Financial markets will remember 2022 as the year when rates started rising, breaking a trend that many market participants had come to accept as normal. The war in Ukraine and persistently high inflation brought an end to a bull market with widespread double-digit losses across global financial markets. For the first time in recorded history going back to 1872, both the 10-year US Treasury Bond and the S&P 500 fell sharply in value in the same year (-17.0% and -18.1% respectively – source: Deutsche Bank). Over the last few years, the resilience of investment portfolios has been severely tested by a global pandemic, increased geopolitical risk, high inflation and the reversal of 40 years of falling interest rates.

During 2022 GVF’s NAV declined by 11%. Our fund’s objective is to offer investors a vehicle to compound wealth at a high rate while minimising the risk of permanent loss of capital. The more you lose, the harder it is to get back to where you started. Big losses are a real killer and that’s why our number one priority is to build a resilient portfolio. Avoiding large permanent losses of capital is not the same as avoiding years with negative returns, something investors should expect when investing in public equity markets.

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Our largest detractors for the year were Sberbank (-3.4%), Volution (-3.2%) and Atos (-2.6%).

There have been no further developments on Sberbank since our H1 letter. It is hard to estimate the probability of recovery, yet with the shares valued close to zero the fund is not exposed to any further downside.

Volution’s share price declined -34% in 2022 despite strong results, as investors anticipated a decrease in building activity during an economic recession. We believed the share price in October was overly depressed and increased our position by 1% at a price of 307p. We had previously sold 40% of our position in 2021 due to the higher valuation.  Shares regained some of their losses by year-end, trading at a P/E of 15.6x (on consensus earnings), a valuation we still deem to be inexpensive given the attractive characteristics of Volution’s business and its potential for further growth.

Atos’ IT infrastructure business suffered from the impact of an acceleration of cloud adoption during the pandemic. The company was unable to adjust its cost structure fast enough, which severely impacted its earnings. While we knew cloud migration was a negative trend impacting Atos, we believed this exposure was manageable and the risk already factored into the low share price. In hindsight, we underestimated the impact this would have on earnings. The investment in Atos has clearly been a mistake but as of today, we remain invested as a number of potential positive catalysts still exist.

Our largest contributors in 2022 were investments in Shinoken (+3.2%) and Epsilon Net (+1.7%).

Shinoken, the Japanese real estate and real estate services company, was taken private in a management buy-out. It isn’t the first time we got bought out by management. Although the acquisition price was below our estimate of fair value, the fund did generate an IRR of 23% during our holding period. Hardly something to complain about.

Epsilon Net is actively benefiting from the digital transformation of the Greek economy. The share price increased 24% during 2022 on the back of strong operating results. The company is expected to increase 2022 revenue by +50% compared to 2021, with an EBITDA margin of more than 30%.

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Uncertain times in financial markets can also be a blessing in disguise. With stock prices all over the place, invariably some get seriously mispriced. Judging by the number of investments our fund made this past year, this uncertain environment suits our value approach well. We’re pleased to report that we ended the year with a record 85% of our capital invested, despite selling and reducing a number of positions. In addition to selling Shinoken, we also decided to trim our remaining two positions in Taiwan (Sporton and Thinking Electronic), to a total exposure of 4% given the increased geopolitical risk in the region.

During 2022 H2, we added new investments in Fairfax, Ströer, Eurofins Scientific, and Marlowe. We also increased our positions in Hamilton Thorne and Volution again after their share prices followed the market downturn, which in turn improved the risk/reward.

Although we’re unable to predict the timing and the severity of an economic slowdown (2023 might turn out worse than what is already priced in), we expect attractive returns on our investments if our analysis of the long-term earnings power is approximately right.

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New Investments

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Fairfax Financial Holdings Ltd

Fairfax is a global insurance holding company that's been led for over 30 years by its founder, Prem Watsa. Often referred to as the "Warren Buffett of Canada", Watsa has delivered remarkable results for shareholders. Since 1985, the company's book value per share has grown at an impressive compound annual growth rate of 18%. Watsa's success can be attributed to a combination of strong insurance underwriting profits, savvy investments, and well-timed share buybacks.

