FRENZEL & HERZING VALUE INVESTMENT
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Dear followers,

the time has come again for our weekly link collection. This time featuring an enlightening article on management compensation, how Charlie Munger picks stocks, seven patterns of inefficiency when pricing a business, some thoughts from the Brooklyn Investor and an ‘Economist’ comment on John Nash’s nobel price 1994, in remembrance of his great life that ended three days ago.

nash

We will be back shortly with our latest investment story. Stay tuned and enjoy your week!

Welcome to a further piece of our ‘Value Essentials’ series. ‘Financial Shenanigans’ is written by Howard M. Schilit, PhD, CPA and Jeremy Perler, CFA, CPA. It presents an empirical journey through many accounting tricks in an entertaining way while teaching its readers what to look for when analyzing balance sheets. This blog post is by no means a summary of all the facts given in the book. It is merely meant to give you an idea and remind you of the key lessons. I would highly recommend reading it as soon as possible, as it is also part of our recommended reading list that you find on our website. After all, there are passages that show the recklessness of managers and the absurdity of huge frauds (that have stayed unnoticed for decades) which makes the reading experience quite joyful.

 

financial shenanigans  

NOTE: In this post we directly quote the book. If you find this interesting, please consider buying it (e.g. via this link).

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  • METKA 1
  • Metka 2
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  • Metka 3
  • Aggreko
  • MENA
  • Engery deamand per capita
  • Evolution of the Energy mix
  • Margin Development
  • Development of ROCE and ROE
  • Net Sales By Region

Today we would like to present you METKA, which is probably one of the cheapest stocks in the world. Before we start with actual valuation, we provide an executive summary as this is a rather long post. Afterwards we would like to highlight the history of this over 50 year old company.

 

1. Executive summary

 

The share price is € 8.60. The company was founded in the year of 1964 in Volos Greece and was floated in 1973. In 2008 METKA’s share price hit a high of € 17,50 and slumped in the aftermath of the financial crisis to a share price level of around € 5.50. Since 1999 the Mytilineos Group owns 50.4% of Metka. Ioannis (current CEO of METKA) and his brother Evangelos Mytilineaos together own 31.8% of Mytilineos Group, split almost evenly.

 

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Dear followers,

first of all, we want to wish happy easter to all of those who celebrate! As you know, we share some useful reading from time to time. These are some easter eggs that we think you might like:

 

 

I want to close this entry with some thoughts about chosing business partners. Here is a short quote from “The Ides of March”, a movie from 2011.

 

There is only one thing that I value in this world, Steven, and that’s loyalty. And without it, you are nothing. You have no one. And in politics? It’s the only currency you can count on. That’s why I let you go. Not because you’re not good enough, not because I don’t like you. But I value trust over skill.

 

I think that in business life, there are lots of situations in which you have to be certain you can rely on your peers and I have always spent time getting to know the great people I deal with. Charlie Munger found his own words for this:

 

 Choose clients as you would friends.

 

Some time ago, I heard a talk about by Kent Hahne, the founder of several international food chains (Vapiano, L’Osteria et al). He was very clear about the importance of shared values and friendship in business. For him, it was the ‘key ingredient’. I have to add that I absolutely agree on his thoughts. I hope that I continue to be as lucky as I have been so far when encountering partners, as loyalty is crucial for any long term business relation. Finally, we want to thank all the subscribers that have stayed with us so far. Let’s keep the discussion alive. Happy Easter!

After the success of our last presentation one year ago we are happy to announce two upcoming presentations about value Investing. The first will be held by us at the 23.02.2015 19.30 on the EBS Campus in Oestrich-Winkel in room N3 the presentation will be presented in german and will deal with an introduction to Value Investing and two case studies. The Case studies will be interactive and contain a long pitch which we have not yet presented on the blog. The second will take place on Monday the 09.03.2015 18.30 in N3 and is presented by Frank Fischer of Shareholder Value Management AG eg. Frankfurter Aktienfonds für Stiftungen and is held in english. The topic of this presentation is Value Investing in Crises. You are kindly invited two both presentations but as place is scarce you have to quickly fill out the form below with you name and the number of guest first so that we can plan. We would be glad to host many visitors.

 

ebs

 

Please enter your name into this form to join: http://goo.gl/forms/RyiZmAbqnk Thanks.

