In 2018, global equity markets posted negative returns (MSCI ACWI -8,93%) and GVF was down 3.13%. This is the first negative annual result since starting the fund in 2011. Our time horizon to achieve a high compounding rate of return stretches over many years and we therefore accept to suffer occasional results as in 2018. Our goal is to invest in companies that meet our quality criteria when our analysis indicates a potential return of 15% and we exit the company when our expected return drops below 8%. When our portfolio ‘matures’ and the valuation of our combined portfolio companies increases, the expected returns inevitably drop. When viewed like this, our portfolio at the start of 2018 was rather ‘mature’ but we believe that our current portfolio sits at the opposite end of that spectrum. The fund’s cash position has been declining and we made several new investments with high expected returns. In addition, the share prices of our existing portfolio companies declined with the market correction, generally without a decline in the estimated intrinsic value, thereby increasing our expected return. Together these developments have contributed to our confidence in the attractive risk-reward of the current portfolio and we are personally adding capital to our investment. For investors who are considering an investment in the fund, now might be a good time to join us.

Cash

On several occasions in the past, we have made the case that holding cash has the benefit of lowering risk, without necessarily detracting from long-term performance. We are now reaping the benefits of not being fully invested in a down market and having cash to pick up shares at more attractive valuations. Last year, certain investments reached our estimate of intrinsic value and the cash position increased to 54% of assets under management. But during the correction in the latter half of the year, we have taken advantage of the lower valuations and have since reinvested 19% of AUM.

Competitive Advantages

GVF has had investments in Europe and in the US but also in places like Hong Kong and Taiwan. The fund can own shares in large companies but predominantly holds smaller capitalisation stocks, which are not liquid enough for large institutional investors. The ability to invest with a long-term perspective in a market focused on short-term earnings results, the flexibility to stay in cash when attractive opportunities are scarce and the ability to pursue opportunities irrespective of geography and company size, are very important competitive advantages of the fund. Companies with sustainable competitive advantages can sustain superior returns on capital. The same is true for investment funds.

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During the quarter we added to five new positions. We already described Dream and Sporton in our previous letter. One new position is still relatively small, and we hope to add more on price weakness in the future. We will describe the remaining two new positions below, followed by the fund’s five largest investments, which have been updated.

Volution Group PLC

Volution Group PLC (Volution) is a leading supplier of ventilation products to the residential and commercial construction industries in the UK, the Nordics, Central Europe and Australasia. Ventilation is an attractive niche in the building products industry and benefits from significant barriers to entry. The ‘friendly middleman’ concept applies to this business as the end-customer is typically not choosing the brand of his ventilation products. In practice, this decision is usually made for the customer, either by the contractor or the architect. These ‘friendly middlemen’ generally pass the cost through to the end customer and prioritize easy-to-install, reliable and familiar products that can be delivered quickly. These characteristics prevail over decisions on pricing. Additionally, the cost of most items is low compared to the cost of labour and the overall project cost. Prices for individual products range from a few pounds to about a £1’000 for the most expensive commercial heat-recovery ventilation element. Volution has a portfolio of long-established brands and guarantees fast delivery of thousands of different products through its distribution networks. The company benefits from scale advantages and can organise this at a low cost. It generates just under half of its revenue in the UK, with a 50% market share in residential RMI (Renovation, Maintenance & Improvement), 40% in residential new-build and 20-25% in commercial buildings. In Sweden, their market share in residential RMI is over 70% and in most of their other markets Volution is top 3 with a market share of 20-25%. Volution generates more than 50% of their revenue in markets where they are much larger than their number two competitor. Would-be competitors are also deterred by the depth of the product range required to be competitive. For example, Volution offers more than 10’000 SKU’s (Stock Keeping Units) in the UK RMI market alone. It makes little sense for a distributor to source products from smaller ventilation brands that offer cheaper products but only have a fraction of Volution’s product catalogue. The ventilation market in Europe is typically fragmented and consists of many companies of varying size and scope. Volution’s geographical markets are generally characterized by the predominance of established domestic companies with local brand portfolios and niche applications. The concentration of local participants is to a large extent a consequence of loyalty to familiar products, brand awareness and reputation. Other factors are the significant time and effort required to establish strong sales teams and distribution channels, and to comply with local regulatory requirements. Once a brand has strong local presence, it becomes difficult for competitors to displace it. In a market with dominant local brands, growing by acquiring competitors makes more sense, which is why Volution decided to expand outside the UK through acquisitions. Once integrated, they continue to operate under the acquired brand names in the local market.

The demand for their products is a function of activity in construction markets, both new-build and refurbishment. Regulation and consumer trends have been a tailwind for the demand of Volution’s products. Stricter building regulations have resulted in a shift towards air-tight buildings, resulting in increased use of Volution’s higher margin value-added systems and other more environmentally friendly solutions. Today, we see a clear step-up from the standard unitary fans we are all too familiar with, to a need for improved indoor air quality. There is also a continuing shift in customer preference for quieter and more aesthetically pleasing fans that in addition offer better energy efficiency. These come with a higher selling price and profitability.

