During Q3 we sold one of our largest investments, Judges Scientific, as the share price reached our estimate of fair value. At the time of our investment our analysis indicated that Judges’ results were suffering from temporary problems. This analysis has proven to be correct and the operating performance recovered resulting in an attractive return of 106.87% over our 23-month holding period. We hope to own this great business again in the future. The sale of the fund’s holding in Judges Scientific had reduced the capital invested to 45.9%. We’re therefore in a good position to take advantage of the correction that is currently taking place in global equity markets. Since the end of the third quarter three new companies have been added to the portfolio and we are currently building up a fourth one. We are describing two of these new positions in this letter.

Sporton International Inc.

This Taiwan based, Taipei listed company is a rare gem that you probably have never heard of and one we would characterise as an Asian Hidden Champion. Sporton International Inc. (Sporton) operates in the TIC-sector (testing-inspection-certification), an activity we like due to the high barriers to entry and predictable recurring revenue streams of a captive client base. We profiled this industry in the past with our investments in ALS Ltd. and Exova Group Plc. (2016 Q1 letter).

When we arrived at the company for our meeting with management, it quickly became clear that Sporton’s head office was a great example of (not) spending shareholders’ money. From the reject old sofas in the reception area to the low-ceilinged office cubicles with Spartan lighting; it would make Warren Buffett immediately feel at home. All signs of a no-nonsense management style that we place great value on and most certainly doesn't give away the dominant position this company holds. Sporton is active in the field of testing and certification of IT-products. The company holds the global market leader position for international certification and testing of smartphone and wireless communication devices. The smartphone industry is currently in a period of transition between maturing 4G technology and a nascent race to adopt 5G technology. The last waves of technological advances (3G & 4G) allowed Sporton to increase revenue and profit margins and the company expects the same to happen this time. Considering its recent lab capacity expansion in China and the US, we expect this revenue increase to be even bigger than in preceding periods. Testing and inspecting electronic devices is country specific and it is always a legal requirement before they can be sold. Initially, the Federal Communications Commission (FCC) tested all electronic devices sold in the US, but when the market grew, the FCC started to authorise commercial labs to do the testing and certification. Sporton was founded in 1986 and was one of the first labs to be authorised by the FCC. Today, Sporton has the largest market share of US FCC filings for personal communication systems and is the only firm focused on this type of testing and certification. Its main competitors are smaller subsidiaries of much larger companies such as Bureau Veritas, SGS, UL and Intertek. These smaller competitors generally test the lower-end smartphone and Wi-Fi equipment. New entrants face substantial barriers to entry; the testing industry is a capital and technology intensive industry that heavily relies on its engineers and high-tech labs. No new meaningful competitors have entered this industry for over a decade. Sporton generates 90% of its revenue from testing and certification. The balance are sales of EMI shielding components (electro-magnetic interference) which are complementary to the testing business. Testing and certification include compulsory and compliant testing services for electronic devices. Sporton is one of the few companies that can provide both.  The main types of products tested are phones (44%), products such as keyboards, monitors and peripherals (34%) and Internet of Things (22%). The majority of sales are generated in Taiwan and China, which is also where most products are developed and manufactured. Currently, 18% of sales come from the US and Europe. Sporton has a very diverse client base of more than a 1000 customers, with the largest one accounting for less than 5% of sales. We like this part of the TIC-industry because, 1) Electronic devices will always need testing and certification services for EMC (electro-magnetic compatibility) and safety as long as Electro-Magnetic Interference (EMI) exists. EMI is caused by the electric- and magnetic field created when using electronic devices. 2) Safety tests are also required for electronic devices because of risks for electric shocks, energy hazards, fire, mechanical and heat hazards, radiation hazards and chemical hazards. 3) Specific absorption rate (SAR) testing is a mandatory test because of regulation regarding the rate at which energy is absorbed by the human body when exposed to a radiofrequency energy (RF) 4) Telecom carriers will always require wireless devices to be tested to guarantee compatibility with their hardware and software. Because Sporton has earned this leading position in testing services, it participates in the national and international Standard Setting Committees of the communications industry. Sporton has eight service locations in Taiwan, three in China and they recently opened their first lab in the US. Utilization is high with half of the labs running 24/7 on a three shifts system and the rest running on 16 hours per day divided in two shifts. As we mentioned before, most of the manufacturing of electronic devices takes place in China and Taiwan and Sporton’s service stations are located close to their clients’ factories and R&D departments. The main reason for setting up a new lab in San Jose (Silicon Valley) was because the US has become more protective about its technology.  A local US lab allows for cooperation with US clients in such a way that they’re comfortable no confidential information will be leaked. Other than the expected growth of 5G over the recent 4G, mostly due to the complexity in the new technology (and testing), Sporton expects to see a further driver of revenue growth with Internet of Things (IoT) devices and smart cars. Management expects revenue growth of 8-10% p.a. over the medium term. The capacity increase that came online in H2 2018 should further boost revenue growth to over 10% into 2019 and 2020. The current operating margin is 27% and Sporton believes it can increase this to 35% when 5G testing takes off. The company’s CEO & Chairman still owns 27.1% of the business and takes no salary. Additionally, the risk of bad capital allocation is reduced as the company makes no acquisitions and sets a policy of paying out most of the profits through dividends. The dividend pay-out ratio is 79%. Sporton’s share price has been falling in the last 36 months and the fall even accelerated with a 35% drop since the beginning of the year. We see this partly due to the still relatively small quantity of 5G smartphones being certified, combined with a concern of a slowing Chinese economy and an unfriendly trade tariffs environment. The shares trade at 15.2x trailing earnings and at 12.8x net of the excess cash on the balance sheet. The dividend yield is 5.3%. At this valuation, we do not need the company to reach management’s targets to achieve an attractive return. Over the last five- and ten-year periods, revenue grew at approx. 10% p.a. with average operating margins of 29% versus 27% today.