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Higher Frequencies: Chicago Board of Trade Futures Market

Avoiding the buzz: Low liquidity beats the market

 

One aspect or explanation why Value works is the low trading volume which is often typical for companies in which we invest. A new paper by Roger Ibbotson and Thomas Idzorek, Roger Ibbotson is a partner at Zebra Capital Management and finance professor at Yale and Tom Idzorek is head of investment methodology and economic research at Morningstar, in the Journal of Portfolio Management which analysed 40 years of stock returns by putting them into a perspective to the average trading volume of the last year.  The Paper finds, stocks in the least popular quartile outperformed those in the most popular segment by seven percent. In their paper “Dimensions of Popularity,” Ibbotson and Idzorek identify the most common market premiums and anomalies, such as:

  • Small cap—Smaller capitalization stocks outperform larger capitalization stocks
  • Valuation—Value companies beat growth companies
  • Liquidity—Less liquid stocks beat those with more liquidity
  • Momentum—Stocks trending up will continue to trend up

Because the risk-return framework does not explain all these premiums and anomalies seen in the market, the researchers propose the unifying “theory of popularity.” The authors explain that the most common market premiums and anomalies are associated with a stock’s popularity or unpopularity. For example, if investors “vote with their dollars,” small cap companies have gotten fewer votes. Value companies commonly have something wrong with them, which makes them unpopular.

 

If an asset has characteristics that investors really dislike, such as low liquidity, little name recognition, or high volatility, its price will be lower and therefore its expected future returns will be higher, all other things being equal. According to the theory of popularity, if an investor were to rank stocks by popularity, he or she could buy a basket of unpopular stocks and systematically rebalance as the stocks become more popular by buying a new portfolio of relatively less popular stocks. As some of the stocks in the portfolio become more popular over time, they become more valuable and the investor will see appreciation. This cycle happens normally in Deep Value situations where trends tend to revert to the mean.

 

“Risk has become a catch-all for all of the attributes that investors do not like, but riskiness does not explain all the anomalies we see in the market. Value premiums are a perfect example. Stocks with low market-to-book ratios or low price-earnings ratios are not necessarily more volatile or less liquid, but we know that over time value stocks beat growth stocks. We need a new model for explaining investment performance that goes beyond risk and return. Popularity may be a better lens through which to view investment behavior,” Ibbotson said. “Many of the well-known market premiums are associated with unpopular stocks. Unpopular stocks tend to be smaller, less liquid, and perceived as lacking growth potential. These stocks, with their low relative prices, may offer investors better future performance as they move along the spectrum toward popularity.”

 

Have a good week.

Recently BPER announced a change in the CEO position of the Group and the CHF jumped after the Swiss National Bank abandoned the CHF/EUR exchange rate of 1,20. Ariane de Rothschild will replace Christoph de Backer, which served BPER for three years, on the 31.01.2015. You can read the full press statement here. You can find our initial analysis here which we think is still intact despite the fact, that the new exchange rate possible decreases the Net Profit a little bit.

Ariane_de_Rothschild

Christoph de Backer was the head behind the ongoing transformation and strategic repositioning of BPER. As we have read some rumors in the newspaper, this transaction has not pleased everybody and some older employees have left the group. The change was quiet surprising for us and we already observed some recent changes in the last years and months which are probably a result of the coming change. For example a new position of a Deputy CEO was created and Sabine Rabald, who worked for the Group nearly 20 years, was announced to serve in this role. But If you read the annual statements of the past years the change is not that surprising as it looks at first. Benjamine de Rothschild mentioned several times that the lead of the group will be taken over by a women in the foreseeable future. As Ariane de Rothschild already served in different banks in New York and Paris and has an education which is focused on finance we  see the change not as a negative step towards the future.

 

Lately the Group announced the acquisition of an extra stack in OROX Asset Management which should strengthen the Property Funds business of Rothschild. The overall stack is now at 82% and the purchase price was not disclosed.

 

In our view the semiannual result of the group was quiet satisfying, the business profit which is the best proxy for the ongoing operations rose by 32,4 %. Sadly this growth was not seen in the Net Profit of the Group which dropped by 18,8% for the half year, due to the result in the extraordinary income, which was quiet high last year. The total Assets under Management in the Group rose slightly by 1% in the half year. This is not really impressive but is explainable with the sale of non-core businesses in Italy. The like-for-like AUM rose by 4%; way more in line with our expectations of the groups’ expansion into Asia. The Tier I ratio remained unchanged on 36,9% under Basel III which is a really comfortable buffer.

