The second quarter of 2016 brought us back to familiar territory of persistent global central bank support and less negative news flow surrounding the Chinese economy. This all helped asset and commodity prices to reflate significantly. Only at the very end of the quarter did markets wake up to an additional ‘known unknown’, as the UK voted to leave the EU. Theresa May, the incoming Prime Minister, confirmed the populist vote by saying ‘Brexit means Brexit’. How this will develop over the coming years is something we leave to experts and speculators; our main concern is to assess the potential impact in a variety of scenarios on our portfolio companies, and more specifically on our UK listed companies (LSL Property Services Plc. & Exova Group Plc.). Whilst we accept that the vote created uncertainty, we believe that the reasons for owning these quality businesses are intact with regards to the Brexit vote. Brexit now features on the list of things we watch out for and could impact our businesses negatively, but we currently don't see it featuring high on the list.

BAIDU Inc.

In our 2015Q4 letter we described the characteristics of our ideal portfolio company. The intrinsic values of our investments are a function of the future free cash flows after investments for growth. We therefore pay a lot of attention to the predictability of sales and operating margins and the return on the company’s incremental invested capital. Sustainable high operating margins and high returns on this invested capital are highly correlated with sustainable competitive advantages. Prof. B. Greenwald from Columbia University’s Graduate School of Business co-authored ‘The Curse of the Mogul’ about the media industry in which he sums up the real sources of competitive advantages; economies of scale, customer captivity, cost and government protection. Bringing this into the context of our portfolio, a few years ago we passed on an investment in Google Inc. because we lacked conviction in the durability of its competitive advantage. After all, we thought it’s just as easy to type bing.com as opposed to google.com. We were evidently wrong. With our recent investment in Baidu Inc. and our better understanding of the search engine business model we are handed a similar opportunity to invest in an exceptionally well managed company with durable competitive advantages and a long path of growth ahead.

Dominant search engines benefit from economies of scale both by the relative size of their fixed costs and network effects; they retain customer captivity of both consumers and advertisers because of habit and switching costs, and they secure a major cost advantage through proprietary technology and machine learning. The ability to learn from each user to improve the search results implies that the search engine with the most users is in the best position to continuously improve its search algorithm. Internet users reach for the search engine that offers them the most efficient tool to find relevant information on the internet and advertisers are attracted to the platform with the most users, resulting in a positive feedback loop (i.e. the network effect).  As a result, Google and regionally dominant search engines such as Baidu, have stable market shares and high returns on capital, characteristics that correlate highly with competitive advantages. Over time we have become more confident that Baidu is this rare company that seems to have elements of all three of the most important sources of competitive advantages that we identified; economies of scale, customer captivity and cost structure. This resulted in our investment in Baidu after its recent share price decline.

Baidu Inc. was founded in 2000 by its current CEO Robin Li, and it already had a market share of 70% of all internet search in China by the time that Google decided to leave the country because they were unwilling to comply with local Chinese government regulations. Today Baidu is the dominant search engine in China with 80% market share; its sales growth is in excess of 30% per year, it has a 50% operating margin and generates 300% return on capital. The Chinese government policy is generally supportive of internet companies and is a promoter of increased internet penetration across the PRC. Growing personal income, elevated levels of internet consumption and increasing internet coverage are all supportive of growth. Today, China has more than 900 million smartphones but this represents only 50% market penetration. Growth in online advertising should offer Baidu a long runway for success despite competition from other Chinese internet giants such as Alibaba and Tencent.

Baidu was on our wish list, but out of reach in terms of valuation. More recently we identified 3 reasons why the stock price dropped 30% from last year’s peak. Firstly, general investor concerns about a cooling Chinese economy. Secondly, more stringent government regulation regarding online advertisement after the death of a Chinese student who used an experimental cancer treatment that he found on a Baidu related website. In a widely read post before his death, the student blamed Baidu for directing him to the hospital & treatment via a sponsored advertisement that masqueraded itself as objective information. Finally, recently declining operating margins and poor visibility on the quality of the underlying growth businesses. All these factors helped to push the stock further down.

We believe Baidu can still continue to grow revenue significantly, even if the Chinese economy grows at a slower pace than it used to. Online advertising revenue growth is slowing but forecasts still have it growing at rates >15% over the next 3 years (source: iResearch, The Economist).

As we described above, the spectacular growth Baidu has experienced has not been without problems. However, the CEO is showing strong leadership in correcting the advertisement scandal and seems determined to do the right thing. With regards to declining operating margins, the segment results reveal that operating margins in ‘search’ have been stable around 50% over the years despite spending 15% of sales on R&D. It is true that overall operating margins show a declining trend since Baidu started investing in O2O (online to offline) because it supported years of losses during the race for market leadership in new businesses such as online travel, group-buying (think Groupon) and takeout delivery services. However, several recent developments provide us with more transparency on the value of this set of businesses. For example, in exchange for its online travel business, Baidu received a 24% stake in Nasdaq-listed Ctrip worth more than $4.5bln. Also, frustrated by the low valuation the stock market gives to Baidu and in order to improve earnings visibility towards investors and analysts, Robin Li made a buyout offer of $2.8bln for iQiyi, a subscription based video streaming service (think a crossover between YouTube and Netflix), an offer he later felt compelled to withdraw because some minority shareholders believed the offer to be too low.

