industrial revolution upended this. Source of wealth shifted from land to capital.
Social mobility emerged with new rags to riches lives now possible. Business model of factories were
scalable allowing for the formation of previously unseen fortunes. New industries emerged increasing the
standard of living of everyone. Cities grew in power and influence as more and more of the economic
activity centered there. Wealth and power were no longer limited to land productivity but could grow based
on capital accumulation and new business launches. Scale and access to capital protected businesses from
competition. Wealth and power became concentrated in fewer hands.

We see a similar level of business change currently under way. Luckily for investors like us, this brings an
even higher level of opportunity than the industrial revolution. Current secular winners tend to be
knowledge / information based companies that have a much higher return on invested capital, a larger
addressable market and stronger and more defensible competitive positions than their industrial
predecessors [Table 1].

Industrial companies Knowledge Companies
Source of competitive advantage ·        Scale

·        Brand

·        Information

·        Network Economies

Competitive Dynamics Additional scale and brand yields lower incremental benefits to leader overtime allowing smaller players to survive Additional information and network economies makes the leader’s product value for its customer wider and wider vs. its competitors

 

Industry structure Large players have superior economics but several competitors can stake their claim on the market: leader tends to peak at 20% to 40% market share

 

Winner take most or even winner takes all: not uncommon for leaders to have higher than 50% market share
Capital intensity Medium to High:

 

Most businesses generate no excess free cash flow while growing or even need additional capital to grow

Medium to Low:

 

Most players can self-finance growth and still generate strong excess free cash flow

ROI Medium and stable

 

Extremely high and growing
Incremental margins High variable costs so incremental margins tend to be not much higher than average margins

 

Extremely high incremental margins: build it once and sell it many times with very low incremental costs
Geographic expansion Internationalization requires medium to high levels of additional capital with unclear path to success Minimal additional capital required;

Potential to leverage existing information and network economies increases chances of successful expansion

 

New Product/Service launch Medium to high additional capital required and medium levels of success Low additional capital required and high chances of success for adjacent product launches

 

Table 1

We have written about a few of these knowledge-based companies in the past but we have more attractive
ones currently in our portfolio. We are happy to take your calls and walk you through our current thinking.

The emergence of knowledge companies is an exciting development in our lifetimes. That doesn’t mean
that industrial companies will disappear, just like the industrial revolution didn’t mean the end of agriculture.
It also doesn’t mean that all knowledge companies will survive and prove to be extremely attractive
businesses. Discernment is important and that is what Somar brings to you.

We have an exciting journey ahead and we are excited to share it with you. The level of secular change has
never been greater in my lifetime. The speed of change has never been faster. And the availability of
investment opportunities has never been wider. We look forward updating you on our progress in the years
to come.

 

Somar Turns 1 – May 2017

Somar Turns 1

One year ago, we partnered to start the Somar journey. 12 months later we are off to a good start and look forward to the future with strong confidence. My conviction that Somar will deliver superior risk-adjusted returns to our investors has never been higher: our performance is ramping up nicely; we have a highly professional, cohesive and committed team; and a stable and growing group of investors.

Since its inception, Somar had a gross return of 12.37% and a net return of 6.93% vs. 17.46% for the S&P500, and 20.21% for the Eurostoxx 50 indexes.

Throughout the first year we have kept our net exposure at 50%. That means we expect to have half of the risk of the market. Therefore, if the market is up 10% we expect to be up 5%. And conversely, if the market is down 10% we expect to be down 5%. Any return above this expectation should be viewed as value being added by our stock-picking ability.
We strive to offer you the highest service and peace of mind. We have built Somar into a high-performance organization with the highest professional standards. We keep improving and are always looking to increase the service we offer you. Please let us know if there are areas where we can do better for you.

Since our inception we have been blessed to have you as our partner. You have shared our vision of investing long-term in secular winners. As one of you told me: “In the long term, the stock price will follow the sustainable growth in profit”. We are happy to report that in the first 12 months some of you have continued to reinforce your original investment in Somar and, as I write these lines, we have not received a single notice for redemption. This, together with our performance has allowed us to grow our assets more than 50% in our first year, and we have recently crossed above $25mn of AUM.

We continue to have substantially more attractive investment opportunities than capital to deploy. We will close the fund well in advance of that being close to a consideration. Currently we plan a first close when we reach $100mn. We are finding a lot of opportunities in emerging secular winners in Europe and the US. Attached we share a summary of our investment in Zooplus, the European online pet retail leader which is a good illustration of the type of investments we focus on.

