Dear partner,
With the risk of becoming repetitive, we would still like to emphasize the fact that as a fund, we do not buy products on the stock market for trading purposes. We purchase shares of companies. It is crucial to consistently maintain this distinction. We also believe that this will be much more important in the future than it has been in the past ten years.
The profits achievable in the stock market always stem from a combination of earnings growth (per share), dividends, and the difference in what people are willing to pay for the shares, expressed in the price-earnings ratio (P/E).
It is this last factor that has the most influence on the markets in the short and medium term. The P/E ratio is what differentiates between a bull market or a bear market. It is this P/E ratio that can make markets manic or depressive.
Certainly, the economy also experiences fluctuations, but they are often of shorter duration, less pronounced, and tend to stabilize. As a result, we can generally count on earnings growth of 4% to 6% and dividends of 2% to 4%, amounting to a total return of 6% to 10%, even during weaker market periods.
The happenings in the stock market largely revolve around sentiment. If investors perceive the future optimistically and expect substantial profits for the companies, they are willing to pay more for current earnings, which translates to a higher P/E ratio. The valuation of a company is, after all, based on its future potential.
If investors are pessimistic and anticipate negative developments, they foresee slower or even declining future profits, and thus, they are naturally unwilling to pay as much for current earnings. This results in a lower P/E ratio.
Therefore, it is certainly not wrong to occasionally reflect on this sentiment and the prospects of earnings.
Where do we stand today?
In general, we can still assert that the price-earnings ratios (P/E ratios) in global markets are high. It therefore seems logical that these P/E ratios will decrease. Does this automatically mean we will experience a declining market? Not necessarily. If earnings continue to rise while stock prices remain stable, the P/E ratio will also decrease.
However, a rapid and significant adjustment of P/E ratios can only be expected if the economy enters a recession or depression.
So now the question arises: How is the economy faring? We do not know, and that is not our focus. If we do begin to speculate and philosophize, we envision various possible outcomes. Our investment strategy does not require a specific stance on the overall economy. Our approach is not centered on the general economy but rather on our companies and their future, always taking into account potential challenging times. While a recession or even a depression naturally impacts all companies, it will create more opportunities than problems for us and our businesses. Of course, this will have an effect on stock prices.
What do we see?
Although it is not of paramount importance for us to know what the overall economy will do, we naturally observe and read a lot. Today, we still see strange situations as a result of COVID-19, such as oversupply or shortages of certain products and delayed deliveries. This occurs despite the lifting of restrictions some time ago.
The war in Ukraine also plays a role. A few weeks ago, we witnessed a peculiar development concerning Wagner in Russia. The escalation or resolution of the war will also impact the economy.
In Europe, and increasingly in America, we also see a strong focus on the environment and the Green Deal. Taking care of the planet is undeniably crucial. Unfortunately, the execution of these initiatives is often subpar or even dangerous, and as we have come to expect from politicians handling other people’s money, it comes with significant costs.
Closer to our own world, inflation and rising interest rates are two factors causing concern. Higher interest rates make everything more expensive. This primarily applies to loans for homes or cars, but loans for business assets also become considerably more expensive, making certain projects that were profitable two years ago potentially unprofitable today or only break-even.
The question is to what extent these interest rate increases are currently being felt. Many loans have been taken at a fixed interest rate or on terms of 3 to 5 years that are yet to be adjusted.
Although the interest rate increase is significant compared to where we came from, historically speaking, interest rates today are still not very high. Will the shock be significant due to the substantial rise, or will it be mitigated because interest rates are still low? Will we adapt like Turkey, where the economy continues to operate despite high interest rates and massive inflation?
As Belgians, we tend to view the inflation issue through our own lens and see that purchasing power remains stable or has even increased thanks to automatic indexation. This is a unique mechanism in Belgium and Luxembourg. Other countries do not have this mechanism, which means that purchasing power is adjusted with a delay. The question then is how this affects consumer spending in those countries.
Looking at interest rates, we see that companies have relatively high levels of debt, which is understandable given that loans have been cheap. Now, companies are faced with higher financing costs combined with cost increases due to inflation. This will exert pressure on companies’ profits because it is simply not possible to pass on all costs to consumers.
Governments are not concerned about higher inflation as long as the population can be reassured and the culprits can be blamed elsewhere. Inflation makes their debt burden relatively smaller. If there is no inflation, taxes will inevitably rise. However, we should not view this through a Belgian lens, where it seems nearly impossible to further increase taxes. In the rest of the world, there is still room to reach Belgium’s level.
Lastly, we also observe a trend of deglobalization. There is a resurgence of local production or, at the very least, larger inventories are being maintained. This also leads to rising costs.