For our analysis we started by using the above valuations for these 2 businesses (Ctrip & iQiyi). We then gave nil value to the other O2O businesses such as the group-buying and takeout delivery services. We deducted the cash that the company pledged for O2O from the excess cash at the Baidu Inc. holding company. This implied a valuation of 10x our 2016 estimated after-tax earnings. We believe this is a compelling valuation for a business with the attractive characteristics we summed up.

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For the quarter ended June 30, 2016 the fund had 16 listed equity positions. The 5 largest positions in the fund represented 32.35% of assets under management.

Summary of the 5 largest positions of the fund:

Boustead Singapore Ltd:

This Singapore-based company is a conglomerate of 3 quality businesses, which are fundamentally different. The underlying divisions simultaneously went through headwinds, which allowed us to invest at an attractive valuation. The businesses consist of 1) a 51.2% participation in recently spun-off Boustead Projects Ltd; a design, build & lease real estate business that owns a portfolio of new and recently build high-end fully let industrial buildings. It counts IBM, Airbus, Bombardier, Rolls-Royce, SD Schenker and SDV amongst its tenants. 2) an asset light global engineering business active in the niche market of direct-fired process heater systems, mainly for oil & gas refineries. 3) a distribution business of Esri geospatial software, which has a 60% market share in geographic information systems (best explained as a professional Google Maps, mainly for governmental use). These 3 businesses have high operating margins and generate high returns on invested capital. They are led by a chairman who focuses his entrepreneurship on shareholder value creation. We were able to purchase this conglomerate for respectively 5x and 12x the normalised earnings of the energy and geospatial businesses, and paid 55% of intrinsic value for the real estate assets. A potential catalyst exists in moving the real estate assets into a REIT structure and the conservative balance sheet also allows for opportunistic acquisitions.

Compugroup Medical AG:

This is the second time we were able to invest in this Koblenz-based medical software vendor. It was one of the first investments of the fund, which we successfully entered and exited between 2012 and 2014 for a 105% return. We think this medical software business is of very high quality with high barriers to entry and a dominant position in virtually all the markets it operates in. It has very sticky customers (mostly doctors) with extremely low churn rates, no cyclicality and high free cash flow generation due to the low capital requirements to run the business. The business model is also helped by the continuous pressure from governments to cut public health spending by increasing connectivity. As we kept in touch with this company after our exit, we got more comfortable with a German initiative that was recently turned into Law. It will connect all the public health stakeholders with compatible software. Compugroup, being a leader in this field, was part of the government development program and once implemented, we believe the company will secure years of sustainable growth. We re-entered the equity at 12.5x cash earnings.

EM Systems Co Ltd:

This Osaka-based medical software business is the leader in pharmacy software in Japan.  The company sells soft- and hardware to 23% of pharmacies in Japan. The country is not as advanced yet in its implementation of medical software to control and cut public health spending as compared to Western countries. However, our experience in this industry gives us confidence in the future recurring revenue stream. The company is led by an owner-operator with a good track record as both an operator and a capital allocator. When the company recently moved over to a cloud based subscription model, the market punished the share price, ignoring years of stable future cash flows once the transition was complete. In addition, the company owns a prime office building in central Osaka. We purchased the shares at roughly the value of the real estate, covering our margin of safety. If the company makes good on its promise to sell the real estate, then we will have received this great company almost for free.

Keck Seng Inv (HK) Ltd:

This Hong Kong listed company originally started accumulating and developing real estate in 1977 in the Portuguese enclave of Macau. Over the years the founding family moved from ‘build to sell’ to ‘build to hold’. Today it is a diversified real estate investment holding company, majority owned by its founding owner-operator chairman. Its real estate assets are spread over the globe, primarily in the U.S., Vietnam, Macau, China, Canada, Japan and Singapore. Keck Seng’s main assets are the W San Francisco hotel, the Sofitel hotel in New York, the Sheraton hotel and casino in Ho Chi Minh City and residential real estate in Macau. The company also has a very conservative balance sheet. Using market values, the company compounded at 17% p.a. between 2003/2013. We made our investment at a discount of 85% to Net Asset Value, excluding the excess cash.

Sberbank Rossi PAO:

The fund invested through the London listed ADR’s in the equity of the largest bank of Russia. The opportunity presented itself following President Putin’s 2014 forays into Ukraine and the subsequent international pressure on the Russian Federation. For the record, we are not particularly big fans of financials, mainly for 2 reasons; we avoid leverage and we find bank balance sheets typically too opaque for our fundamental analysis. But the strength of Sberbank’s balance sheet, its exceptional historical profitability, its durable competitive advantages, its very strong management, its long runway of growth and finally a depressed valuation, all contributed to our conviction of investing in a very controversial situation. For the 10-year period to December 2015, Sberbank’s book value per share in Euro terms compounded at 14.3% p.a., despite the financial crisis in 2008 and the current crisis. The Ruble also lost about 58% of its value against the Euro over that period. Sberbank dominates the Russian banking sector with >40% of all deposits and a retail branch network over 10x the size of its nearest competitor, resulting in a significant funding cost advantage. On the lending side the bank focuses on higher quality borrowers. Viewed in a global context Russia remains substantially underbanked, based on the low % of GDP of banking products such as deposits, lending, insurance and credit cards. We believe Sberbank is very well positioned to benefit from this long-term growth potential. We made our first investment in Q1 2014 at 4x trailing earnings and 80% of book value. We subsequently made further investments as the share price declined when the economic situation deteriorated. Griffin Fund’s current country limit for Russia is 4% of AUM at our cost price.

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