„The most common cause of low prices is pessimism — some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.“
- Warren E. Buffett
PERFORMANCE
Dear RICHTWERT Partners & Co-Investors,
On 7/21/2020, I wrote to you that I believe the euphoria surrounding many growth companies is overdone, speculative and dangerous, and that I therefore would not participate with our capital in the euphoria, even if it meant that we may do less well than the overall market. As Market Twain once said, "There are two times in a man's life when he should not speculate: when he can't afford it and when he can."
Until a few months ago, investors were willing to fantasize decades ahead and pay very high prices even for very young growth companies. This contributed to the S&P 500 Index gaining 28.7% in USD, 27% in EUR, and 26.6% in CHF in 2021, while our portfolio performed 7.2% in USD, 16% in EUR, and 10.6% in CHF. The stronger performance in EUR and in CHF came about because the rise of the USD in 2021 favored our investments in the United States.
Our portfolio companies' operating performance was approximately 14% in USD compared to 17% in the previous year. The delta between the share performance of our companies of 7.2% in USD and their business performance of 14% in USD arose from the fact that investors took an excessively pessimistic view of Grenke and our Chinese businesses, which they still do at present. I have more to say about this in the section How Is Our Capital Invested and What Are the Prospects?
A few months later, investors' mood is unrecognizable. Massive support measures by governments and central banks during the pandemic, coupled with supply bottlenecks, have boosted demand and tightened supply. Complicating matters are the war in Ukraine, rising energy prices, and regulatory measures as well as new COVID outbreaks in China (see Market and Innovation Leaders in China). Consequently, we are experiencing high inflation rates and rising interest rates as well as a rapidly cooling global economy.
Many overvalued companies have suffered share price losses of 50-90% since the beginning of the year (i.e., they were recently valued at 2-10 times as much). Some are still too expensive, while others now offer very attractive opportunities.
The most popular cryptocurrencies, which were supposed to protect against inflation among other things, have more than halved in value since their highs. I still believe they are probably worthless because governments want to be in control of money and will not allow non-government-backed cryptocurrencies as official payment methods.
Also virtually gone are the young investors who focused solely on themes and disruption, touting their investment strategies on YouTube and TikTok channels, who had never experienced broad-based price declines. I liked that they had "skin in the game" (i.e., they also invested their own capital) and look forward to those who persist and advance. Investors and businesses need investment managers who think and act like owners.
Meanwhile, the S&P 500 Index fell almost 20%, even as energy companies in the index posted a nearly 60% gain.
Although I had invested our capital far from overvaluations, our portfolio was temporarily down by up to -30%. I attribute this to two developments, which which I consider to be temporary exaggerations:
While last year hardly any price seemed too high to most investors, in recent months, investors not only sold off overvalued companies, but also high-quality companies that were fairly or even undervalued, in an undifferentiated manner. Grenke, HelloFresh, Meta Platforms and Warner Brothers Discovery, where we are invested, are good examples of that. This is not surprising, because over the last two years in particular, many investors had entered the stock market who were neither capable of, nor interested in, valuing businesses. They only went along because stock prices were rising. Now that prices have fallen, they lack any reference to evaluate their investments in a fundamental and objective way.
I had invested close to 30% of our capital indirectly and directly in China because leading and very innovative Chinese businesses were valued much more favorably than similarly strong companies in the US. However, over the last 12 months, the Chinese economy cooled sharply mostly due to regulatory actions by the Chinese government and most recently due to COVID outbreaks and lockdowns. The fact that our Chinese companies were valued attractively to very attractively has been of little interest to most. As you will read in the Market and Innovation Leaders in China section, I view the market reaction as unreasonable and value our investments in China highly.
You may now be asking yourself:
Couldn't one have anticipated such macro risks and acted accordingly?
How do we know that our portfolio companies are undervalued?
What is the point of investing in high-quality, undervalued companies if their shares can fall as much or even more than the overall market?
In respect to 1:
You will find my thoughts on the first question in the section Investing Under Uncertainty.
In respect to 2:
In the section How Is Our Capital Invested and What Are the Prospects? I explain why I regard our investments as undervalued.
