When we opened the fund to external investment partners, we shared our views on the characteristics of companies we consider for the portfolio. We believe this is of such importance that we don't mind repeating them. We listed them as follows:

1. Predictable sales and a long runway for growth
2. Sustainable, high operating margins as a result of a durable competitive advantage
3. High returns on incremental invested capital
4. A strong balance sheet
5. Management with a good track record as both operators and capital allocators and a strong alignment with shareholders
6. A share price that allows for a target return of 15% p.a. under conservative assumptions

Good investments have been very hard to find this year. We did find a few new companies that would confidently clear the first few hurdles of our list, only to fail on the last point: valuation. This meant our watch-list of potential candidates became larger, but our discipline refrained us from buying into these companies at market prices we believe would offer us returns too low for the risk taken. We are however confident that our work will bear fruit at some point in the future. Readers of our letters know we assume nothing when it comes to macro-economics, and we avoid making predictions for when such time will arrive. All we can deduct from the hundreds of companies we analyse, is that today global investors are prepared to assume a lot of risk for very little reward by owning investment assets at current market prices. However, earlier this year we started analysing a company that caught our curiosity and by the third quarter we were confident enough to become shareholders. This great company goes by the unassuming name of Golden Friends Corporation (GFC) and is listed on the Taiwan Stock Exchange in Taipei. GFC is the third largest elevator manufacturing company in Taiwan and is also the exclusive distributor for global elevator company Toshiba.

Recurring revenues

We like companies with recurring revenues, but not all recurring revenues are equal. For example, the industry of aviation engine manufacturers is frequently associated with high quality recurring revenues because once the airplane is bought, the customer is then retained for a lifespan of high fee-generating maintenance & spare-parts contracts in a strictly regulated flight safety environment. But, we have so far passed on these companies when they presented themselves, even at fair prices. We reckon that the aviation engine industry will require years of highly capital-intensive R&D without certitude that the new airplane model will be able to generate enough revenue to recoup the development capex. High initial design expenditures, opacity of which engine type will be the new best seller, cyclicality of oil prices influencing new airplane orders & availability of financing, all add too much risk to the business of selling aviation engines. Recurring revenues are also to be found in the elevator industry. Here they work on similar dynamics of selling a new product, followed by years of maintenance and upgrades to keep up with ever increasing safety regulation. Selling elevators seems a safer business. In the elevator industry, manufacturers generally do not sell products at a loss in the hope of gaining customer business and recouping the initial outlay through means of profitable maintenance contracts. Indeed, except for mainland China, where cut-throat competition and loosely enforced regulation make the elevator business a loss-making venture, we are not aware of any other country where the elevator industry is not a profitable one.

Elevators

The global elevator industry is so woven into the fabric of daily life, that we hardly notice their presence unless they malfunction. Technological progress has over the years smoothened the ride, but the basic elements of a metal cage being hoisted by cables are still present today as they were over a 160 years ago at invention. The industry is consolidated with Otis Elevators (USA), Schindler (Switzerland), ThyssenKrupp (Germany) and KONE (Finland) taking up 70% of the global market between them. Elevators are a one-time sell item, with a lifetime service contract. After the sale, typically more than 90% of buyers of elevators prefer to entrust the maintenance contract to the original manufacturer. Like for other forms of transport that can inflict harm to humans, these maintenance contracts are not optional. Indeed, the non-discretionary maintenance contract, when well executed, looks like a high-margin, multi-decade annuity for the elevator companies. These profits grow with every additional maintenance contract and are recession proof. The elevator industry also benefits from a strict regulatory environment, which we safely can say is steadily increasing; this in contrast, for example to regulation in the banking industry, which seems to move like a pendulum over the economic cycles and crises. The elevator industry also supports high returns on capital aided by the above characteristics and the upfront payment for maintenance. All these elements, predictable and growing revenues, high operating margins and attractive returns on capital, seem to point to a high-quality industry, which at the right price, we would like to own in our portfolio. Today however, investors large and small are prepared to own elevator companies at prices far above our valuation threshold; in fact, the characteristics of this industry are so well recognised that they trade closer to 25x~30x their earnings. But unlike most investors, our fund is nimble and has a mandate to look where most cannot. The challenge was to look for smaller locally listed elevator companies that show the same characteristics but at prices we find attractive.

