Dear partner,
Paul Johnson, professor at Columbia Business School and Director of the Gabelli Center for Global Security Analysis, inspired us with his presentation in Omaha for Guy Spier’s ValueX group. He discussed the price of growth.
As value investors, we strive to rationally determine the value of an asset, excluding emotions from our calculations. However, market pricing is a combination of emotion and rationality.
Let us first clarify what we mean by emotion. The primary emotion affecting investors is fear. This human phenomenon sometimes leads to unrealistic pricing in the stock market. Companies can be shunned due to fear of unrealistic horror scenarios. On the other hand, the fear of missing out (FOMO) can result in high prices and high growth expectations.
As a value investor, you estimate the value of a company, which can be divided into two parts. One part is the current value at the status quo, meaning the value if the company no longer grows. The other part is the potential for growing profits, which also creates value. Implicitly, this means the value investor also considers profit growth. Growth is an essential part of a company’s value.
What are we aiming for? It is the assessment of whether the market price reflects realistic growth. We want to explain this exercise of separating the current value and the value attributed to growth.
Let us start with an example that everyone can easily understand. When you buy something for 1 million and it yields a net 100,000 annually, you have a 10% return on your investment. If it only yields 50,000 per year, you have a 5% return. This is straightforward.
Consider the example of buying about five student apartments in a building. Suppose you require a 5% return and the current net annual income per apartment after all costs is 6,000 euros. The building then generates 30,000 euros annually. If you assume no growth in rental income, you can pay a maximum of 600,000 euros (i.e., 30,000 / 5%).
If you assume you can index the rent by 2% annually due to inflation, then your required return at purchase today can be 3% (since there is an additional 2% growth due to the index). In that case, you can pay 1,000,000 euros to generate a 5% gross return over the years. The formula used is 1,000,000 = 30,000 / (5% – 2%). Therefore, you can say that the pricing includes a part of the current value, namely 600,000 (because 600,000 x 5% = 30,000), and the other 400,000 relies on the lifelong rent indexation of 2% (thus growth in rental income).
We can use the exact same principles when we use the price-earnings (P/E) ratio of companies as an indication of expected growth. Let us replace the student apartments as an investment with publicly traded companies.
- the purchase price is the market capitalization on the stock exchange;
- the rental income is the net profit of a company;
- the growth of rental income becomes profit growth;
- and the required return is the required return.
It’s no more complicated than that.
When you buy a company with a P/E ratio of 15 and assume there is no profit growth, you are essentially saying that you require a return of 1/15th or 6.66%. Conversely, if you require a return of 12%, you would only pay a maximum P/E of 8.3 if there is zero growth.
We can perform the exact same exercise as with our building by splitting the market capitalization (i.e., market value) into part A which meets our return requirement without growth and part B which reflects the growth. This way of looking at things allows us to determine what bird we have in hand and how many we still need to shoot from the sky.
Let’s take a well-known example to illustrate this. Everyone knows Apple: Apple’s stock price has performed remarkably well. Look at this 10-year chart:
From $20 to $30 ten years ago to a breakthrough above $200. Let us now look at the enterprise value at the end of each year for the past ten years. The enterprise value is the market capitalization plus debt minus cash. This gives the following chart:
In ten years, the enterprise value increased from $400 billion to more than $3 trillion recently. All values are as of December 31, except for LTM (Last Twelve Months), which is as of the date of writing (mid-June 2024).
Since Apple repurchased approximately 30% of its shares over that period, the enterprise value per share increased even more. This is illustrated in the following chart.
This chart reflects the value the market assigns to the company (after accounting for debt and cash).
Now let’s look at the value that can be attributed to the current operational profits and the value paid for future growth. To make this calculation, we need to divide the annual operational profit by our required discount rate (or our desired return). Compare this to the example of the student apartments. The desired discount rate can vary, but the principle is identical.
In 2013, Apple made about $36 billion in operational profit after taxes. For simplicity, we will assume a 10% return requirement. This means that you would value Apple at that time at $36 billion / 10% = $360 billion. The actual enterprise value of Apple at that time, specifically on 12/31/2013, was $370 billion. This means that an investor who bought Apple back then would earn a 10% return if the company’s profit did not grow. In other words, there was hardly any growth priced in. So far, so good.
We now perform this calculation for each December 31st of the past ten years. This gives the following view:
What does this chart tell us? The orange bar represents the annual profit, discounted at our 10% return requirement. This is the value of the company without growth. The green bar closes the gap between the orange bar and the actual market value. It is the amount the market is willing to pay extra, indicating the value the market expects for future growth or the Market Implied Value of Growth.
