Letters

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