In general, insurance companies have two main ways of making money – underwriting profits from the insurance business and investing the “float”. Underwriting profits consist of the earned premiums remaining after losses have been paid and administrative expenses have been deducted. Float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests this cash to enhance earnings.

In the last two years, the insurance industry suffered heavy losses due to natural catastrophes. Last year, these losses were further exacerbated by negative returns on their holdings in bonds and equities. On the flip side, this creates a favourable environment for higher insurance premiums as insurance companies attempt to restore profitability. In contrast to many of its competitors, Fairfax has a bond portfolio with a very short duration (1.2 years) and therefore suffered smaller losses as a result of the rising interest rate environment. This helped protect its strong balance sheet and should allow Fairfax to take advantage of the favourable underwriting environment.

In addition, a short-duration bond portfolio implies that over the short term, the proceeds from maturing bonds can be re-invested at the prevailing higher rates. This positive impact on earnings will be significant with a bond portfolio of $36bn in comparison to a market capitalisation of $11bn (at the time of our investment).

Poor market sentiment gave us the opportunity to purchase the shares at a 23% discount to book value (our estimate includes gains on announced divestments) and 7x our estimate of normalised after-tax earnings. In typical fashion, Prem Watsa further boosted the book value per share by taking advantage of the low valuation and bought back 11% of shares outstanding over the 12-month period to September 2022. The positive outlook for earnings, the value creation opportunity from share buy-backs and the low valuation made for an attractive risk-reward addition to our portfolio.

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Ströer SE & Co KGaA

It is the second time we invest in the out-of-home (OOH) advertising sector, following Clear Media Ltd in 2013/2014. For those unfamiliar with the term, out-of-home advertising is any type of advertising that reaches consumers when they are outside of their homes. This includes billboards, bus shelters, subway signs, and other forms of advertising in public spaces.

OOH advertising can be an attractive business for two reasons. Firstly, it has remained resilient in the face of online marketing disruption, and the roll-out of digital panels has further helped to sustain its relevancy and growth. Secondly, the industry is characterized by strong incumbents and high barriers to entry, making it challenging for new players to enter the market.

Regional scale is essential for profitability in OOH advertising as it enables companies to offer competitive prices to advertisers who want to reach a large number of people in a specific region. Scale in panel locations, however, can only be obtained over time due to the scattered and long-term nature of contracts with municipalities and private landlords.  Furthermore, established companies with significant scale and resources make it difficult for new players to gain market share. This creates a scenario whereby new entrants need scale to be competitive but cannot achieve it without incurring significant losses over several years.

Ströer, in particular, struck us as an interesting case for a few reasons. The company dominates OOH in Germany with a 63% market share compared to 25% for JCDecaux, with little overlap between the two businesses. JCDecaux focuses on street furniture and runs global campaigns for the LVMH’s of this world. Ströer in contrast is focused on billboards and screens and generates 60% of its out-of-home revenues from local advertisers under long-term contracts (not campaign-based). For this reason, Ströer’s revenue has been more robust in a downturn when compared to its competitors. During the Global Financial Crisis (2007-2009) revenue declined by just 8%.

Ströer’s exclusive focus on Germany gives it a different growth profile versus international peers. The German market has historically lagged in the adoption of digital panels. In contrast with other markets where much of the buying power is concentrated in big cities (e.g. London, Paris, …), Germany is more fragmented. Therefore, the high cost associated with installing digital panels versus working with analogue screens made less financial sense.

Today this dynamic has changed because of the lower cost and increased appreciation for the flexibility of digital panels. Digital panels allow running multiple campaigns on the same screen. Triggers such as time of day, weather, location or the customer’s own data, can all make ads more relevant to people in any moment or mindset. These new capabilities are an appealing proposition to advertisers.

The 2026 management plan describes how the increase in digital OOH will support revenue growth for the next ten years, as only 2.5% of Ströer’s current inventory is digitalised. Revenue from a digital screen is 3x to 4x higher with similar margins of approx. 50%.

Ströer also generates 30% of operating profit from other activities such as online advertising, call centres and door-to-door campaigns. Customers can run campaigns on different channels. For example, if Ströer runs a campaign for Adidas running shoes on roadside screens, they can simultaneously run a digital campaign on Ströer-managed sports websites. By offering multiple products, Ströer can develop closer relationships with its customers.