What do we observe? In 2013, we see a tiny green line, representing $10 billion on an enterprise value of $370 billion. Until 2018, the market anticipated very little growth in the stock price. Starting in 2019, the stock price exploded. If we were to plot these figures “per share,” the differences would become even more pronounced since the company buys back and destroys shares. Profits, as well as growth expectations, are thus gradually distributed over fewer shares.
This allows us to split the stock price into a ‘hard current value’ and a ‘hope-for growth value.’
The ‘hope-for growth value’ was negligible about ten years ago (the green line). For years, it fluctuated between -20% and +30% of the enterprise value. The market was uncertain, oscillating between slight growth and slight decline. Since 2019, the market consistently expects growth, with more than 60% of the value attributed to growth. As of today (mid-June), 69% of the market value is determined by the expectation of future profits.
Consider what this means. It indicates that you are paying more than twice the ‘hard current value’ for future growth. In other words, future profits are being valued at double the current profits. For clarity: that future growth must be realized to achieve your 10% return.
To fully understand the chart (though this is just a footnote): we split the ‘hard current value’ into the company’s capital (red line) and the premium above book value based on profits (blue line).
Why this exercise? What insights does it provide? Let’s look at a famous investment decision.
Warren Buffett, through his Berkshire Hathaway, is a major shareholder of Apple. Apple represents a significant portion of Berkshire’s value. And when did Warren buy his shares? Exactly, during the period from 2016 to 2018, when the market saw no growth in Apple. And when did he sell 10% of his position? Exactly, last year. Even for him, the growth projections became too exuberant.
This simple exercise allows us to determine for any stock how much value we attribute to current profits versus growth (green line). Currently, 69% of Apple’s stock price is based on growth.
When we perform this exercise with a required return of 12% (we find 10% a bit modest for the risk taken) and look at the Magnificent 7, we get the following share of growth in the current valuation of the enterprise value:
- Google 67%
- Meta 68%
- Apple 74% (so 5% higher than with the 10% return requirement)
- Microsoft 78%
- Netflix 81%
- Tesla 89%
- Nvidia 89%
Now, we have already mentioned that growth is an obvious part of valuation. However, growth is uncertain, and the more growth you factor in, the more risk you take and the less margin for error you have in the future.
A very simple DCF (Discounted Cash Flow) exercise teaches us that to achieve the median of 78% for the Magnificent 7, a company needs to grow annually by 21% for ten years and then grow at the inflation rate thereafter. This means that profits need to increase nearly sevenfold in ten years. Not impossible, but very challenging.
We look for companies where the exercise is less challenging. For example, take a company that grows 10% annually for the next five years, then grows 5% annually for another five years, and thereafter follows the inflation rate. Such a company has a 45% growth expectation built into its price. 55% of the value is based on current profits. We feel comfortable with companies where less than approximately 40% to 50% of future profits need to come from growth. Compare this to our student apartments.
Let us now perform this exercise for a less glamorous stock. Our own Tessenderlo.
First, I will show you two charts.
The stock price literally did nothing for 10 years.
For our investments, we aim for a 12% return, and this applies to Tessenderlo as well. In this chart, you can clearly see that there is hardly any growth expectation priced in:
Orange bars: The enterprise value of Tessenderlo per share, based on the profit in that particular year (discounted at 12%), follows the profit evolution.
Green bars: The profit growth expectation that is factored into the stock price.
What can we make of this?
- In 2013, before the takeover by Luc Tack, there were high growth expectations (large green bar). And indeed, growth followed (as shown by the subsequent increase in the orange bar).
- 2022 was an exceptional profit year with €261 million in operational profit after taxes. Consequently, the value calculated based on that profit is high, and the company’s profit can decline while still justifying its market value as of 31/12/2022. This results in a negative green bar.
- For the current stock price, I have used a normalized annual profit (operational profit after taxes) of €186 million, which is the average of 2021, 2022, and 2023. If we consider this profit as ‘normal’ (which seems a very reasonable assumption), about 75% of the current value is in that normalized profit. 25% needs to be realized through growth. The question now is what that 25% means. It is not 25% annual growth. It is simply the portion of the value that must be achieved through profit growth.
- You can translate this into several years of growth at a certain rate to achieve a profit that gives us the desired 12% return. What profit needs to be achieved? The formula for this is €186/(1-25%) = €248 million operational profit after taxes. There are multiple possible scenarios:
- If the company reaches €248 million after five years, that means an annual growth of 5.9%.