In respect to 3:
High quality and undervalued companies may not offer protection from overreaction in the short term, but that does not change the fact that after such overreactions, they offer phenomenal opportunities at even lower risk. I love irrational overreactions just as Peter Lynch eloquently highlights in this short video:
First, such businesses are better protected against unpredictable risks; second, they often widen their advantages over competitors during difficult periods; third, they can buy up competitors cheaply or buy back their own shares below value, thus maximizing value for remaining shareholders.
Over time, investors broaden their time horizons again, recognize the potential of undervalued companies and reward investors who have been willing to ignore or even better exploit overreactions. In the words of Patrick Collison: “Pessimists sound smart. Optimists make money!”
Investing Under Uncertainty
No one can repeatedly predict macro risks and capital markets. The most esteemed macro investors, economists and central bankers are wrong more often than they are right. I myself always expect risks, but I never know when they will occur, how severe they will become, or how long they will last. The reasons are obvious:
There are too many interdependent variables at the macro level.
Investor intelligence tends to neutralize, so identifiable macro risks are often already priced in. Therefore, even if one could predict macro risks, one still cannot know how markets will behave.
Companies are not static and usually adapt to circumstances.
When markets recover, they often do so rapidly leaving behind those trying to catch the bottom.
However, not being able to predict does not mean you cannot invest successfully. If you invest in a farm, for example, you also know that there will be both profitable and poor years. The same applies to businesses. When and to what extent uncontrollable risks occur, is known only in retrospect. Consequently, you focus on what you can influence (As a manager, for example: location; who you hire; what you grow/produce; how you control costs; and as an investor: a price that takes risks into account).
No one would think of selling a good farm or business because they think they can predict the weather or the world economy in the coming months or years. But the fact that securities can be traded at any time tempts investors to try their luck with macro predictions and market timing anyway.
In the stock market, it is not timing that is crucial, but investing in good companies for the long term and staying invested. Not because timing is not important, but because successful timing is a game of luck. Therefore, I put myself in the position of a long-term owner and focus on the competitive advantages of the few companies we invest in and the prices we pay for them. Over the medium and long term these factors are both more important and more predictable than macro events.
Of course, it is difficult when the market tells you your portfolio is worth 30% less, but we must never forget that market prices in the short term are nothing more than snapshots of sentiment. In 2019, for example, our portfolio was up nearly 60%, but the value of our companies was up "only" 19%. The price increase was three times the increase in value because our companies were previously undervalued. Today, I believe that our companies are severely undervalued again.
We are well advised to use "market moods" to our advantage or ignore them. Benjamin Graham, the pioneer of value investing, summed it up aptly more than 70 years ago: “The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons’ mistakes of judgment.”
Successful investing in stocks requires a long term view and multilevel thinking. Since both are rare at the moment, it is all the more important that we take them to heart.
Distinguishing Between Noise and Signal
Most events lose much of their significance when one takes a multi-year and global perspective. The conflict between world powers is nothing new and will outlive us all. Many talk about living in a new age of confrontation, but this is only a distorted European perspective. For instance, who still thinks and talks today about the recent wars in Iraq and Syria, which were also proxy wars between the West and the East? Since 1950, the price of oil has fluctuated between $20 and $180 per barrel with an average price of about $60. Inflation has been higher than many have perceived and interest rates have been way too low for more than 10 years.
Interest rates have risen and will likely continue to rise for the time being, but no one knows how far or for how long, as technology as well as digitization are also advancing rapidly. Books, televisions, monitors, musical instruments and much more will become obsolete in just a few years, much like vinyl records, Walkmans and CDs. It also begs the question how long inflation will remain elevated when the global economy loses momentum, as can currently be observed.
In the section How Is Our Capital Invested and What Are the Prospects? you will discover that we are invested in many world leaders with dominant competitive advantages. Is it so surprising
that these companies sometimes get more heavily regulated?
that the laws they have to comply with often lag behind developments?
that politicians seeking reelection look for scapegoats?
that media outlets that sell headlines pounce on them in a biased way?
that these companies usually adapt successfully to the circumstances and move forward?
