Letters

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.

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[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.