"…the only incontrovertible evidence that the past offers about the financial markets is that they will surprise us in the future. The corollary to this historical law is that the future will most brutally surprise those who are the most certain they understand it." Jason Zweig in the WSJ (06/01/2021)

As we've described in our H1 letter, we took advantage of the increased volatility in equity markets to add new companies to our portfolio and to increase stakes in some existing positions at cheaper levels. These decisions have been responsible for our positive performance this past year. Without these actions, the portfolio would have ended the year approximately flat. We always manage the fund taking into account unexpected situations will happen. This translates into the type of businesses we buy, the prices we pay and how much capital we are prepared to put at risk in any one company. Based on the operating results of our portfolio companies, we believe our strategy has worked well in a year where coronavirus had an enormous impact on our lives & the ensuing economic activity. In this letter we’ll describe how the crisis affected the portfolio companies and share our rationale behind the new investment decisions we took in 2020.

Almost a year into this crisis, we expect no significant impact on the earnings power of the vast majority of our companies. Operating results are encouraging and share prices have recovered quickly from the market lows seen in March. Over the year, only two investments had a meaningful negative performance contribution (>1%): Costain -2.3% and Shinoken -1.2% [2]. Our concerns with Costain date from before the pandemic. We refer to our previous letter for a detailed explanation of what went wrong. For Shinoken however, our investment case is still on course and it remains a large position for the Fund. The share price initially dropped substantially on little news and was still -14% lower at year-end on lower profits, as the mortgage approvals and sale of new apartments were disrupted by COVID-19 containment measures. Overall, currencies also had a negative effect on performance for the portfolio as most currencies depreciated against the Euro.

On the flip-side: over the year, the following seven investments had a positive performance contribution of more than +1% for the Fund: Thinking Electronic (+6.3%), Softbrain (+3.5%), Volution (+1.8%), Hamilton Thorne (+1.6%), Tyman (+1.5%), Sporton (+1.4%) and PSG/Capitec (+1.2%) [2].

New investments 

The initial sharp declines in equity prices offered the Fund the opportunity to increase investments in some existing holdings. As mentioned in our H1 letter, we were able to materially increase our stake in Thinking Electronic, a global leader for thermistors and varistors. We had visited the company in 2018 but at that time had not been able to establish a meaningful position as the share price had increased rapidly. The lows in March of 2020 allowed us to establish a 6.5% position for the Fund. The company’s relentless focus on operating improvements and high margin niche applications resulted in record earnings and the stock price more than doubled from our purchase price. This prompted us to sell half of our holding in October as the valuation no longer warranted a full position.

During the year capital invested increased from 66% to a historical high of 84%. Altogether, we added five new investments of which we’ll discuss three in more detail.

Delfi Ltd.

As much as we like Belgian chocolates, we have found a new appreciation for the Indonesian variety this summer, when we invested in Delfi Ltd. Delfi is a second-generation family business in chocolate confectionary located in South-East Asia. The company has been a market leader in Indonesia for decades, with a market share of 40-50%. Today, over half of the shares are still in the hands of the Chuang family.

Founded in the 1950s, the company owns a number of popular brands, including “SilverQueen”, which is synonymous with chocolate for many Indonesians. In the early days, former President Sukarno did not allow foreign competitors in most industries. This allowed the company to make the most of its first-mover advantage; i.e. build several brands and establish a vast distribution network to gain market dominance. The son of the founder and current CEO John Chuang, now in his early seventies, took over in 1984. When the company IPO’d on the Singapore Stock Exchange in 2004, it became an investment success story, until the tide turned on them just a few years ago.

The crown jewel is the Indonesian “own brands”-business, complemented by an agency business representing other FMCG (Fast-moving consumer goods) brands in a wider range of product categories. The company also has a presence with own brands and agency brands in other regional markets such as the Philippines, Malaysia and Singapore, but has not yet managed to make these markets contribute meaningfully to profits. The large and more volatile cocoa ingredients division was sold in 2013 to Barry Callebaut AG. What remained was a powerhouse, compounding revenue at 20% per year for well over a decade, while sporting EBITDA margins of 15% overall (and even in the mid-twenties in its home market of Indonesia). Shareholders were handsomely rewarded with a 20% annualised return since its IPO, and a share price that rose above SGD 4 in 2013. Ironically, with the cocoa-ingredients business sold, the business began to slow down in 2015 with a revenue decline of -19% on the back of weak consumer sentiment in Indonesia, a weakening currency, and an increased competitive threat from large foreign multinationals.

