“All past declines look like an opportunity, all future declines look like a risk” Morgan Housel

Our fund did not escape the terrible start global equity markets made in 2022. Coronavirus, rampant inflation, and war in Eastern Europe made the markets anticipate lower corporate profits and increased the cost of capital. The economic and geopolitical outlook is uncertain - as it always is - yet market sentiment has drastically shifted from optimism to pessimism in the last six months. As we stated on numerous occasions in past letters, we cannot predict the unpredictable, instead, we focus on controlling the controllable. Very few businesses are immune to economic recessions, but some cope much better than others. Therefore, we always focus on robust cash flows and competitive moats as well as financial strength, to identify companies that can survive and even thrive in a crisis. A key element of our strategy is to build a resilient portfolio based on three pillars: safe companies, diversification and discounted valuations.

A good example to illustrate how diversification helps to reduce risk is our investment in Russia. The fund has had an investment in Sberbank for several years, which we now value close to zero due to unprecedented government sanctions. Political risk was the main reason why we decided to limit our overall country exposure to 4%. The risk profile and valuation would have justified a high conviction position of 7%, was it not for Sberbank being a Russian bank. In this case, our country limit helped cap the loss to -3.4% of the fund’s capital. Never pleasant, but we believe our discipline keeps this potential loss manageable.

Other large detractors to our performance were the investments in Kaspi.kz (-3.9%), Volution (-3.5%) and Tyman (-2.1%), despite all three companies reporting strong results. Kaspi.kz initially declined because of social unrest in Kazakhstan and later because of its close economic ties with Russia. The impact on H1 was inflated due to the strong increase in the share price last year. In 2021, we took a 5% position, which increased to 7.34% by the end of the year due to the stock’s outperformance. In stark contrast with the drop in share price, Kaspi’s adjusted net income showed a strong increase in H1 despite the difficult environment. Management is now expecting 2022 earnings to increase 27% to 30% compared to previous year, which is at the top end of prior guidance. What’s all the more remarkable is that Kaspi achieves this growth, while paying out most of its profits to shareholders in the form of dividends and share buybacks. Kaspi is currently valued at 7x this year’s earnings and has a 9% dividend yield.

Our holdings in Tyman and Volution were affected by the negative market sentiment for building-related companies as a result of rising interest rates and fear of an oncoming recession. We have had conversations with the CEOs of both companies these last weeks and see no reason to change our investment thesis. At the time of writing, Volution came out with a trading update and confirmed strong revenue growth and stable operating margins at 21%, despite an industry-wide supply-chain disruption and inflationary pressures. Tyman published H1 results with revenues up 15% and operating profit up 5%. Lower margins reflect a lag in price recovery of input cost inflation and should recover over time. The share prices of Tyman and Volution dropped -40% and -52% respectively from their recent peaks in 2021. Yet, for well-positioned companies with a strong balance sheet and a positive long-term outlook, it is highly unlikely that the intrinsic values would decrease by 40% to 50% as a result of a recession.

These two themes we described above, exposure to Eastern Europe (Sberbank/Kaspi.kz) and to global building activity (Tyman/Volution), go a long way toward attributing the first half losses of the fund. Approximately -13.7% of the -18.96% negative performance is related to these four companies. We think it is impossible to predict the geopolitical outcome in Russia. However, for Kaspi.kz, Tyman and Volution we are convinced they offer a great risk/reward if one is prepared to look past the current market turbulence.

Market volatility can test a listed equity investor’s nerves, yet one should never forget that owning productive businesses that can re-invest capital at attractive rates of return builds wealth. Winston Churchill is credited with saying “Never let a good crisis go to waste”. The silver lining to tumbling equity prices is a favourable environment to find opportunities that meet our investment criteria. During the period under review, the fund was not only able to increase its allocation to several of its core holdings but also add four new investments. These additions increased the invested capital to 81.24% at the end of H1.

New investments:

Willis Towers Watson Plc (WTW)

WTW is a global leader in insurance broking as well as consulting for retirement plans, health benefits & compensation and corporate risk. The company generates approx. €9bn revenues in more than 140 countries with over 44,000 employees. WTW operates in an oligopolistic market with high barriers to entry and generates highly recurring revenues with low capital intensity. WTW and its competitors have consistently exhibited non-cyclical organic growth as the need for advice and risk-management solutions typically intensifies during turbulent times.

