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.

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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.