Delfi responded by eliminating 40% of SKU’s with lower profitability, increasing advertising & promotions and insourcing distribution to supermarkets and convenience stores ('the modern trade'). Lower sales combined with higher expenses resulted in profits 50% below its peak. More recently, the company was well on its way to restore both sales and profitability until COVID-19 hit.

We believe Delfi's competitive advantages to be largely intact and sustainable going forward. Intricate knowledge of local consumer tastes, several strong brands coupled with the scale that allows for local production and an unparalleled distribution network are formidable barriers to entry, making Delfi a local gem. Growth over the long term is supported by a growing middle class, while operating leverage should provide upside to operating margins. Management currently targets 18% margins compared to 13% in 2019.

We bought shares at 0.72 cents, just over 10x our estimate of normalised free cashflow. Delfi is a 5% position for the Fund. The business characteristics, the growth potential, the financial strength of the company, a depressed valuation and the significant strategic value of their assets should the family ever decide to sell, all contribute to our downside protection and the prospect of generating an attractive return going forward.

Softbrain Co., Ltd

Softbrain (4779:TYO) is the second-largest developer of Customer Relationship Management (CRM) solutions in Japan with a 15% market share, behind global leader Salesforce. The company also has a field marketing business with 350 corporate customers, mainly consumer goods manufacturers who out-source the management of point-of-purchase promotions and surveys to Softbrain. The CRM business generates 70% of the company’s operating profit. Softbrain differentiates itself from its competitors with a user-friendly interface, flexible solutions, training and support. Low penetration of CRM software in Japan (compared to other developed nations) contributes to a positive outlook on growth. The launch of new products targeting specific industries is likely to grow sales further. Management targets sales growth of 20-30% p.a.. At our purchase price of 8x after-tax profit adjusted for excess cash, we could achieve our target return of 15% p.a. even if the company falls short of these targets. We took a 3% position in March at JPY 372 and sold our entire stake towards the end of the summer at JPY 866, after a bid close to our estimate of fair value from a Tokyo-based private equity firm. While we welcome the spectacular return on this investment, it should be noted that we never invest in the hope of being taken over. An ideal investment is one that keeps on giving and one we never need to sell.

NICE Information & Telecommunication Inc.

NICE I&T (036800:KRX) is a leading Korean Payment Processor and part of the NICE Group, a conglomerate of high-quality financial services firms. A payment processor facilitates credit card transactions between merchants and financial institutions. NICE I&T is the number one in offline transactions (VAN "Value-Added Network" segment) and number four in its online segment ("Payment Gateway"). The companies’ one-stop shop solutions, its reputation for reliability, thanks to its own data centre infrastructure, and its large-scale operations form its competitive advantage.

Offline payment processing is characterised by a growing number of payment transactions driven by consumer spending & the move from cash to electronic payments (low double digits over the last few years, excluding 2020). This growth in transactions however, has not translated in revenue growth as the government has reduced the fees per transaction, which has more than offset the market growth in recent years. In this environment, NICE I&T has been able to keep sales more or less stable by increasing its market share in credit card transactions to about 19% in 2019, up from 16% in 2013. While it remains a risk that further fee cuts will hurt the VAN-business, we take comfort in the fact that they currently sit at low absolute levels (and are much lower than fees in the US & EU).

In contrast, the online "Payment Gateway" business has seen very high growth. Despite its late start in 2013, NICE I&T has been able to grow into the number four position with a market share of about 14%. Sales from this division surpassed the VAN segment in 2019, even before COVID-19 gave e-commerce a boost. However, this segment has only recently begun to contribute meaningfully to profit margins. A payment processor needs scale to achieve profitability and margins in this segment are substantially lower compared to the VAN-business due to higher competition (3% for PG vs 14% for VAN in 2019).

We expect the online business to drive profit growth going forward, driven by growing e-commerce and further margin expansion. While the industry grows at about 20% per year, the company targets to further gain market share by growing at 25%. Operating leverage (i.e. when revenue growth outpaces cost increases) should lead to higher growth in profit, with margins increasing further from 3% in 2019 to 5% in the coming years.

While we expect profit growth from NICE I&T, we are not paying for it. We acquired our stake at a valuation of 8x earnings (4x our estimate net of cash). A safe balance sheet, encouraging signs in corporate governance, a low valuation and growth prospects, make for an attractive risk-reward. We sized NICE I&T a 3% position in the Fund.