Companies with the above characteristics are rarely available at discounted valuations. Yet, in the case of WTW, the share price had been affected by company-specific problems in addition to general poor equity market sentiment. In July 2021, regulatory issues caused WTW and Aon to cancel their agreed merger. Since then, new management was put in place and a plan was outlined with a strategy and financial targets for 2024. Increased focus through streamlining activities and new hires (after a period of attrition during the merger process), should boost organic revenue growth to 5%. Operating leverage and cost savings, mainly from IT and a reduced real estate footprint, are expected to increase operating margins to 24-25% in 2024 (12% annual growth vs 2021). An estimated $10-11bn, a combination of cash available and future free cash flow generated by the operating business, will be used to drive shareholder value through share buybacks and dividends. We believe the shares are undervalued and every share bought back at current levels will increase the intrinsic value of the remaining shares.

The downside protection from the resilience of the business and management’s commitment to significant share buybacks is very strong. We expect to generate an attractive return on this investment if WTW achieves its targets. At cost, the fund paid approx. 10x 2024 target earnings per share.

CSAM Health Group (CSAM)

CSAM is the leading provider of specialised software for public hospitals in the Nordics. Its highly specialised software solutions are instrumental in the clinical care processes of healthcare providers and in enabling emergency responders to enhance public safety. Products include niche solutions in public safety, connected healthcare, women and children’s health, laboratory information management systems (LIMS), medical imaging, medication management, and health analytics. CSAM is managed by Sverre Flatby (CEO) and Einar Bonnevie (CFO), who together own 21% of the company.

What attracted us to CSAM is the high margin and predictable long-term revenue stream. Most of the workflow processes for hospitals are highly specialised and take between 5 and 15 years to change. Software connected to the actual workflow therefore generates predictable recurring revenues over a long period. This is reflected in a churn rate of less than 2% and recurring revenue representing 70% of total sales.

The company estimates the market for their specialised software at NOK 3bn in the Nordics and the European market at 10x that size. With run-rate sales of NOK 400m and 10% market share in the Nordics, CSAM is the largest player in a fragmented market with many small companies and niches. This gives CSAM the potential to grow revenue at 40% p.a. through organic growth and M&A in the Nordics & Europe (as they have done in the past).

CSAM grows organically at 5-10% p.a. through new users, add-on components and annual price increases of 2-3%. Growth is supported by the increased adoption of technology in healthcare and this trend is likely to continue for some time.

Management has successfully completed about a dozen M&A deals during their tenure, providing a measure of confidence that they can continue executing their roll-up plan. CSAM acquires software companies with recurring revenue, intellectual property, and people to maintain that recurring revenue. The acquired companies are very small and typically lack the scale to be profitable. Historically, acquisitions have been done at EV/Sales of 1-2x with a Buy-Integrate-Build strategy to boost margins to 30% after 2 years.

Management has an ambitious sales target of NOK 1bn by 2025, as they continue to execute on their acquisition strategy and organic growth initiatives. During our call, Sverre and Einar explained that a 30% EBITDA margin with a cost structure supporting their growth plans (50% margins if they stopped growth investments) is realistic. Historically, the reported margins have been significantly lower, as the acquisition of break-even (or loss-making) businesses depressed margins until CSAM was able to integrate them. Recently, the company decided to increase its growth investments, mainly by adding personnel and this depressed margins even further. In combination with poor equity market sentiment, it drove the share price down by approx. 50%. At the current share price, we believe the risk-reward is very attractive.

A business with the characteristics we described above should be able to thrive, also in a difficult economic environment. The predictability of the revenue stream is truly exceptional and protects our downside. The company has a long runway for growth, both organically and from M&A. The high gross margins of 90% and the fact that CSAM achieved 29% adjusted EBITDA margins in a period without acquisitions during Covid, gave us confidence that 30% margins are within reach. If our analysis proves correct this investment should generate an annual return of at least 15%.

Hirequest Inc (HQI)

At first glance, you would not identify Hirequest as a candidate for our portfolio. Indeed, this is a US staffing company exposed to cyclicality, seasonality and active in a low-margin industry. What piqued our interest was that owner-operator Rick Hermanns runs Hirequest as a franchise model, which is a-typical for the sector where a corporate-owned model is the standard (e.g., Manpower, Adecco, Randstad). Rick started the company in 2002, still has more than 40% of the shares and has decades of experience in the industry. Over the years he perfected the franchise model and grew the business to what it is today; a franchisor earning a royalty fee of approx. 6.5% on growing system-wide sales (term used for total sales across the entire system of franchisees) of $400m.

The key value proposition of their franchise model is a better alignment of incentives as the franchisees, who own their businesses as opposed to being employed, are motivated to grow sales and keep costs down. Turnover of key employees is always a risk in this type of people’s business and the franchise agreements reduce this significantly. As a franchisor, Hirequest provides its franchisees with better workers' compensation insurance, financing, processing and software, than what they can get if they were a small local independent staffing company. Organic growth is supported by growing sales at the franchisees and by opening new offices. Franchisees are highly motivated to grow sales as it has a direct impact on their earnings and the value of their business. Successful franchisees are also motivated to acquire additional franchises.