This year was the year with my lowest portfolio return which was till 1.12.2014 6.21% after taxes and trading costs including an average cash level of 27.8%, the final result with volatility will be send to me on the 17th of January, but I don’t think that there will be a big difference in the results. This is my weakest performance since the real start of my trading history in the year of 2008.

 

As we cannot and will not discuss our Portfolio Holdings in public we have to speak about the things which were related to the performance. In my opinion we made two major mistakes. First of all, time management. We spend a lot of our time on legal issues related to the German regulation (which did not really take us ahead). This time was missing for good analysis work to evaluate companies. But this is the price that you have to pay if you try to achieve everything on your own.
 

Second, we made fundamental mistakes like the one with Vetropack and with it and our due to our legal structure the mistake of dead money. If a company cannot achieve any growth at all the time plays against you and it doesn’t matter which price you pay. This is something which I learned over the last year and where I would like to give you a short excerpt and math example out of a presentation of RV-Capital:

 

“Whether appropriate or not, the term ‘value investing’ is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, a low dividend yield – are in no way inconsistent with a ‘value’ purchase.” Berkshire Hathaway 1992 Annual Report

 

The math example to it:

 

  1. If you buy a business with no growth and 2% cost inflation for a EV/EBIT 10 in T0 you end up paying an equivalent of EV/EBIT 38.7 in T4.
  2. If you buy a business with no growth and no cost inflation you end up with the same EV/EBIT of 10 in 4 years. (Example: Vetropack)
  3. If you buy a business with 5% growth and no operating leverage, you pay an EV/EBIT of 7.8 4 years from now
  4. If you buy a business with 5% growth and operating leverage, you only pay EV/EBIT of 5.4 4 years from now which is clearly a bargain.
  5. If you take company 4 and add pricing power to this equation you end up with an EV/EBIT of 3.2 in 4 years.

So you can see on this easy example: growth matters

“• Focus on the multiple relative to the business and not the absolute
multiple
• At nearly all times, the great business will trade on a higher multiple
than the value business
• For the truly long-term investor, the great business (properly
analyzed) beats all other businesses at almost any price.
• There is a time horizon arbitrage in great businesses trading at high
multiples
• It is perfectly valid to invest in non-great businesses, but be sure to
pay a lower relative multiple
• Longevity of growth is far more important than the rate of growth” RV Capital

 

Furthermore I learned that in investing similar to my favorite sport climbing, it is all about a good fail protection. That is also a reason for the quiet low portfolio transaction and high cash amount. We have only 5 companies from our first goal of 10-12. furthermore I would like to highlight the importance of a defensive thinking and aggressive acting. What do I mean with this? In my opinion it’s about understanding second, third and more level of influence and the time horizon which it takes to affect the underlying stock price. An example can be seen in the Oil and Gas industry where a low oil price isn’t that bad in the short term. But if the oil price stays low for a longer time horizon, like half a year or longer, Oil companies cut back production and CAPEX. As detailed budgets are normally made on a yearly basis and up to 5 years in for big projects, it takes some time till the CAPEX directly influence the earnings of companies which are related to exploration.
 

Furthermore it takes even longer to feel this influence for companies which are not directly related to the exploration. This has led some investors into paying peak earnings for a cyclical company.  Observation has tought us that many losses for investors came from the purchase of low quality companies at time of favorable business conditions. This only means that purchasers view the current good earnings as equivalent of the EPV of the company and assume that prosperity is a synonym for safety. But this is often not the case.
 

Personally 2014 was challenging for both of us: Felix was able to finish his internship, receive good grades in university and lastly score a nearly perfect GMAT score, which he needs for his further studies. For me it was all about finishing my Master, doing the CFA research challenge and the first level of the CFA.
 

In 2015, Felix is hopefully about to enter one of the top universities abroad and to improve as a value investor; the only thing that’s left of my studies is my Master Thesis which I will start in the next couple of days and the level 2 of the CFA which I hope to pass in June. Furthermore I would like to correct some mistakes in my analytical thinking to become a better value investor.
 

