To my fellow shareholders,
We are fast closing in on our second anniversary of CV Capital (our financial year end is 14 January). As we come to the end of our second year, I would like to detail key mistakes and successes in 2019 which I have not previously covered.
There are two types of mistakes in investing, mistakes from action and mistakes from inaction. One of the biggest mistakes in 2019 was inaction on my part. My friend and teacher, Tony Hansen of EGP Capital invited me to a meeting with the CEO of a payment processing company which was growing strongly and was quite cheap. I thought it looked like a good opportunity but a sharp uplift in the share price within two days of the meeting caused me to wait. Mentally it is hard to buy a stock after seeing it go up 20% but about a week later, the company announced that it sold an overseas business resulting in the doubling of the share price. The lesson is that what happens in the past doesn’t really matter, if we understand the business and if the stock is cheap, we should at least buy some immediately.
The other mistake which I actually made last year but is now acting like an anchor on our returns was over weighting our investment in Steamships. Based on cost, we allocated 13.4% of the fund into Steamships. My investment thesis was that this was a “blue chip” company trading below the book value of its investment properties whose earnings would be getting a massive tailwind from the development of large gas fields in PNG (namely Papua LNG and P’nyang) and other big mining projects. The chart below shows the expected capital expenditure for mining projects in PNG including Papua LNG.
When we made the investment, the government under the leadership of Peter O’Niel was very supportive of these projects. However in May 2019, Peter O’Neil was replaced as prime minister by James Marape. After taking over leadership the new PM shored up public support by stirring up nationalist sentiment with slogans such as “take back PNG”. This led to the government attempting to re-negotiate the Papua LNG deal with the project owners. After months of negotiations, the new government finally backed down and agreed to honour the terms of the Papua LNG agreement. As a result of “losing face” over the Papua LNG re-negotiations, the government is now trying to play hard ball in the P’nyang negotiations (which has not been signed). As P’nyang is integral to the overall Papua LNG project, the entire project is now in limbo as the negotiations between the project owners and the government appear to have come to a stalemate. Given my thesis had assumed that the economic stimulus from the project would have started by end of 2019/ start of 2020, that assumption has now gone out the window. Even though I still believe we will make money from Steamships over the medium term (even without these LNG projects Steamships has property development pipeline which should grow their asset base and contribute to future earnings growth), it has acted as an anchor on the overall portfolio return given its significant weighting (our paper loss as at 31 December 2019 is circa 22%). Given the uncertain nature of PNG politics, it was a mistake to have put so much weight on this investment.
Moving onto our wins, I’ve previously discussed Baby Bunting in our September 19 report and how it has greatly contributed to the returns for this financial year. I’ve got nothing to add but to reiterate that I believe Baby Bunting is fast on its way to become as dominant in its category like Bunnings is in theirs.
Another win has been Salmat. We acquired the shares at 55 cents in the last quarter of 2018. At the time, the Company had about 40 cents of cash per share and two business segments. The catalogue business was in structural decline but the managed solutions business was growing. I figured that both businesses were worth $120 million in total (60 cents per share) and that it was a possibility that the company would divest all its assets and shut shop. Therefore, at 55 cents it was trading below its intrinsic value of $1 (cash plus value of businesses) with a possible future catalyst. Fast forward to today the Company has sold both businesses for $125 million and will no longer have any operations come end of Februray 2020. I’m quietly confident that Salmat will distribute most if not all the remaining cash to shareholders over the next 6 months. Although it looked like my valuation of the business segments were spot on, in reality I overestimated the value of the catalogue business and underestimated the value of the managed solution business. Revenue for the catalogue business fell more than my forecast and due to its fixed cost its earnings declined at an even greater pace. With the conclusion of the sale of the managed services business in February 2020, the Company should have circa $174 million in cash and 20 million of franking credits. Therefore, before closure costs and other statutory expenses, it could potentially distributed 97 cents to shareholders (cash plus franking credits). With the shares trading at 81.5 cents as at 31 Dec 2019 and including dividends received, our return has been 57% over a 14 month holding period.
We also had success in an investment which I’m not yet ready to disclose. It is a financial institution operating in a frontier market, let’s call it Bank XYZ. I was attracted to this investment because it had close to 60% market share in its home market, growing its net profit at low teens, generated returns of equity (ROE) close to 30% which is unheard of in Australia for a bank but more importantly did not earn those high returns by lending to high risk borrowers. It could make those returns because of its dominant position in its home market coupled by a lack of competition. When we made the investment, it was trading on a price earnings multiple of 6x and was paying a dividend yield of 10%. Its valuation is cheap because it is listed on its home stock market which has poor liquidity, unsophisticated group of local investors and hardly any foreign investors. Management is aware of the problems with its local stock market and have told me a future option is to get a secondary listing in a more sophisticated stock market. If that happens, then I believe that its price earnings multiple would get re-rated to 12x instead of the current 6x. While waiting for that to happen (fingers crossed), we’re getting paid a 10% dividend yield which is not bad. Even without a secondary listing and assuming the price earnings multiple of 6x remains constant, my valuation calculation suggest that this investment could yield a 400% return over a 10 year holding period (equivalent to a 22% compound annual return). We’ve own the investment for more than 18 months and our total returns (including dividends) up to 31 December 2018 is 40%.