Golden Friends Corporation

Our latest investment is a Taiwanese company founded in 1974. The company is currently chaired by Tang Bo Long, who took over in 2015 from his father, founder Tang Song Zhang. GFC is the third largest elevator company in Taiwan with 25% market share, on par with Mitsubishi Elevator, and just below market leader Yungtay Engineering which has 30% market share. If it wasn't for its loss-making Chinese activities, Yungtay Engineering would also have been an interesting company for the portfolio. Aside from being the long-standing distributor for high-end Toshiba Elevators in Taiwan, GFC has also established itself under its own brand for the lower-to-middle segments of residential property development. One of the promising initiatives of the new chairman has been to increase the profile of GFC’s in-house brand and bid with their top-of-the-range ‘Genesis’ models for higher margin projects in commercial property developments. In a declining Taiwanese real estate market, the focus on selling more expensive, high-end elevators helped stabilise revenues in 2016 (while new unit sales had dropped 30 percent!). On the maintenance side, Taiwan has an installed base of approximately 230’000 elevators, of which 33’000 are under contract with GFC. The company manages to convert new-sales into yearly maintenance contracts at a rate of 80%~90%. We estimate that today the maintenance division already represents 66% of GFC’s profits. This is an important indicator for the stability of earnings, as the more profit is derived from maintenance, the less they are susceptible to new unit sales in a fluctuating real estate market. Another factor which made the investment case more interesting was the large number of elevators that were built during the last property boom, some 20 years ago. These elevators estimated to number 57’000, of which 10’000 are under maintenance contract with GFC, are now all due for modernisation or replacement. GFC can earn higher-margins on these replacements as they are of a technological nature, like circuit boards, rather than on mechanical items, like lift cages. Last year, the Taiwan Ministry of Interior also increased the regulatory regime for elevators older than 15 years with bi-annual safety checks, which will contribute to a steady growth of maintenance revenues going forward. From a balance sheet perspective, GFC has low working capital requirement as inventory and trade receivables are offset by new order deposits and regular upfront payments from maintenance contracts. The company has paid out more than ¾ of free cash flow as dividends, since going public in 1997. At our purchase price, we valued the company at 9.3x EV/EBIT or a P/E of 12.6.  

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For the quarter ended September 30, 2017, the fund had 13 listed equity positions. The five largest positions in the fund represented 30.57% of assets under management.

Summary of the five largest positions of the fund:

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 had 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 from each other. 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.

Judges Scientific plc:

Judges Scientific (JDG) is listed on AIM, a sub-market of the London Stock Exchange and home to smaller companies with less regulatory burden than the main market. JDG specialises in the acquisition and development of a portfolio of scientific instrument businesses. JDG designs, assembles and sells high quality scientific instruments with a focus on material sciences and vacuum environments. JDG generates sales of approx. £56m; 60% from universities, 10% from testing firms and the rest from a diverse group of researchers with pharma, biotech, commercial and industrial backgrounds. More than 80% of sales are exported. Whilst most of the company's products have a long lifecycle, many of these products are sold into diverse markets and into different countries. The businesses share the following characteristics: sustainable profits and cash flows, high operating margins, high returns on capital, high and stable market shares in small niches, high fixed costs (mostly specialised personnel, many PhD’s), low capital requirements and asset light. Since its IPO in 2005 it generated a total return to shareholders of approx. 28% per annum over the 12-year period. When the company came with two negative trading updates to announce poor operating results for reasons we believe to be of temporary nature, the share price declined to a level we found attractive.

C.Uyemura & Co Ltd.:

The company is active in a niche market of the Electroplating Chemicals Industry and is not particularly small (market capitalisation = ¥53b~US$484m) but does a great job of hiding itself. The company is listed on the Second Section of the Tokyo Stock Exchange, usually reserved for small caps with extreme low transaction volumes. Although the company has a 20-year history of growth and profitability, they never made an effort to get onto the First Section of the Tokyo Stock Exchange, unlike their two main Japanese competitors (JCU & MEC). Whilst the industry is consolidating and at best growing in the single digits, it has very high barriers to entry. The industry has seen no new players for several decades due to product complexity, know-how, customer service capabilities and reputation. There are only a small dozen companies active in this space. The three largest making out 60% of the market and Uyemura, together with three Japanese players have about 20% market share. Electroplating Chemicals are an attractive niche in the surface treatment industry and an important component in the production of printed circuit boards. Whilst the process is critical in the production of mainly mobile phones, PC’s and car electronics, the expense to the client is small in comparison to its overall manufacturing cost. This is a balance we like to see because rational customers don’t act penny wise and pound foolish on the small but critical components of their end-products. Uyemura is either a supplier or sub-supplier to most smartphones including iPhones and also for example for Toyota Motors in the car industry. Even in an environment of slowing demand for mobile phones does Uyemura manage to keep margins high because of the higher specification requirements in the latest smartphones like the iPhone 8, X and future iterations. This business has a very high customer retention rate, is asset-light, operates with high margins and has limited need of extra capital and thus is generating lots of cash. At our purchase price, the company’s market capitalisation is 2/3 covered by cash and 4/5 covered by cash + owned real estate. These excess assets give us good downside protection. The Uyemura family still owns 25% of the company. If we back out net cash & real estate, then we are paying 1.3x EV/EBITDA. We believe this is a very cheap valuation for a good company with a long history of profitability, a stable market share in an industry with very high barriers to entry and the other characteristics we described above.