To sum it up: our main aim for 2015 is to get better in the evaluation of the value of growth, spend more time on companies and be more rigorous in our selection of companies which enter our portfolio. And of cause the other necessary university stuff 😉

In the first part of our analysis we explained the business model of Delticom; now we would like to give you and inside in its valuation. But before we begin with the number crunching we would like to start with a short summary of the key takeaways of our first part:

  1. Some other Value-Investors think that the problems of Delticom are only short-term issues: EBIT-Margins will bounce back to their old highs.
  2. Delticom has a really light business model: everything is outsourced to third party distributors.
  3. No use of purchase power: Delticom uses a fixed premium on the purchase price of every tire, sometimes it uses a flexible mark up to account for seasonality and inventory management.
  4. No customer captivity due to long purchase cycles of over 4 years.
  5. No lock-in of fitting shops.
  6. BBE-Study assumes that the online market share will reach 15% in 5 years, e.g. 2020. In an overall saturated market. (You can see the development of 2014 here)
  7. Bad strategic behavior in the acquisition of Tirendo and bad own brand strategy (The tires get really bad reviews.)
  8. Too high ROCE and ROIC even with small EBIT-Margins, which we will explain in the hereafter

What do we mean with too high ROCE and ROIC, and why is the biggest advantage of Delticom also its weakest spot?

Many other investors think that Delticom is able to return to its old EBIT-Margins, but we don’t think so. Why? The answer lies in the Business Model of Delticom which is extremely asset-light. As you can see in the chart below, the Capital Employed of Delticom is 7,1 % of 2013 Revenues, relatively low in comparison to other companies, but for Delticom itself higher than in the year of 2006 (6,6%) and virtually sky-rocketed from its low in the year of 2010 (0,9%) where Delticom also has shown its highest EBIT margin (11,1%).  The combination of high EBIT-Margins and low Capital Employed lead to an astonishing high ROCE of 276% in the year of 2010. Furthermore the ROCE was still high (51%) in 2013 where Delticom only had a EBIT-Margin of 3,6% and a Capital Employed of 7,1% of revenue. This high ROCE’s is also the reason why this business is so attractive for every competitor, if you cannot defend your turf with a big moat. As we don’t think that Delticom has a moat, we think that every time the EBIT-margins are high enough new competitor will enter the game.

 

CE Delticom

 

So let’s come to our valuation of Delticom.

We have explained already that we don’t think Delticom has a moat and is a pure execution business only, so we use a discount rate of 10%. If we discount our Earning Power Value, assume an EBIT-Margin of 4% in the future and subtract the debt of Delticom we end up with a fair value of 16,62 EUR per share. This is not far away from our current trading price of around 17,5 EUR and is in our opinion quiet low  for an evaluation without any future growth.

 

Delticom was able to growth its revenues by 17,7% p.a. over the last five years. If we now assume a growth of 8,8% in average over the next 5 years (10% in 2015 declining to 7% in 2018) which we think is quiet conservative, we end up with an N-EPV of 28 EUR per Share in the year of 2018 or an IRR of 13,7%. (Capital allocation is assumed to be stable: 43% dividends, 3% growth CAPEX, 2% change in NWC and no share repurchases.) If you than use the Growth Multiple of Greenwald to calculate the Terminal Value with a 3% growth rate, you end up with an N-EPV of 37,92 EUR per Share at the end of the year of 2018. Which is equal to an IRR of 20,1%.

 

We also used the approach of total Market size as an approximation but where not really satisfied with this approach. Therefore the reasonable share price of Delticom should be around 30 EUR which gives you a nice little upside. But if we think in our 3 pillars Model, we end up with a fair or cheap price but with neither a beautiful business, nor a management we would like to be engaged with. (You can inform yourself here and take a look at the insider trading)

 We wish all of you a happy new year!

Disclosure: No Position

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In our today’s report we feature an idea which was already mentioned many times by other value investors. However, our outcome is different in one point which leads to a completely different picture. Here you can find the analysis of Profitlich&Schmidlin and from others (We have to add that these two funds share one platform). We would like to present you our 3 cents on Delticom. The online tire store Delticom was often proclaimed to be a value investment. Besides its growth rate that was because it used to have a solid balance sheet, an easily understandable business model, and because its extremely high returns on equity.

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