In summary, consumers are being pressured from all sides because the pressure on companies ultimately affects consumers as well. It is evident that due to all these trends, consumers will spend more money but buy less than before. Demand will decrease, which means that companies will have to adapt and align their workforce with this new reality, leading to reduced demand and likely a recession.
In itself, we do not need to fear a recession. As unpleasant as it is for people losing their jobs, it is part of the normal economic cycles that force companies and individuals to become more efficient, making them stronger for the next growth cycle.
I would like to make use of the metaphor from our friend Vitaliy Katsenelson:
Recessions are like forest fires – small ones are healthy for the forest, as they get rid of dead wood and convert it to fertiliser. However, the longer you suppress the fire (with the best intentions, thinking you are doing a good thing) the more dead material the forest accumulates. Eventually, when fire does pay a visit, it is more devastating and its effects are more long-lasting.
How to invest.
When we combine generally high valuations with the expected pressure on corporate profits, we do not see promising prospects for the stock markets.
As mentioned earlier, these economic concerns have little influence on us. We continue to search for companies that can survive, improve, and grow in all circumstances. We are also realistic enough to understand that such growth never occurs in a straight line and is tied to economic reality.
It is crucial to know what you own and what it is worth. This enables you to seize opportunities during moments like these, when worries prevail, such as with Somero where the outlook for the construction sector is not favorable. It takes courage to buy at lower prices.
Our quest always continues for companies that offer the best possible quality for the price we have to pay. The balance between quality and price is an ongoing exercise that often requires a great deal of patience. The price will eventually come to you; there is no need to chase after stock prices, at least not in a mature portfolio. Cash is also an option, although it carries more risk in the current environment than a few years ago.
Expectations
As investors, we anticipate that the coming years will not be easy. The stock market needs to move away from past excesses, and it will not always be pleasant to witness. At times, we may wish we had started with something simpler, like a Cake Box store. However, we approach this with passion and a determination to navigate through these turbulent waters, where our goal is not to seek the fastest route (highest returns), but primarily a safe route that will take us to our destination, even if that route comes with some waves.
The advantage for us as value investors is that even during calm seas, we were mindful of the dangers and never overloaded the boat (i.e., bought heavily leveraged companies). Not only will our companies be less affected by rising interest rates, but there will also be a renewed focus on cash flows and current assets rather than solely dreaming about the future.
The potential decline of some companies will create opportunities for our companies and us as investors.
The fund
The Chess Capital fund started three years ago, and those who invested at that time are currently in a profitable position. However, the profits may be less than what we had initially anticipated and envisioned. Looking back at everything we have experienced during this time, we are not dissatisfied.
However, some investors who entered in 2021 are currently experiencing losses, and we are genuinely sorry about that. Unfortunately, this is part of the investment process, and there will always be unpredictable events, with examples like the war in Ukraine and the COVID-19 pandemic, which can have a significant impact on the short-term performance of the stock market.
Nevertheless, we are looking towards the future with confidence in our current portfolio, expecting that even those who entered at the peak will eventually achieve profits and that the long-term returns will meet our expectations. We draw this confidence from our knowledge of the underlying companies in the fund.
While the fund holds 26 positions, our expectations are particularly connected to Cake Box, Tessenderlo, Kamux, Exor, Sofina, Deceuninck, Somero Enterprises, and Smartphoto. These eight positions will largely determine the future returns. It is not necessary for all eight positions to be huge successes, as that is how the stock market works. A few significant winners are sufficient for exceptional returns.
Transactions
In the first half of the year, the additional purchases of Somero, Tessenderlo, and Sofina were more significant than the three new acquisitions. Our position in Somero increased from 126,000 shares to 285,500 shares. We were anticipating a drop in the stock price for this position. We also took advantage of the dip below €29 for Tessenderlo and the bargain opportunity of Sofina below €200.
The sale of Kernel still remains painful, as we have discussed before.
During the period after the transition to the new structure, we not only further increased our position in Somero but also said goodbye to X-Fab. The stock price rose faster than expected, and as a value play, we like to take profits when the price reaches fair value. X-Fab has a strong order book, and the future looks very positive. However, significant investments still need to be made, which will put pressure on cash flow for some time.
For us, this was an opportunity to sell and take profits. We may not say a definitive farewell, but rather a “see you later” for X-Fab.
X-Fab was purchased in September 2020 at an average price of €2.98 per share and was sold in June for €9.81 per share, resulting in a profit of 229.4% over a period of less than three years.
Here is an overview of all the positions that have been sold since the start:
Since 1 January this year to 30 June, these are the biggest winners and losers:
Since the start of the fund (including before the merger), this gives the following picture for the companies still in the portfolio.