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Summary of the five largest positions at year-end

Volution Group Plc (8,89%):

Volution, a leading supplier of ventilation products, showed strong operating performance during the crisis with sales and operating profit for the FY to July 2020 declining just 8% and 11% respectively. The company also announced a strong start of their new fiscal year with organic sales growth of 6.8% and operating margins of 20% for the period from August to November 2020. Margin improvement has been achieved ahead of schedule as the company has used the disruption caused by the pandemic to implement changes that it would otherwise have made over a longer period. In December Volution announced the acquisition of Dutch-based ClimaRad for GBP 54m, at an 11x EV/EBITDA multiple. ClimaRad is a fast-growing, profitable market leader in the supply of decentralised ventilation systems in the Netherlands. Volution’s share price increased to GBP 2.79 from GBP 2.57 at the start of the year, yet during the market turmoil we were able to increase our stake at GBP 1.55.

Boustead Projects Ltd & Boustead Singapore Ltd (7.42%):

During 2020 the share price of Boustead Singapore increased 5% while Boustead Projects finished 11% lower. Key to our investment thesis is the value of a portfolio of industrial real estate in Singapore and management’s intention to monetise these assets. After closing of the stock exchange on the last day of the year the company announced the sale of a significant number of properties to a private property trust. The shareholders meeting will decide in the coming weeks on the approval of this transaction and the use of the proceeds. We hope that the company will pay a significant special dividend. The share price of both companies has gone up in response to this development but the discount to fair value remains too large.

Shinoken Group Co Ltd (6.85%):

Shinoken is a Japanese real estate-developer that caught our interest because of its property management business and the products and services sold to both the owners and the tenants of apartments and condominiums developed by the company. This ancillary business to the development business creates a growing and recurring revenue stream with a high-profit margin and high returns on capital. We believe this business alone covers our purchase price and we get the property development and construction businesses for free. The depressed valuation was the result of negative market sentiment following several scandals with mortgage applications in the industry. None were related to Shinoken. The company expects operating profits to decline by 10% compared to 2019 as condominium sales were disrupted by COVID-19 emergency measures and stricter rules on mortgage applications. We see both as temporary. The share price ended the year 14% lower. Our medium-term outlook for Shinoken remains unchanged. The recent launch of a private REIT further diversifies the business risk and rounds out our investment case.

Imerys S.A. (5.32%):

This French company operates a specialty chemicals business and is the global leader in mineral-based specialty solutions for industrial applications. The company sells its products to a wide range of industries in over 140 countries. Imerys’ products are used to add gloss and opacity in paints, improve conductivity and reduce weight in plastics, purify liquids and increase the lifespan and charging speed of batteries, to name but a few applications. After exiting the building materials and metal processing business, Imerys has become a pure player in specialty mineral solutions, focusing on specialty niches to bring high value to its customers. Imerys generates 75% of revenue in markets where it holds the number one position. Imerys provides key components to their customers’ products, but this represents just a small percentage of the overall production cost. This gives Imerys some pricing power and limits the company’s exposure to volatile commodity markets. During the great recession, profit margins were still 8.3% in 2009 vs 11.4% in 2008 and moved on to 12.2% in 2010, an indication of the strength and resilience of the business. Coincidentally, a few days after we invested in the company the CEO stepped down, but the strategy to address the low organic growth and improve operating margins was quickly reaffirmed by the incoming CEO. The impact on profit from the sale or closure of several lower-growth or marginally profitable businesses, one-time charges from the operational turnaround, talc litigation fines in the US and a European industry malaise, all contributed to a share price decline of 60%. We were able to acquire a stake at less than 10x our estimate of current year’s earnings. The improved business mix and a substantial cost-saving initiative are likely to drive higher organic growth and higher operating margins. The resilience of Imerys’ business and the price we paid for the shares protect our downside in case this scenario fails to materialise. The company reported for the first nine months of 2020 a revenue drop of -15.9% and operating income was -41% lower than last year. End markets are expected to continue recovering and management’s focus remains on cost savings and cash generation. At the beginning of the year shares traded around EUR 37 and finished the year just above EUR 38. We took advantage of lower equity markets to increase our position at EUR 29.

Hamilton Thorne Ltd. (5.26%):

U.S.-based, Toronto listed Hamilton Thorne Ltd (HTL) is a C$190m company that supplies equipment, software and disposables to In-Vitro Fertilisation (IVF) Labs. Demand for HTL’s products and services returned to near normal in most regions during Q3 after the IVF industry had slowed materially in Q2 due to COVID-19. Analysts forecast 2020 adjusted EBITDA to decline by approx. -20%. The share price increased to C$1.40 from C$1.05 at the start of the year. Our medium-term outlook for the company remains unchanged. HTL’s market is expected to grow at 5-10% annually. The introduction of new products, important cross-selling opportunities from the acquired businesses and market-share gains from smaller and less competitive companies, should allow HTL to grow organically in excess of 10% for many years to come.

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