- If the company reaches €248 million after ten years, that means an annual growth of 2.9%.
- The good news is that our return is realized not only through profit increases but also through dividend payments and share buybacks. The sum of dividend yield plus share buybacks equals ‘free’ return. At the current stock price, we have a 3.2% dividend yield, and at the current buyback rate, you can add a few more percentage points.
- Our conclusion is that with the current dividend yield and share buybacks, Tessenderlo will provide us with a 12% return, driven solely by the expected inflation. This is a comfortable situation with low risk.
If we extend this exercise to the compounders in our portfolio and use the normalized profit as the average of the last three years (to smooth out any irregular fluctuations in profit figures), we get the following percentages as the portion of the valuation attributable to growth expectations:
- Cake box 37%
- Smartphoto 28%
- Tessenderlo 25%
- Deceuninck – 6%
- Somero Enterprises -59%
Cake Box and Smartphoto require a bit more growth than Tessenderlo. Notably, Somero and Deceuninck are valued so cheaply that they can even shrink and still meet our 12% return requirement.
This method of analyzing enterprise value was introduced to us by Paul Johnson. It is a great tool that helps every investor consider the value of the ‘now’ and the value based on ‘hope’. The less hope that is factored into the price, the less the investment relies on future market developments, and thus, the fewer surprises we encounter.
The lower the stock price, the lower the enterprise value, and the less growth the company needs to achieve to meet our return requirement. This is another way of saying that buying a stock at a low price requires less growth to achieve your investment goals. This is precisely our approach. We favor situations where we take on little risk and have modest growth expectations.
A look into the stock market
We have discussed and written several times that this is a strange market, with the Magnificent 7 and the continued undervaluation of small caps, which is precisely our speciality.
We are not satisfied with the results; they are not good enough compared to the market. We have already written about the reasons several times. Instead of repeating the story again, I have collected a number of tweets from other investors, so you can also see that we are not the only ones noticing this.
In this tweet, Jason points out the discrepancy that the entire stock market is being driven by a limited number of stocks.
Such movements have never held up in the past.
Someone else points out the same in the S&P 500: the increases are due to a handful of large stocks and are not supported by the entire index.
Kurtis calculated the returns of the S&P 500 from the past. It turned out that historically, the 450 smallest stocks (of these very large companies) outperformed the 50 largest, except in recent years.
This is also not surprising, as NVIDIA alone accounts for 34.5% of the total return of the entire S&P 500 this year. Indeed, one company contributed more than a third of the index’s gains, despite there being 499 other companies, including Microsoft, Alphabet, Apple, and Amazon.
Or presented another way:
NVIDIA alone has driven 34.5% of the S&P 500’s total return this year. In other words, one company has contributed more than a third of the index’s gains, alongside Microsoft, Alphabet, Apple, and Amazon, which also play significant roles.
And what about the small caps for this year?
A loss of 2% while large companies are up 15% in America.
On Saturday, June 29th, we could read the following in the Belgian business newspaper De Tijd:
And finally, there are already people who have started praying for us. Also, note the weak results of both the small-cap and value factors. However, these two factors have historically shown to outperform the market average.
Finally, we also want to highlight this statement from the renowned value investor Robert Robotti:
Because recently I hosted a dinner about a month ago, so I had about 10 of us there and I invited a bunch of people who are still in value investing, active management, managing much less money than they used to. Including people who don’t do it anymore because they converted to a family office because they’ve given up and they’ve given back the money and don’t want to do that anymore.
This is what we are currently seeing in the market. All of this points to the adage “It’s darkest before dawn.”
While it is very frustrating for us not to achieve the results we aim for, you will not see us change our strategy, something we even see happening today at major firms like the French Carmignac. Changing strategy, especially today, in our view, is absolutely the wrong choice.
The Fund
The second quarter started strong, but the gains of early April were relinquished in the last weeks of the month. This was followed by a strong May, only to be followed by a weak June. Let’s not beat around the bush: there was a slight hope that the turning point was at hand for smaller stocks, but unfortunately, it has not materialised yet.
We have no control over when the market will turn. As mentioned several times, our focus remains solely on increasing intrinsic value. Following the significant correction applied late last year, intrinsic value was able to rise again due to strong corporate results and a few new acquisitions.
Results T-Class
Results A-Class
Our five largest positions are:
The following positions had the most negative impact on the result since January 1st.
The following positions had the most positieve impact on the result since January 1st.
Transactions
Where in the first quarter we only added to our position in Bonava and mostly sold other holdings, this quarter we deployed a significant portion of our cash position.