Finally, Ströer has two important, non-core assets, that are growing rapidly (Statista & Asam Beauty). These were added as a means to diversify revenue at a time when the company was concerned about the disruption risk from online advertising. Thisconcern proved to be unfounded as OOH has held up well in the face of increased adoption of digital marketing. Nevertheless,these investments turned out highly valuable and Ströer seeks to monetise these in the next 2-3 years.

The fund made an investment when the share price had dropped almost 40% on fears of a severe economic slowdown in Germany. Adjusted for the non-core assets, we estimate that we bought the core business at less than 10x after-tax profit for 2022. We believe this valuation is attractive for a resilient business with good growth prospects.

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Eurofins Scientific SE

Eurofins is a global leader in food, pharmaceutical and environmental testing. The company was founded by Frenchman Gilles Martin in 1987. Through successful acquisitions, Martin grew Eurofins from a small French laboratory into a company that performs more than 450 million tests each year.

Demand for Eurofins’ services is resilient and benefits from long-term growth drivers. Testing services continue to be essential, regardless of economic conditions, as the need for safe food, water and pharmaceuticals, as well as environmental protection, remains resolute. Key growth drivers include rising wealth and increased life expectancy, consumer demand for quality goods and services, with new technologies opening new markets for testing. Complexity has helped to push these services to be outsourced while customers focus on their core competencies and reduce costs.

Eurofins’ markets are still highly fragmented with multiple sub-segments and a large number of smaller and medium-sized laboratories offering a limited portfolio of testing, a regional presence and a local customer base. The company strives to be the number one or two service provider in every niche laboratory testing market in which it operates through a combination of organic growth and acquisitions. They leverage their scale advantage to position themselves as a first-choice provider based on innovation, quality and breadth of offering. In addition to growth opportunities from M&A, being the most efficient operator also allows for market share gains.

The company’s increased orientation towards BioPharma, Genomics and other Life Science activities, as well as towards faster-growing economies in Asia are the main drivers behind the recent upgrade of its mid-term organic growth objective to 6.5% (up from 5%). The company aims to achieve overall revenue growth of 10% annually through organic growth and self-funded acquisitions. Earnings growth should also benefit from improving profit margins as a result of efficiency gains from IT investments and the implementation of a hub-and-spoke model for the testing labs.

Eurofins is one of the real success stories amongst European listed companies. The share price multiplied 366x since the IPO in 1997, a compound annual return of 26% over a 25-year period, nothing short of astonishing. The recent negative impact on earnings from the cost of integrating a large acquisition in addition to the drop in Covid testing-related revenues, combined with poor equity market sentiment, caused the share price to drop almost 40%. The fund made an investment at a 40% discount to our estimate of fair value.

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

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Update on the five largest positions of the fund^[2]:

Epsilon Net SA (8.42%)

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. The company is actively benefiting from the digital transformation of the Greek economy. The share price increased 24% during 2022 on the back of strong operating results. Epsilon Net is expected to increase 2022 revenue by +50% compared to 2021, with an EBITDA margin of more than 30%. We took advantage of a temporary dip in the share price to increase our position. Epsilon trades at 18x our estimate of 2023 earnings.

Fairfax Financial Holdings Ltd (7.99%)

see long-form description above

Volution Group PLC (7.59%)

Volution, a leading supplier of ventilation products, continued to show strong operating performance as a result of the increasing awareness of indoor air quality, coupled with ever-tightening regulations on energy efficiency. A trading statement for the period up to the end of November 2022 confirms organic revenue growth in excess of 5% at stable profit margins. The share price of Volution declined 34% as investors anticipate lower building activity during a recession. We increased our investment at these lower levels.

Delfi Ltd (5.64%)

Delfi is the market leader in Indonesia’s chocolate industry with a strong ‘own brands’ portfolio and a vast distribution network. For the first 9 months of 2022, the company reported 20% revenue growth and a near doubling of after-tax profit driven by sales growth of premium products and disciplined cost control. The share price remained more or less unchanged bringing the valuation down to a single-digit P/E of 8.3x on 2022 consensus earnings.

Willis Tower Watson PLC (5.52%)

see long-form description in our 2022 H1 letter

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