The third quarter of 2016 was noticeably less volatile. Post-Brexit and pre-US elections, most developed markets traded up in anticipation of US Fed rate increases and extended ECB asset purchase programs. We watched our current portfolio companies rebound with the market and hardly did any transactions. Towards the end of the quarter, we found two new companies that fitted our investment criteria. We look forward to profiling them once the right position size has been achieved in the portfolio. During the quarter, we also parted with a company we had already briefly described as one of our top five positions and which we will now discuss in more detail.

STI Education Systems Holdings Inc.

As we explained in our initial letter, we invest with a broad mandate to look for value worldwide. This particular investment took us to the Philippines. We had learned about STI a good year before the price dropped to a level we were comfortable to make an investment. STI is short for System Technology Institute and is active in the business of private education in the Philippines. The Philippines are a developing country of 100ml people with a per capita GDP of less than US $ 3’000 and 7.1% unemployment. More than 50 percent of Filipinos are under the age of 30 and youth unemployment is high at 16.4%[2].

STI did a great job in capturing the demographic demand created by an increasingly younger population looking for basic employment. Tertiary education at STI offers practical job-specific education, which in turn creates opportunity for the low-to-middle-income group of the population.

STI is the holding company for 3 entities: 1/ STI Education Services Group: this is the largest part of the group and comprises the fastest growing, tertiary education provider in the Philippines. 2/ West Negros University; a recently acquired private university. 3/ a 20% minority stake in a pre-need insurance company called PhilPlans, which STI bought from AIG in 2009 and is part of a growth plan to attract future students who bought a pre-need insurance contract that would cover the STI tuition fee.

STI was founded in 1983 as an IT school by former IBM executives. In 2002, Eusebio Tanco, a passive shareholder at the time, bought out the founders and partnered with Monico Jacob to run the company. Mr Tanco & Mr Jacob are experienced businessmen with a good track record of value creation for shareholders in the Philippines.

STI’s focus is on the for-profit tertiary education, more specifically the vocational degrees. Students graduating from STI are well-trained to join prominent companies, like for example Starbucks, Denso or Infosys. We need to mention that STI doesn't necessarily qualify within the top colleges in the Philippines, but a competitively priced tuition fee between $1’000 and $3’000 for respectively the two year (20% of enrolment) and four year (80% of enrolment) programs, together with these recruiter companies’ prominence, has created a solid national brand name. STI has seen its student enrolment steadily increase over recent years, from 66’000 in 2011 to +90’000 in 2015, and it now operates more than 85 campuses, both directly owned and through a franchise model.

Up until 2011, the compulsory education system in the Philippines had been unchanged since it was first introduced in 1945. It consisted of a ten year program; six elementary and four junior high school education. You will notice the absence of Kindergarten and two senior high school years. This meant that students went from grade 10 straight into higher education, whether it being for a vocational degree or a university degree. To lift the Philippines onto the global standard of education, new rules known as K-12, were voted into Law in 2011 & 2013. The purpose was to introduce one Kindergarten and two senior high school years to the old curriculum starting in the 2016-2017 academic year (which incidentally runs from June to March). The potential impact of the new Law on higher education providers was severe, with no new students for two academic years, and a disrupted student intake pattern for a total of five academic years.

Whilst these upcoming changes were well documented in advance, they created a lot of uncertainty. During the run-up to the changeover it became clear that introducing grade 11 & 12 would also put a lot of strain on the government to build the extra classrooms and hire more high-school teachers. The government and for-profit education companies combined their efforts and found a middle-road solution to handle the excess capacity created by the vacuum of the introduction of K-12. Filipino students entering grade 11 are now given a choice; they can join a public school or use a voucher of certain value towards attending a private institution that offers grade 11 & 12. STI’s response to the new Law was to provide and aggressively market grade 11 & 12 and increase student numbers to compensate for the lower fees they could charge high-schoolers compared to tertiary education students.

STI was the first non-government school to be awarded the grade 11 & 12 licenses but the results of their efforts were unknown until just a few weeks ago when the company released quarterly earnings for the period including the new schoolyear intake.

STI is listed on the Philippine Stock Exchange and had a market capitalisation equivalent of €97ml at the time of our investment in 2015. We paid less than 6x trailing after-tax earnings and excluding the excess assets, less than 4x earnings. It was our view that the companies’ earnings at that time were a conservative estimate of the earnings power once the impact of K-12 would have worked its way through the next five years. We estimated that under normal market conditions, STI deserved a P/E multiple of at least 12x, implying a potential 100% increase from our investment cost. This would result in an annualised return of 15% p.a. over a five-year period.

Our downside was protected by a strong balance sheet in addition to the real estate owned by the company that, at cost and at market value, was worth double our investment. Our analysis concluded that even a negative scenario, where the company could not compensate for the anticipated revenue loss arising from K-12, would most likely result in an attractive investment if we had time to wait until the negative effects of K-12 had disappeared.