In my last quarterly report, I mentioned that we were casting a wider net in search of undervalued securities. This search took me to places like Hong Kong and Russia where we have made some small investments. I would like to provide a quick summary of the criteria’s used in selecting our overseas investments:
- I mostly limit my selection of opportunities to stocks which are profitable and in mature industries that are not in structural decline. I avoid any turnaround stories, companies with no track records of earnings and companies which are not conservatively leveraged.
- Given the higher risks associated with some overseas markets and my lack of local knowledge, I try to select stocks whose valuations are so cheap that there are unavailable in Australia. As an example, I screen for companies whose market capitalisation are below their current assets (cash, stock, trade receivables) less total liabilities value (known as net nets). These net nets are so cheap that if the carrying values of the current assets approximate their market values, an investor would make money by shutting the business down. And if the carrying values of the current assets are overstated, there are usually some fixed assets (non-current assets) which could potentially be monetised at a value greater than zero (given the market assigned no value to these assets). These net nets are extremely cheap and at this point in the cycle they rarely show up on the ASX. Ones that do show up are usually high risk, overleveraged or have dodgy management etc.
A net net which we recently discovered and invested in is a company listed in Hong Kong called Chow Sang Sang Holdings International (CSS). CSS was founded in 1934 and is the 7th largest jewellery company in the world (by revenue). Based on Deloitte’s Global Power of Luxury Goods 2019 report, the top 8 global jewellery companies are as follows:
When I was researching the industry, I was surprised that a Hong Kong company took top spot and that Hong Kong companies dominated the list. The rise of the Chinese middle class and growth in their jewellery consumption over the past two decades has made China the largest jewellery market in the world and these Hong Kong companies have exploited this trend by expanding their retail footprint into China.
CSS’ shares suffered a 30% drop between April and Oct 2019 mainly due to the protests in Hong Kong. This resulted in its market capitalisation falling below HK$6.5 billion which looked very attractive when compared to the value of its current assets less total liabilities of HK$7.3 billion. At this level it was trading at price to earnings ratio of 6x, paying a 7% dividend yield with the share price being at a 10 year low. In my opinion, CSS is an unbelievably high quality net net for the following reasons:
- Its brand has a long history in Hong Kong associated with quality and trust. Most Hong Kongers would know this brand and consumer trust is essential when selling expensive jewellery.
- Culturally the Chinese have an affinity for gold. Not as much as the Indians but gold is traditionally given at weddings and births. I believe the demand for gold jewellery is likely to increase as the Chinese middle class expands and becomes richer.
- The last financial report shows CSS had cash and gold inventory worth HK$9.4 billion and debt of HK$2.2 billion compared to market capitalisation of HK$6.5 billion.
- The management team is made up of descendants of the company’s founder and has jewellery retailing in their DNA. They are also the largest shareholders which suggest that their interests are closely aligned with minority shareholders.
Over the past 9 years CSS has grown their footprint in China by 130%. As of June 18 they had 534 China stores vs 87 stores in other locations (HK/ Macau and Taiwan). The chart below shows revenue growth from CSS China stores vs HK/ Macau stores over the past 8 years.
My thesis is that even in the very unlikely event that Hong Kong doesn’t recover from recent events, over the next 5 – 10 years, revenue from China will eventually dwarf HK/ Macau as the Chinese middle class expands and becomes richer. CSS has no plans to increase their HK/ Macau footprint but is focusing on opening 50 new stores in China annually. Although the Chinese stores on a per store basis currently generate significantly less revenue than HK/ Macau stores (as they sell products at lower price point), their profit margins are higher due to the lower rent and wage cost. This investment provides a cheap entry point for exposure to the fastest growing middle class in the world.
We did make a few more smaller investments which I’m looking to buy more of and once we’ve finished buying I’ll talk about these in more detail in the next report.
The portfolio appreciated marginally by 1.4% in the December quarter. There were ups and downs in the portfolio. Given that we are nearing our second year anniversary, I’ve decided to change how we present the results and show the returns both on an annual basis and since inception.
CV Capital’s objective is to beat the benchmark over the long term (3 – 5 years) and although some of our early investments are now coming to fruition, there are still many investments which has not played out yet. Therefore, I’d prefer to form a more concrete judgement of our performance after our third year anniversary. The table below shows out performance (before taxes). Our cash position is circa 12% of the portfolio and the unit price (including taxes) as at 31 December 2019 is $1.24 (rounded).