What got us really excited about Hirequest is the large opportunity to acquire small staffing companies and convert them to their franchise model. The returns on these acquisitions can be spectacular as demonstrated by the acquisition of Command Center in 2019. Rick explained that Hirequest paid $18m and then sold the Command Center offices to franchisees for $18m. The result for Hirequest is a long-term royalty stream at effectively zero cost.

The returns on the other acquisitions were also attractive and with approx. 45,000 independent staffing companies in the US, there’s no shortage of opportunities for further acquisitions. Current cash flow should allow Hirequest to continue to grow system-wide sales with $100m per year to reach their target in five years of $1bn sales with $35m~$45m net income. This compares to a current market capitalisation of $193m.

The risks we identified in our thesis are changes to US labour laws and a deep recession. Hirequest runs a capital-light business, except for the capital needed to finance the accounts receivable as workers are paid before clients pay the franchisees. Another risk is the capital required to support or acquire franchisees during an economic downturn. When we pushed Rick on the growth rate, he told us that staffing is a cyclical business, and he wants to be prudent with debt. He has been in this business for decades and experienced multiple recessions. Furthermore, we see Hirequest doing very well and reaching its targets with a conservative balance sheet, without the need to take excessive risk.

Compugroup Medical SE (CGM)

We have described CGM in previous investor letters. We had been shareholders of CGM in the past but sold the shares when the price had increased to a level where we believed the risk-reward was no longer attractive. Although the business has evolved since our initial investment, the company still has many of the characteristics we look for, such as market-leading positions, non-cyclical and recurring revenues, high operating margins and good long-term growth potential.

CGM develops and sells software and IT services for the healthcare sector in Europe and the US. Doctor’s practice management software covering all clinical, administrative, and billing-related functions is the largest segment. CGM also develops software for hospitals and pharmacies. Finally, CGM is also active in data-driven products which provide healthcare organisations with valuable information for improving and optimizing their services such as medical decision support tools, and drug and therapy databases.

Europe still has significant catch-up potential in digitisation of healthcare, for example, just 19% of German hospitals are digitised versus 73% in the US and only 44% of healthcare professionals exchange clinical data digitally^[2]. Government programs across Europe are pushing the digitisation of essential parts of healthcare and this regulatory tailwind has only been reinforced by the recent pandemic.

Companies with the above characteristics are rarely available at discounted valuations and we took advantage of current market sentiment. Aside from the overall declines in share prices, several company-specific developments contributed to a 50% drop, such as a decline in profit margins as a result of growth investments, scepticism about a US acquisition and high management turnover. Growth investments, mainly in R&D, are expected to boost organic sales growth to 5% p.a. and operating leverage should improve operating margins from 22% to 27%, increasing earnings by more than 40% from current levels. At 19x this year's earnings we believe our downside is well protected, with attractive upside if management achieves its 2025 targets.

Our next letter will be out in the first weeks of January 2023. Wishing you all a safe and healthy continuation.

***

Update on the five largest positions of the fund^[3]:

Epsilon Net (8.08%):

Epsilon Net is a Greek software company, dominant in the local market for HR/payroll and accounting software. It also has a fast-growing enterprise resource planning (ERP) business. We believe the company will benefit from the digital transformation of the Greek economy. 2022 Q1 results were in line with management expectations to increase revenues this year by 50% compared to 2021, with EBITDA margins of 30%.

Volution Group Plc (6.83%):

Volution, a leading supplier of ventilation products, continued to show strong operating performance as a result of the increasing awareness of the importance of indoor air quality, coupled with ever-tightening regulations on energy efficiency. Days ago, the company came with a trading update for the financial year ending July 2022. Earnings are expected to be at the top end of market expectations with revenue expected to grow by 13% (7% organic) and operating margins maintained at 21%.

Delfi Ltd (5.94%):

Delfi is the market leader in Indonesia’s chocolate industry with a strong ‘own brands’ portfolio and a vast distribution network. The company reported good Q1 results with revenue and EBITDA increasing by 11.4% and 13.9% respectively.

Shinoken Group Ltd (5.48%):

Shinoken is a Japanese real-estate developer offering services to both owners & occupiers; it sources the land, applies for planning permission, then builds and sells the apartments and condominiums. It also operates a business that offers a whole range of property management services. These services include the actual management of the properties, finding tenants, collecting rent, providing rent guarantees, insurance, electricity, gas, etc. This creates a growing recurring revenue stream with a high-profit margin and high returns on capital. 2022 Q1 results showed an increase in sales and profit from both real estate development and property services. The valuation remains very attractive at 5.6x after-tax profit.

CompuGroup Medical SE (5.22%):

See long-form write-up above