A personal note

I realize the current media narrative around active management has not been supportive over the past 12
months. Therefore, it took courage and vision for you to join our project. I am grateful for your trust and
committed to reward you by continuing to deliver superior risk-adjusted returns.

We are off to a great start and we see a large opportunity ahead. Given the large amount of secular change
and speed of change we believe the future years will come to be known as the golden age of secular investing
and value creation. Thanks for joining us on this exciting journey.

 

A Personal Story – April 2017

A Personal Story

My dad is a medical doctor. He started his career in a hospital, working all night at the emergency room.
His passion was serving as a community doctor. Therefore, when I was 10, he moved our family to the
Portuguese countryside and built his practice there. Every day he put in long hours: leaving home by daylight
and coming back for dinner at around 8PM. Most nights, he would see patients after dinner at our house and
occasionally he drove at night to do domicile consultations. He built a stellar reputation: one of my
schoolmates’ family told me that my father saved the life of his grandfather. It is hard to overstate how
proud I am of him.

My dad taught me the value of hard work and of striving to be the best you can at your craft. As a normal
boy, I wished my parents would give me a computer or a guitar. They always provided for my basics but
made me earn for my extra-curricular “toys”. So routinely, I took part-time jobs to gather the money needed
to buy them.

One night after dinner, a patient called my dad. His mother was feeling very sick and he needed my dad to
see her. I asked my dad to go with him. The house was far, on top of a mountain with no public illumination.
The night was cold and the road was quite bumpy, filled with potholes. After 20 adventurous minutes we
arrived. My dad tended to the patient, a very poor old lady. On our return, I reminded my dad that I was two
thousand Portuguese escudos (the equivalent of 10 euros) short of the price of the guitar I wanted to buy.
Could he give me the money he got from this visit? He told me, “Pedro, this is a very poor family. They
can’t pay for my services. But they needed a doctor now and I had to come serve them. A doctor’s job is to
bring people back to health.”

This made a profound impression on me. After a full day of hard work, on a cold winter night, rather than
staying at home after dinner and relaxing, my dad generously got out to serve a person in need. And he
didn’t charge a single cent. In fact, he had to pay for gas. He did this out of the generosity of his heart. But
he didn’t see it that way. He believed that his calling was to be a doctor, and the talents he was given were
to be put to the service of the community, regardless of ability to pay. He set for himself the highest
professional standards as a doctor. And he saw that calling as a blessing.

I wanted to follow in his footsteps but medicine wasn’t my calling. The sight of people in pain and bleeding
is hard for me and doesn’t allow me to perform at the peak. My calling is to assist people and institutions in
building and establishing a legacy. That is why I founded Somar Capital. I believe people and institutions
should be able to take control of their financial destiny, dream big and fund those dreams by relying on a
high return on their savings for decades to come. I believe they should be able to plan beyond normal human
life expectancy and build legacies that will benefit generations to come. My family and I have benefitted
from legacies from Mr. Andrew Carnegie (New York Public Library) and Mr. George Baker (Harvard
Business School) to name just a few. I’m inspired by them.

To fulfill this vision, the team has built Somar with the same highest professional standards that my dad
used to build his practice. We are humbled by the trust you put in us and we come to work every day
determined to be worthy of that trust. Our guiding values are: Honest, Humble and Hungry1.
We look for high returns by partnering with extremely attractive businesses that have a superior value
proposition to offer their customers. We look for businesses can sustain their superior customer proposition
over time and have only penetrated a fraction of their target customers. This allows them to grow and build
shareholder value at high rates regardless of the macro-economic cycle.
* * *
A few months ago, my dad approached me to invest his life savings in Somar. He said: “I can’t think of any
better place to put my savings”. Humbled by his confidence and conscious of the weight of this
responsibility I accepted. In addition, I invested my daughters’ savings in Somar. We have three generation
of the Ramos family fully aligned with you, our investors. We look forward to seeing you succeed and
playing our part in funding your aspirations for this and future generations.

Portfolio Construction Process – March 2017

Portfolio Construction Process

We believe Somar’s portfolio management process is accretive to our returns. Our process allows us to

  • Quantify and monitor our expected portfolio performance for the next 12 months
  • Easily weigh trade-offs between opportunities and risks among different industries and geographies
  • Use market volatility to our investors’ advantage by sizing up positions on weakness when their risk-reward improves and harvesting positions on strength as their risk-reward declines