Multi-Level Thinking
Time and again, I observe one-dimensional thinking in stock markets:
Positive news, prices up. Negative news, prices down.
Quarterly expectations exceeded, prices up. Quarterly expectations missed, prices down.
More regulation, prices down.
War breaks out, prices fall across the board except for commodity and energy companies.
COVID winners will all have to suffer as we regain some normalcy.
If only investing were that simple and one-dimensional. Investing is always multi-dimensional and requires multi-level thinking:
The positive/negative news is not as positive/negative as the expectations that were priced into the stock price, so the price should fall/rise, not rise/fall.
More regulation slows companies down, but it also raises barriers to entry for competitors.
War also leads to higher government spending and higher inflation. As always, there will be winners and losers. Too much cash is the last thing to hold in war.
Inflation mostly hurts capital-intensive firms with little pricing power. Commodity and energy firms are definitely capital intensive. Contrary to the currently prevailing opinion, I doubt that commodity and energy firms have pricing power. When demand exceeds supply, energy and commodity prices increase, conversely they decrease without the firms being able to influence them much. They may be highly profitable for a few years because they have already made investments, but new investments will be needed at higher prices. I believe there are more attractive investment opportunities in the medium term.
COVID has also accelerated many things in the long term and irrevocably changed consumer expectations and behavior. Exceptions certainly confirm the rule, but hundreds of millions will work more from home in the coming years, for example. Even after COVID, movie theaters will no longer fill up as they did before. Digitization and e-commerce will continue to increase. Certainly not all COVID winners will suffer, some will continue to triumph in the medium and long term.
How Is Our Capital Invested and What Are the Prospects?
I have summarized our investments thematically to make it easier for you to recognize and remember what you own. This thematic grouping may give you the false impression that I look top-down for themes and trends and invest accordingly. This is not so! In reality, I always take a bottom-up, company-by-company approach and only invest in companies that I can understand and value, whose management I appreciate, and which I believe are undervalued.
The concentration in the financial services, media/entertainment/communications, marketing and consumer goods/services sectors is because I think I can better understand these businesses and their competitive advantages and thus more reliably identify undervalued opportunities.
I will say one thing up front: I estimate that about 70% of our portfolio is worth twice what their current share prices reflect in May 2022, while the remaining 30% is also undervalued. Inflation, rising interest rates, war, and potential recession are legitimate concerns, but the fact that roughly 70% of our portfolio is valued lower by the market today than in March 2020 when the pandemic threatened to shut down economies around the world shows you the extent to which investors are writing off our companies. Philip Fischer was right: “The stock market is filled with individuals who know the price of everything, but the value of nothing.”
Overall, our companies should be able to increase their intrinsic value by an average of 12-20% per year, but their current share prices are just 13 times their annual earnings. Most real estate in German-speaking countries is at least twice as expensive, although it will probably grow in value less than half as fast as our businesses. I would not be surprised if our portfolio would be valued two and a half to three times as high in about 5 years.
In saying so, I assume that the war in Ukraine will not escalate further internationally and that inflation will not remain so high in the next few years that we will see interest rates of over 6% for several years. Should these scenarios materialize, all assets, not just shares in businesses (stocks), will be under strong pressure. However, even under these unfavorable scenarios, I expect our companies and investments to at least perform satisfactorily. I cannot say the same for many other investments.
Financial Service Providers with Inflation Protection
Approximately 30% of our capital is invested in attractively valued, specialized or leading financial service providers that offer good protection against inflation and rising interest rates.
Bank of America and Wells Fargo are leading and very financially strong U.S. banks. They benefit from inflation and rising interest rates because they have very large customer deposits for which they pay little or no interest, and which they can use to make loans at higher rates in the future. They were undervalued for a long time because hardly anyone believed interest rates could rise, and now that interest rates are rising, investors fear a recession. Sometimes you just can't please investors. Yet they are more strongly positioned today than they have been in the last 50 years and are well positioned for almost any scenario, but especially if interest rates rise.