We purchased F.I.L.A., Cloetta AB, and re-entered a position in X-Fab. Additionally, we increased our holdings in Sipef and Maersk.
F.I.L.A. is an Italian manufacturer of pencils and related products. It caught our attention recently because the company listed its Indian subsidiary on the stock exchange. By subtracting the value of the remaining stake that F.I.L.A. holds in this subsidiary from its total enterprise value (EV), F.I.L.A. is trading at an EV/EBITDA of 2, which is extremely cheap.
Cloetta is a Swedish confectionery manufacturer known for brands like Red Band, Sportlife, Venco, and Läkerol. Despite challenges from the pandemic, inflation, and high sugar and cocoa prices affecting its numbers, we view this as a temporary issue and see the company as undervalued.
With X-Fab, we previously mentioned in our sales notes that it was not a farewell but rather a “see you later.” We didn’t expect to reunite so soon. X-Fab is facing declines in electric vehicle sales, but trading below book value makes it simply too cheap to ignore. We initiated a new position, anticipating the possibility that the price could drop further before it begins to recover.
No positions where sold or reduced.
Company news top 10
Our top ten positions together represent 55.7% of the fund’s value. Additionally, we have 6.7% in cash, which means the remaining eighteen stocks together account for 37.6% of the total portfolio.
Due to additional purchases and no sales, the number of positions has increased to 28.
Cake Box
Cake Box published its results for the fiscal year ending on March 31. The key takeaway is that it’s back to business as usual. Revenue grew by 8.7%, and gross margin recovered thanks to more stable costs.
A more refined restyling coupled with a national marketing campaign also contributed positively. Additionally, the company opened 20 new stores, bringing the total to 225. Finally, new customer software and the e-commerce site now allow customers to order online and pick up within an hour, currently a unique offering in the sector.
Operating profit increased by 15.1%. Unfortunately, the United Kingdom significantly raised taxes, limiting net profit growth to just 10%.
Luceco
Luceco provided a brief update on the first quarter, stating that they are pleased with the results. Revenue increased by 6.2%, driven by the normalization of purchases from customers who cleared their excess inventories. This had a significant impact on operating profit as well.
Exor
We couldn’t write anything about Exor for 2023 last time because we were still awaiting the annual report. The net asset value increased by 32.7% in 2023, driven primarily by Stellantis, which rose by 59% in value, and Ferrari, which increased by 52%.
Since then, Stellantis has given back some of these gains amid the overall weaker market for cars, lower production volumes due to the transition to new models, and competition from Chinese cars. Despite this decline, our portfolio still shows a solid 50% increase.
Exor’s stock price has been rising roughly in line with its net asset value, indicating that it remains undervalued. For us, this has been one of the most successful stocks so far, with a gain of 111%.
We also see their investment in Philips as a positive development; Exor’s stability and expertise could lead to a win-win situation.
Tessenderlo
The news from Tessenderlo was less positive. Initially, when we learned that Stefaan Haspeslagh was stepping down from his roles as chairman and CFO, we assumed it was due to his desire to retire at 65. However, when it was revealed that he was appointed CEO of Deceuninck (which we see as positive news for Deceuninck), rumors surfaced indicating differences in vision regarding the involvement of the Tack family within Tessenderlo.
This development does indeed alter our long-term view of the company. The Tack-Haspeslagh duo had been highly effective, with Haspeslagh advocating for the interests of smaller shareholders, serving as a counterbalance to Tack, who listened to his perspective.
What remains unchanged are Luc Tack’s capabilities, Tessenderlo’s significant undervaluation, and their robust share buybacks executed at these very low valuations. Since April alone, they have bought 826,250 shares for €20 million, averaging €24.25, well below book value.
Kamux
In the first quarter figures of Kamux, there was nothing particularly noteworthy. Revenue increased and operating profit partially recovered, resulting in a spectacular 285% rise, but the base was weak.
Most notably, analyst interest appears to be returning; attendance on the analyst call was higher than before.
Next Meeting
We hold our quarterly meeting on 25/7. If you have any questions, please feel free to submit them in advance so that we can prepare accordingly.
These are the details for the meeting:
Quarterly video conference Chess Capital
thursday, 25 juli · 7:30 – 11:00pm
Timezone: Europe/Brussels
Link for video: https://meet.google.com/qgt-woci-wxr
Or telephone: (BE) +32 2 896 35 36, pincode: 962 699 695#
More phone numbers available: https://tel.meet/qgt-woci-wxr?pin=6993633874627
Gathering at 19h15, start at 19h30
Kind regards and thank you,
Sam & Joël