Our five largest positions and cash were at 30 June:
T-Class results
The T-class only opened in October 2021. Figures from before have been recalculated prorata the performance of the A-class. Pro memoria: “T” stands for “Three” and symbolises the three-year commitment.
Our calculated net asset value per T-Class share is €1,534.28 and is very attractive at 77% differential.
A-Class results
Our calculated net asset value per A-Class share is €1,879.89 a difference of 77% from the share price.
As long as we can grow this intrinsic value, we are satisfied, the price will follow with time.
Company news core positions
We would like to keep you updated on the developments regarding our core positions.
Somero Enterprises provided a trading update for the first five months of the year, where they wanted to warn us about the slowdown in the US market, which will impact their revenue and profits.
Currently, the US market is still very active, and their customers’ order books are filled with projects at factories, data centers, and medical facilities. Things are also going reasonably well in Europe and Australia.
However, due to the rise in interest rates and the more challenging access to financing for their customers, along with delays in permits for large complexes, they are seeing slower project starts in the United States. There have been no cancellations so far, but these delays have an impact on the timing of Somero’s equipment purchases.
Additionally, there is a delay in the production of the revamped S-22EZ. Furthermore, there is still a limited supply of concrete in America.
All of this has led Somero to expect a 15% to 20% decrease in revenue for the first half of the year. They anticipate a 10% decrease for the full year. If the production of the S-22EZ improves, a portion of the lost revenue can be recovered.
Somero learned from the 2008 crisis and is responding rapidly to changing circumstances. They have already reduced costs and made adjustments to their workforce.
This warning caused a decline in the stock price, presenting an opportunity to buy.
In the fiscal year ending on March 31, 2023, Cake Box had 205 franchise stores, indicating a growth of 20 stores in one year. Additionally, three new kiosks were added, bringing the total to 18 by the end of March.
The revenue from these stores increased by 9.6% to £72.1 million. However, when looking at the like-for-like growth, which represents the growth of stores open during both twelve-month periods, there was only a 1% increase.
However, it is worth noting that the second half of the year performed much better. The first half experienced a decline due to inflation and the lifting of COVID restrictions, resulting in more vacations abroad. And when people are on vacation, they obviously cannot consume cake at home.
Cake Box’s revenue itself increased by 5.6% to £34.8 million. The gross margin also improved by 1.4 percentage points to 49.4%.
As mentioned before, Cake Box deliberately chose not to pass on all the higher costs to franchisees in order to keep prices in stores rising less than or equal to inflation. Additionally, the costs for Cake Box itself also increased significantly. Overhead costs increased due to necessary adjustments to the management team, additional controls, investments in IT, and more.
These investments were not only necessary to catch up with previous growth but also for future growth. For instance, £2 million was spent on capital expenditures for improvements in distribution centers and bakeries, a newly launched website this month, an improved ERP system, and an expansion of the fleet with refrigerated vans.
The higher costs have had an impact on Cake Box’s profits. Operating profit decreased by 28.6% to £5.58 million. Net profit even decreased by 32.9% to £4.23 million.
Despite all the investments, the net cash position increased by 15% to £6 million, indicating how strong Cake Box is in generating cash. They also reward shareholders by increasing the dividend by 6.9% to GBp8,125, resulting in a dividend yield of 5.75%. This gives us time to wait for the stock price to rise.
The positive trend from the second half of the year continued with a like-for-like growth of 5.4% in the first eleven weeks of the fiscal year.
Question from a partner
Q: Good afternoon, could you please clarify for me what those different amounts are on the monthly statement we receive since the new fund was established? Not clear to me what subscription and closing amount reflects.
Answer: The subscription amount should be seen as the value in mid-May 2023, at the time of creation of the new fund. Everyone subscribed (in Creand’s systems) at that time. They could not include the history of the old fund in their systems. So you should also find that number on the ‘merger notice’ you used to receive from Creand. ‘Closing’ is the value on the last day of the month of the relevant NAV calculation.
Next meeting
We are maintaining the rhythm of quarterly video meetings. We are planning the next meeting on Thursday, 27 July. Doors open from 19h15, start at 19h30.
Chess Capital Q2 quarterly meeting
Thursday, July 27 – 7:15 – 10:30pm
Time zone: Europe/Brussels
Participation information for Google Meet
Link for video call: https://meet.google.com/vst-mrcv-diu
Or dial: (BE) +32 2 896 38 97, PIN: 923 939 360#
More phone numbers: https://tel.meet/vst-mrcv-diu?pin=3741453114994
Kind regards and thanks,
Sam & Joel