CEO Ronnie George owns 2.8% of the company and approx. 50% of his compensation is performance linked. We see current management as good operators and good capital allocators based on high operating margins and EPS growth, achieved with a conservative balance sheet. The stock had declined 33% from its peak, driven by general negative market sentiment and concerns over Brexit in particular. At 9x our estimate of current-year after-tax earnings, the valuation is attractive for a well-managed company with a strong market position in a niche with regulatory tailwind; a consistently strong cash flow generator with good prospects for both organic and inorganic growth. Historic organic growth was 3% despite being depressed by the decline of the UK public RMI business, a headwind that is likely to disappear over time. Management is focused on continuing its strategy of growth through acquisitions and it has the financial means to take advantage of the large opportunity-set in a fragmented ventilation market. Operating margins have the potential to improve as the company keeps growing and higher margin products become a larger part of the business mix. Management is confident that it can improve the returns of the lower margin businesses it acquires. The high margin UK public RMI business is now bottoming out and has become a smaller piece of the business mix. Cost overruns on establishing a new assembly facility in Reading (UK) also had a negative impact on profit margins for 2018. Management expects this to be completed by the summer of 2019, which should eliminate a major drag from the 2018 performance. We made Volution a 5% position for the fund.

Premier Technical Services Group PLC

Similar to Volution, Premier Technical Services Group PLC (PTSG) is a company that we have been following for a while now. Thanks to recent share price weakness, we were able to acquire a large position for the fund. PTSG is active in some lucrative niches within the industry of facilities management, an industry that didn't look very interesting to us at first glance. It provides a host of specialist safety-related facility services in the UK with strong market positions in installation, testing and maintenance of (a) access and safety systems for working safely at heights, including cradles attached to buildings and fall-arrest systems. (b) electrical systems, including lightning and surge protection systems and fixed wire testing & (c) fire-related hardware (sprinklers, fire extinguishers, fire alarm systems & dry risers i.e. the pipe systems firefighters use for water supply).

PTSG was founded in 2007 by industry veterans John Foley and Paul Teasdale, still today’s Chairman and CEO. Mr. Teasdale founded TASS, an access and safety business, in 1999 and sold the business seven years later to Maclellan Ltd, a larger company from the same sector. Mr. Foley was CEO of Maclellan at that time and had successfully turned it around from a loss-making company with 5ml in revenue to a profitable, 250ml revenue business, albeit with thin margins. After Maclellan was acquired by Interserve PLC, John and Paul decided to team up and founded PTSG, with the purpose of building the UK’s leading niche specialist services provider through a combination of organic growth and acquisitions. Together with two other founding members, they pooled £900k in starting capital to acquire National Cradle Maintenance Ltd., their entry-ticket in the access and safety business. From here onwards, the company’s history reads like a how-to-do ‘buy-and-build’ strategy. Firstly, they expanded the services and geographic reach of their access and safety business through additional acquisitions. Secondly, they entered electrical services by acquiring Thor Lightning Protection Ltd. for a symbolic pound and turned it around during its acquisition year into a profitable business through cross-selling and operational improvements. PTSG further expanded electrical services by adding four tuck-in acquisitions and one electrical services company that broadened their offering beyond lightning protection. In total PTSG acquired 12 companies on very attractive terms, funded through internally generated cash flow and debt, before it raised new capital through an IPO in 2015. Instead of turning to private equity groups for an Owner’s Buy-Out, management floated the company on the London Stock Exchange (AIM) to fund further acquisitions. They returned to the stock market to raise additional capital for acquisitions on two occasions, the last of which was in October 2018 at a share price of 157p. Today, the company has executed 27 acquisitions and integrations and has become the market leader in most of its services activities. It has 133 industry accreditations and services 20’000 customers across 180’000 properties with no customer concentration > 3%. The company estimates its market share between 5% and 12%, depending on the activity, in a very fragmented market that is growing 6-7% p.a. supported by increased regulation. A growing market in addition to market share gains and a successful acquisition strategy resulted in EPS growth at 28% p.a. over the past 5 years.