As it turned out we didn’t have to wait long, as the share price increased substantially in the last few months. We exited the investment when our potential future return under the above assumptions dropped below 8%, realising gains of 58% in little more than a year. But shortly after we had sold, STI announced a large increase in student enrolment figures and the share price increased even further. Although it hurts us to see the gains we missed out on, we take comfort from our conviction that an investment at the price we sold at required a successful execution of the increase in the company’s student numbers to generate the type of returns we target. The investment at our exit price became speculative, relying on this most optimistic outcome. It’s important to mention again that we try to pursue investments that are safe with the potential for attractive returns under conservative - not speculative - assumptions.

In our previous letters, we described the characteristics of the high-quality companies we prefer to invest in. STI is a business of decent quality, but it does not meet all those criteria. Very high-quality companies are scarcely available at prices that offer us a potential return of 15% p.a. under conservative assumptions. We therefore also consider other investment opportunities. High-quality companies offer us downside protection through the high level of predictable profits they generate relative to the amount of capital required. But downside protection can also result from the value of safe assets relative to the price we pay for the company. In the case of STI, we found a set of exceptional circumstances that had severely influenced the company’s share price and allowed for us to make a safe investment with high asset coverage and a high return potential.

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For the quarter ended September 30, 2016, the fund had 16 listed equity positions. The five largest positions in the fund represented 34.57% of assets under management.

Summary of the five largest positions of the fund:

ALS Ltd:  

ALS Ltd is based in Brisbane, Australia. Most local (retail) shareholders still regard this company as the premier minerals testing business it used to be known for. Minerals testing is an oligopoly of three with SGS and Bureau Veritas (BV) competing with ALS. Historically, SGS and BV had a less cyclical business mix and more fixed costs. But ALS started as a minerals tester and developed a unique hub and spoke model. The hub being the centralised lab with highly specialised engineers and the spokes accounting for basic sample extraction and tagging.  During a down cycle, it allows the company to keep the volumes of testing in the hub at a sufficient level, while reducing the cost structure of the spokes. This key difference explains why ALS can still generate 20% operating margins in a down cycle when its two competitors are break-even or even loss-making in their minerals divisions.  We therefore like ALS' position despite this business being cyclical. Additionally, the company recently made an untimely acquisition in the Oil & Gas industry at the top of the cycle, (which it is now exiting). With the commodity recession hitting both the Minerals and Oil & Gas divisions, the share price got decimated by more than 70% from the peak. What investors missed was that the company had been expanding in other TIC areas and their global Life Sciences’ division now accounts for 63% of current EBIT. ALS has an attractive market position in Life Sciences; a non-cyclical business with attractive growth prospects. We invested in the company just after a retail equity capital raise at 8x EBITDA or 10x our estimate of normalized after-tax earnings.

Baidu Inc.:

This company is listed on Nasdaq and is known as the ‘Google of China’. Founded in 2000 it had a 70% market share by the time Google decided to leave the country due to too strict government regulations. Today Baidu is still the dominant search engine in China with 80% market share; its sales growth is more than 30% per year; it has a 50% operating margin and generates 300% return on capital. Growth in online advertising should offer Baidu a long runway for success despite competition from other Chinese internet giants such as Alibaba and Tencent. More recently we identified three 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. Finally, recently declining operating margins and poor visibility on the quality of the underlying growth businesses. We believe Baidu can continue to grow revenue significantly, even if the Chinese economy grows at a slower pace than it used to. Our analysis into the declining operating margins reveals that they have been stable in ‘search’ at around 50% over the years, despite spending 15% of sales on R&D, but they were mostly impacted by their new ventures. Recent developments also provided us with more transparency on the value of these sets of businesses that have been clouding the operating margins in ‘search’. For example, in exchange for its online travel business, Baidu received a 24% stake in Nasdaq-listed Ctrip worth more than $4.5bln. Furthermore, Robin Li, the founder-CEO, made a buyout offer of $2.8bln for iQiyi, the video streaming service (think a crossover between YouTube and Netflix). A bid he felt compelled to withdraw because it was deemed too low by minority shareholders. For our analysis, we started by using the above valuations for these two businesses (Ctrip & iQiyi). We then gave nil value to the O2O (online-to-offline) businesses. 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 described.

Boustead Singapore Ltd:

This Singapore-based company is a conglomerate of three quality businesses, which are fundamentally different. The underlying divisions simultaneously went through headwinds, which allowed us to invest at an attractive valuation. Boustead Singapore consists of the following three businesses: 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 three 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:

We purchased this Koblenz-based medical software vendor at approx. 8x cash earnings. It was one of the first investments of the fund. 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. Despite a strong increase of the share price we maintained a substantial position because we got more comfortable with a German initiative that was recently turned into Law. It will further connect all the public health stakeholders with compatible software. Compugroup, being a leader in this field, was part of the government development initiative and once implemented, we believe the company will secure years of sustainable growth.

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.