Blackstone and Brookfield are the world's leading alternative (real estate, private companies, infrastructure, credit) asset managers. They possess great talent, significant client capital committed for the long term, lots of dry powder to invest, and very good reputations and relationships. Their investments are well protected from inflation and they have clients who shun market volatility and therefore have little choice but to invest in alternative assets.
Grenke is a specialized leasing provider in more than 30 countries for small and medium-sized firms looking to finance office or practice equipment. In the last two years, Grenke was the target of a short-seller attack, which I addressed in the last co-investor letter, and had to undergo large efforts for external audits, while at the same time the pandemic put a heavy strain on the business. Now the burdening factors are behind us and Grenke is focusing on its proven competitive advantages (customer proximity, risk assessment and cost leadership through digitalization) to grow the business again. The current valuation is pricing in single-digit growth from a low level, but I expect more from Grenke because of the large opportunity set and because of Grenke's unique strengths.
Market and Innovation Leaders in China
Another 30% of our capital is invested indirectly and directly in Chinese businesses that are financially very strong, have dominant market positions, and are even ahead of American companies in terms of innovation.
Alibaba is the leading e-commerce provider in China and is also a leader in Southeast Asia. The company serves nearly 1.3 billion customers in China and abroad. In addition, Alibaba is the leading provider of digital payments and cloud IT services in China. Furthermore, it provides significant logistics services for e-commerce and food as well as digital media and entertainment.
Tencent has market-leading positions in no less than six business areas. With Weixin/Wechat, it owns the leading social network as well as the most widespread messaging platform in China and commercializes these via marketing and e-commerce. Tencent is also the leading provider of digital games worldwide. In addition, the company is the market leader in China for video and music entertainment. Moreover, Tencent offers a digital payment platform as well as cloud IT services and productivity software for companies that are top 3 ranked in China. Finally, Tencent holds investments in a large number of promising start-up companies.
Prosus and Naspers have been invested in Tencent since 2001 and own additional attractive investments besides Tencent. The value of their Tencent investment alone is 180% of their current share prices and I find Tencent itself undervalued. Professional investors justify the valuation discount by claiming that Prosus and Naspers' management destroys value, as well as the fact that selling or giving Tencent shares to shareholders would incur taxes.
Yet there is hardly any management worldwide with such a strong track record. The original investment in Tencent may have been fortunate, but the wisdom and patience to stick with it through thick and thin is virtually unparalleled. In addition, the management has accumulated numerous valuable businesses that are currently unjustly undervalued by investors. The investment in Tencent is also held in a way that taxes should not be a major concern.
Distinguishing between reality and appearance means a lot to me, and I am delighted when investors take a superficial and depreciating view of such companies for years, even if that means reporting seemingly less attractive returns to you in the meantime.
Few invest for the long term like owners in businesses led by managers who make decisions that may take years to bear fruits. My pulse, on the other hand, beats faster when I discover such disregarded opportunities, even more so when they are ignored for years, because it allows me to invest more of our capital at attractive terms.
The following response from Bob Van Dijk, CEO of Prosus, illustrates which managers I value:
“What’s the impact of Chinese stocks getting pummelled in the aftermath of the sweeping changes?”
“It impacts our share price. It is a really important point, and good to make here, that we are a long-term investor. We think 10-20 years ahead. In the case of Tencent, we've been deeply invested for more than two decades. And that's the horizon we have when we come into India. We're not there to make a quick buck, we're not a fund. We don't have an exit timing. We stay for the long term. Ups and downs, in the near term, really don't influence a strategy - not in India, nowhere else either.”
According to market participants, our and many other Chinese companies are worth less than half as much today as roughly a year ago. The Chinese economy is experiencing a difficult environment as the government has cracked down on speculation in the real estate sector, regulated the education as well as the Internet industry, and is vigorously trying to contain the spread of the pandemic. In addition, the U.S. Securities and Exchange Commission is threatening to ban Chinese companies from U.S. stock exchanges if they do not have audits of their financial statements inspected by the Public Company Accounting Oversight Board. These factors prompted major investment houses to declare China "uninvestable."