The company’s focus on testing and maintenance has led to strong recurring revenues. Regulatory bodies require property owners to arrange for safety-related inspections on a regular basis. Seventy percent of PTSG’s gross profit is derived from inspection and repair/maintenance; activities that are mandatory and recurring and therefore should be recession-proof. The balance comes from new build installation and is more cyclical. PTSG offers a compelling value proposition to its - mostly blue-chip - customers, as shown by an industry leading 88% customer retention rate. On top of being price competitive, PTSG is active nation-wide and acts as a single point of service for customers wishing to rationalise the number of service providers. Competition is made up of smaller local players lacking the scale, breadth of services and geographic coverage to compete effectively. PTSG is first-and-foremost a people’s business; staff costs amount to 45% of revenues. The key to high profitability is high engineer utilisation levels through density of the contracted work. The group has 31 office locations across the UK - including the Castleford headquarters - from which it deploys service engineers to client sites. By having engineers close to customer sites, PTSG reduces travel time and cost and increases the number of jobs that can be serviced. This enables high service levels at competitive pricing. It’s also a selling point to attract skilled engineers - which unsurprisingly are in high demand - as they can work close to home. The company’s add-on acquisitions strengthen this competitive advantage. The beauty of PTSG’s business model is that, due to the small-ticket size of a typical maintenance visit, competitors are largely focused on the big-ticket installation business. This allows PTSG to service not only its own installed base but introduce a differentiated after-market offering that can pick up share by servicing the installed base of its competitors. Another important component of PTSG’s efficiency is its internally developed ERP/CRM software called Clarity and which is used to schedule, monitor, certify and invoice jobs and provide a workflow audit trail. Additionally, it features a secure client portal, where clients can download invoices and get an overview of the work undertaken, including certification records, in real time. Smaller competitors typically lack this type of technology and associated benefits in efficiency and customer service. We believe PTSG can continue to generate significant shareholder value through organic growth, cross-selling and through complementary acquisitions. The company is the largest player in most of its business lines but still has less than 12% share in each of its principal markets. Management has identified a large pipeline of attractive acquisition targets in existing and adjacent markets to continue its strategy of acquiring, integrating, cross-selling and increasing efficiency. Its track record of successful acquisitions and integrations also helps to convince companies to sell their businesses to PTSG. Typically, owner-managers are interested in playing a part in the enlarged business and PTSG has the ability to negotiate a smaller up-front price with a greater portion in deferred compensation depending on achieving growth and profitability targets by capitalising on PTSG’s existing infrastructure and customer base. The current stock price values the company at below 10x current-year adjusted after-tax earnings and we have taken advantage of the price decline to increase our position.  This is an attractive valuation for a very profitable, recession-resistant business that has grown EPS at 28% p.a. over the past five years and has many years of profitable growth potential ahead. We believe we are well aligned with management, which still owns over 40% of the shares and we made PTSG our third largest position.

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For the quarter ended December 31, 2018, the fund had 15 listed equity positions. The five largest positions in the fund represented 30.16% of assets under management.

Summary of the five largest positions of the fund:

Boustead Singapore Ltd (BP 5,88% and BS 4,35%):

We own both the holding company, Boustead Singapore, and its 51% owned real-estate entity, Boustead Projects (together Boustead). During the year we increased the position to make it the fund’s largest holding with a combined weighting of approx. 10%. The key value driver is a portfolio of industrial properties in Singapore and an asset-light design & build business in the construction industry. After a few years of price declines, the property market in Singapore has been stabilising and Boustead recently announced a record order book including design & build as well as design & build-to-lease projects. This bodes well for future profits for Boustead and ensures that the portfolio of investment properties will soon reach the critical size required for Boustead to launch its own REIT. Today, Singapore REITs trade close to Net Asset Value thereby valuing the underlying properties at the appraised market value. Based on our analysis the share prices of Boustead Projects and Boustead Singapore imply a discount of more than 50% on the appraised market value of their property portfolio thereby offering both downside protection and substantial upside if management can execute its strategy and launch a REIT. Recent developments and a tripling of the order book increased our confidence in a successful outcome.  

Compugroup Medical AG (4,41%):

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 its markets. 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 authorities to control 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 connectivity 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 is now in the phase of implementation. We believe the company will secure years of sustainable growth.

Golden Friends Corporation (4,48%):

GFC is the third largest elevator company in Taiwan with a 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 a pure mechanical nature. The maintenance division is also seeing a boost due to the imposed bi-annual safety checks for elevators older than 15 years. 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 (4,52%):

U.S.-based Hamilton Thorne Ltd (HTL) is a C$100ml company that supplies equipment, software and disposables to In Vitro Fertilisation Labs (IVF), a $1bn niche market segment inside the $15bn 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 the industry consolidation has led to rising barriers to entry. This has worked well as a deterrent to potential competitors from entering 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. In 2017, they made a second acquisition by purchasing Gynemed GmbH, a German company that manufactures and distributes consumables for 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. It is 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% annually. 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.

Sporton International Inc. (6,52%):

Sporton holds the global market leader position for international certification and testing of smartphone and wireless communication devices. Testing and certification includes 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 smartphones (44%), products such as keyboards, monitors and peripherals (34%) and Internet of Things (22%). Most sales are generated in Taiwan and China, which is also where most products are developed and manufactured for the global market. Sporton also 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 established 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. 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 around. 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% in 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 suffering from poor market sentiment. 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. We purchased shares at 15.2x trailing earnings or at 12.8x net of the excess cash on the balance sheet. The dividend yield is also attractive at 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.