Dream International Ltd

On our way back from Taiwan we made a stopover in Hong Kong and took advantage of our time to revisit a company we had followed briefly but never gave serious thought to as an investment for the fund. A befriended fellow investor had mediated a meeting for us with senior management. Dream International Ltd. (Dream) is a leader in the plush and plastic toy manufacturing industry. We expected this industry to be capital intensive and brutally competitive and therefore of little interest to us. Nevertheless, Dreams’ attractive historical financials and low valuation was intriguing.

We learned that more than 80% of worldwide toy production takes place in China by means of thousands of mostly family-run small businesses. The labour-intensive toy manufacturing industry moved to China in the early nineties, attracted by the lower labour costs. At the time, a factory with 600 workers and 300 sewing machines could be set-up for as little as $200,000 and with a pay-back period of less than one year. In those days, thousands of these toy-manufacturing businesses were created. During the financial crisis, sales of toys declined and the large toy companies increased the pressure on their manufacturers to grant larger discounts and better payment terms. During the years following, labour costs increased substantially in China, further squeezing the toy-manufacturing industry. Today, the retail price of a plush bear is the same as it was in the early nineties. However, over those 20 years labour cost increased 4-5x and the cost of materials is up 2-3x. It should be no surprise that many small business owners in China left the industry, often vanishing overnight in an attempt to avoid having to pay salaries, outstanding bills from suppliers and overdue rents. Today, large toy companies like Mattel and Hasbro are no longer accepting the risk of small counterparties and rely almost exclusively on larger manufacturers like Dream. Competition is also decreasing as more competitors are leaving the industry, a trend Dream expects to continue for several years. Another disruptive moment for the industry was the SARS crisis in 2002, when Dreams’ clients were no longer prepared to travel to China. Dream reacted quickly and decided to diversify its production capacity away from China and start operations in Vietnam. Today, the majority of the company’s production is done in the 14 Vietnam factories with only four left in China. Labour cost accounts for approx. 45% of the total production cost of toys with materials representing 42% and manufacturing overhead 13%. Furthermore, the drive to automation is not as effective as you would expect in plush toys and plastic figures, as often they are manufactured in too small batches for automation to make economic sense. Labour costs in Vietnam are more than 50% lower compared to China, giving Dream a substantial cost advantage compared to their Chinese competitors. In addition, and due to their size, Dream is also able to purchase raw materials at lower prices than their smaller competitors. These developments explain the company’s increased sales and profitability over the years, a trend that is likely to continue for some time. Very few competitors have been able to follow Dreams’ example because they lack the financial resources; whereas a toy factory could be built with $200,000 some 20 years ago, today’s factories need to be substantially larger and require approximately $13ml in capex and working capital to support 1’500 workers. Dream continues to plan for one or two new factories in Vietnam each year in order to grow sales to $700ml by 2021, from the $430ml projected for this year. They also expect to take more business from competitors who are stuck with a higher cost structure, mostly in China. Growing sales should enable the company to diversify its client base further. One negative point in our analysis of Dream is its client concentration. Its largest clients such as Funko (plastic figurines) and Disney Japan account for 26% and 18% of sales respectively. Trade tariffs in the US, on the other hand, could be a positive for Dream as companies that sell toys in the US look to source their products from outside China. Finally, our partners will know we have a preference for owner-operated companies and a conservative balance sheet. Dreams’ Chairman, Mr Choi, set up the company in 1984 and still owns approx. 67% of the shares. The balance sheet is solid with less debt than it has cash. Recently the shares declined on concerns over growth in China and the valuation dropped below 8x trailing after-tax earnings. The cyclical nature of the business, client concentration, and the risk of more intense competition when the consolidation in the industry slows down imply that Dream will never be a high-conviction position for the fund. However, a business with the attractive characteristics we described above merits a 3% allocation in the fund.

