Letters

An Inefficient Market

September 2021

An Inefficient Market

Most recent market comments center on how high valuations are, descriptions of risks around the corner (inflation, China Evergrande, pandemic) and the bubble-like behavior in certain market segments (Crypto, NFTs, Late-stage mega private rounds in start-ups).

It seems the most conventional place to deploy capital is in large, mega-cap index funds that track the largest companies in the world. These are followed by dozens of sell-side analysts and hundreds, if not thousands of buy-side analysts, giving some comfort of price efficiency.

It may surprise many to learn that Somar believes there is a highly inefficient segment of the public markets: emerging public listed growth companies. These companies offer their customers materially superior value propositions and are rewarded by market share gains. Some of these companies’ strategies allow them to sustain this advantage for many years into the future. They are however under the radar of most investors.

Why is this? Active investors are moving away from this segment:

  • Active growth investors that traditionally invested in the space are focusing on launching cross-over funds and are deploying most of their capital in private late-stage Venture-Capital rounds. For example, an institutional investor recently told me that Tiger Global has currently deployed $50 bn in private late-stage rounds, much more than their $30 bn Hedge Fund that invests in public securities;
  • Traditional, large-scale public market investors are moving away from active managed funds into large-scale Index-funds that invest in the largest and more mature public companies. In their defense, we must add that the large size of their assets under management (some of them approaching the trillions of dollars), make the investment in a $5bn market cap company not worth it, as a successful outcome would barely move their fund’s overall performance.

These have left an investor coverage “donut hole” on companies that are in-between: growth public companies with high potential, but still below the large market cap required to make them material components of index funds.

The investor drought leads to attractive valuations and a fertile ground for opportunities for a specialist investor like Somar. This inefficiency cuts both ways though. It can last for years and test the patience of investors who applaud the execution but don’t see the operational progress reflected in the shares.

In this letter we selected a few examples to illustrate this dynamic. Many more are available, and we would be happy to talk you through them at your convenience.

First up is Zalando, the leading shoe and apparel internet retailer in Europe. Their growth has been very strong over the past few years (Sales CAGR of 20%+ over more than 5 years) with positive margins despite their growth investments. Amidst this progress, for 4 years the stock went sideways (see figure 1).

Figure 1
Source: Bloomberg

Then suddenly over the past year, the stock more than doubled (despite the recent pullback). See Figure 2 for the sudden contrast in performance.

Figure 2
Source: Bloomberg

A similar pattern emerged at Zooplus: the largest European pet food and supplies internet retailer. Despite strong yearly growth for many years accompanied by profitability (amidst strong investments), the stock moved sideways in the first 4.5 years of Somar’s existence (Fig. 3)

Figure 3
Source: Bloomberg

This year, the stock started reflecting the value created, ending with an on-going bidding war between two Private Equity firms to take the firm private. From the lows of 2020, the stock has appreciated more than 7 times (see Fig. 4)

Figure 4
Source: Bloomberg

Another example comes from Boozt, a leading Nordic apparel, shoe and home e-retailer that went public in 2017. The company executed flawlessly with sales CAGR of more than 30% since IPO and best in class profitability. Despite that, the market lost interest in the company during its first 3 years as a listed company (see fig. 5).

Figure 5
Source: Bloomberg

Notice that all these three companies (Zalando, Zooplus and Boozt) saw their stock cut in half during their “sideways” period. This tests the active investor’s conviction and patience. Only ongoing due diligence and direct observation can support the continuous holding of positions that are underperforming so much.

Over the past year, investors seem to be getting more constructive towards Boozt and the stock has more than quadrupled since its 2020 low (see figure 6).

Figure 6
Source: Bloomberg

Lest you believe that this inefficiency is a feature only of non-US markets, perhaps the most spectacular example comes from the US. Sea limited went public in the US in the fall of 2017. At the time it was the most popular gaming publisher in Southeast Asia (Garena) and planned to use their wide distribution to build the largest e-commerce marketplace in the region (Shopee). I met the team and was extremely impressed by their ability to execute. They were beating local champions (like Indonesia’s Tokopedia) as well as the global champion (Alibaba, operating in the region through its subsidiary Lazada).

Despite impressive and steady execution, and continued market share gains against Alibaba and local champions, Sea limited stock went down by 1/3 in their first year as a public company (see figure 7).

Figure 7
Source: Bloomberg

Unable to understand the disconnect, I travelled to the Sea’s headquarters in Singapore and met with top VCs and entrepreneurs in the region to ensure the numbers reported matched what was happening in the field. This confirmed Somar’s thesis was on track.

Since then, the market took notice of Sea’s potential. Sea Limited is now a mainstream mega-cap company. (see fig. 8)

The company has overdelivered on our original thesis. Not only have they become the leader of e-commerce and gaming in South East Asia, they have also taken significant market share and are fighting for leadership position in Latin America (including Brazil), Middle East and Eastern Europe. They have also started to monetize their payments and financial offering.

Figure 8
Source: Bloomberg

These examples illustrate the market inefficiency that creates extremely attractive opportunities for Somar investors. These opportunities may require patience to be captured. From these graphs, you can understand that our monthly performance figures carry more noise than signal. However, overtime our diversified portfolio should deliver the superior returns our investors expect from us.

It is hard to pinpoint what the catalyst was for the valuation to reflect the value that was being created. What we know for sure, is that over time the market will reflect the inherent value of the business. We also know that the companies’ steady growth every year makes them appeal to a wider and wider pool of large-cap active investors. Eventually, they “graduate” into mature large-cap companies widely owned by the index funds. This gives us comfort that the inefficiencies are self-correcting.

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Disclaimer: This website is for general information purposes only and is not intended to be, nor should it be construed as investment advice, nor a solicitation or offer to buy or sell any securities, related financial instruments, or  interests in the Somar Master Fund, LP (the “Fund”) or its feeder funds. The information contained herein is not complete, and does not contain certain material information such as disclosures and risk factors about the Fund or its feeder funds. Opinions expressed are current opinions as of the date of this material only and are subject to change without notice. Hedge funds: (1) often engage in leveraging and other speculative investment practices that may increase the risk of investment loss; (2) can be highly illiquid; (3) are not required to provide periodic pricing or valuation information to investors; (4) may involve complex tax structures and delays in distributing important tax information; (5) are not subject to the same regulatory requirements as mutual funds; and (6) often charge high fees. 

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