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For the quarter ended September 30, 2018, the fund had 10 listed equity positions. The five largest positions in the fund represented 29.32% of assets under management.

Summary of the five largest positions of the fund:

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 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.

Golden Friends Corporation:

GFC is the third largest elevator company in Taiwan with 25% market share. It is the long-standing distributor for high-end Toshiba Elevators in Taiwan. GFC has also established itself under its own GFC brand for the lower-to-middle segments of residential property development. The new chairman has further increased the profile 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%!). Taiwan has an installed base of approximately 230’000 elevators, of which 33’000 are under contract with GFC. We estimate that the maintenance division 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. During the last property boom in the 90’s an estimated 57’000 new elevators were built of which 10’000 are under maintenance contract with GFC. These are now due for modernisation or replacement. GFC can earn higher-margins on these replacements as they are of a technological rather than pure mechanical nature. The maintenance division is also seeing a boost due to the increased regulatory regime for elevators older than 15 years with bi-annual safety checks. 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 3⁄4 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.

Hamilton Thorne Ltd :

U.S.-based Hamilton Thorne Ltd (HTL) is a C$100m company that supplies equipment, software and disposables to In Vitro Fertilisation Labs (IVF), a $1b niche market segment inside the $15b global fertility industry. The fertility market is interesting because it exhibits characteristics of a high-quality industry, combined with long-term demographic growth potential, as the maternal age has increased over the last decennia and couples are increasingly relying on assisted reproductive technology (ART) to fulfil their wish for children. HTL is facing more regulation and increased demands on the medical standards of their product offerings and industry consolidation leads to rising barriers to entry, working as a deterrent to potential competitors from entering into this niche market. In September 2016, HTL made the first of two transforming acquisitions by buying US-based Embryotech Labs, a provider of medical device toxicology testing services for less than 5x EBITDA. This business has low capital requirements and very sticky customers. Then, in the spring of 2017, they made a second acquisition to enlarge the IVF portfolio by purchasing Gynemed GmbH. A German company that manufactures and distributes consumables for the IVF labs, most importantly the cell culture media. Gynemed is known in the industry for producing the best cell culture with a shelf life double that of the competition. Gynemed supplies 98,5% of all fertility labs in Germany, Switzerland and Austria. This is also a low capex, high margin business (+75% gross) and has very loyal customers. IVF labs that use cell culture media in their certified processes rarely switch suppliers because this requires the whole process to be re-certified. HTL’s market is expected to grow at 5-10%. The introduction of new products, cross-selling opportunities from the acquired businesses and gaining market-share from smaller and less competitive companies should allow HTL to grow organically at 10% or more for many years to come. We estimate that we bought into the new HTL at 12x forward EBITDA. HTL’s only listed peer is (the much larger) Vitrolife AB, trading for 32x EBITDA.

Sberbank Rossi PAO:

The fund invested through the London-listed ADR’s in the equity of the largest bank in 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 two 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, it’s very strong management, its long runway for 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 Ukraine 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 the higher quality borrowers. Viewed in a global context Russia remains substantially underbanked, based on the low percentage of GDP for banking products such as deposits, lending, insurance products 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 cost.