My view is different: unlike many misguided efforts in the West, I believe the majority of regulation in China is right and necessary. For example, China has banned all cryptocurrency transactions and introduced a central bank-backed cryptocurrency that curbs speculation and shady activities; stopped the expensive commercial education market for students; better protected minors from gambling addiction and restricted their gambling time; banned monopolistic business practices; regulated technology companies that provide financial services the same way as other financial service providers and also regulated them to better protect consumer privacy. China has also announced that it will pursue a joint solution with the U.S. Securities and Exchange Commission.
Admittedly, three hours of playtime per week for minors surprised me too, but which far-sighted citizen would not welcome the majority of the measures taken? I wish Europe and the USA would learn from China and proceed in a similarly far-sighted and rational manner.
We should also not overlook that China accounts for about 20% of the world economy alone as a consumer. Moreover, China is also an engine for the world as an export and technology nation. Should China really be "uninvestable", the world would face much graver problems.
Meanwhile, the Chinese government has announced that the wave of regulation will now move into a more orderly mode and that it will support technology companies and the economy as a whole. Despite all the criticism of China's strict COVID strategy, we have to admit that China has had a much better grip on the pandemic than the West. Only in Shanghai have the lockdowns lasted longer, and even there the situation seems to be improving. I am always careful with statistics, but China probably has little interest in underreporting deaths because that would be contrary to their strict COVID strategy.
It is quite possible that we will see the Chinese economy bottom out this year and that the coming years will be more encouraging. In addition, the market-leading firms have announced that they will rationalize their efforts and no longer fight for new customers at any price. This points to healthier profit margins, which are also not currently priced into their stock prices.
I like our chinese businesses; know that they also offer valuable services that they are not yet commercializing at all or are deliberately under-commercializing; consider them undervalued and would not be surprised, provided the war in Ukraine does not take on new proportions, if their share prices were to double again in not too distant future. On top is the attractive medium- and long-term outlook for China in general and for our businesses in particular, which I am still optimistic about today.
Media, Marketing, Communication & Digitization outside China
Another 20% of our capital is invested in Alphabet, Meta Platforms, Warner Brothers Discovery, and Wix.com, all of which offer information, communication, entertainment, and digitalization worldwide outside of China. Together with our Chinese companies, we cover the world very well.
Alphabet owns services such as Google, Android, YouTube, which are regularly used and appreciated by billions and have benefited significantly during the pandemic due to increased digitalization. Furthermore, the fact that Apple has made it significantly more difficult for apps such as Facebook and Instagram to identify users, has given more browser-based apps such as Google a relative advantage. In addition, Alphabet owns Google Cloud Platform, the world's third largest IT cloud service, and has long term investments in many potentially valuable areas. Due to the war in Ukraine as well as the difficult comparison with the excellent last year, there is temporarily some pessimism, which we are happy to take advantage of.
I described our investment in Meta Platforms (Meta), formerly Facebook, in detail in the 2018/2019 co-investor letter. As previously mentioned, Apple has made it significantly more difficult for apps such as Facebook and Instagram to identify users. As a result, it is now more difficult for Meta to display targeted advertising (targeting) and show its impact to advertisers (measurement) as before. In addition, TikTok has successfully positioned itself alongside YouTube, Facebook and Instagram and gained market share among users and advertisers. Both of these developments, coupled with the difficult comparison to the very successful previous year, have resulted in Meta's share price losing more than half in approximately 8 months.
I view this as an overreaction. Meta increased corporate profits by 46% last year, is investing in restoring its targeting and measurement advantages, has introduced Reels, a potent competitor to TikTok, and is investing very heavily in a future shaped by the next version of the Internet, the Metaverse, in which we are not looking at the Internet from the outside as we are today, but are right in the middle of it.
The current share price is pricing in that Meta can barely grow profitably and is completely writing off the massive Metaverse investment. Both expectations are possible but not likely. It is interesting that other still unprofitable companies that are committed to the Metaverse are highly valued, while Meta, which is enormously profitable, has an R&D budget in the billions, as well as staying power, and is led by a very motivated and capable management, is viewed so pessimistically. In the following interview, I explain what speaks for and against Meta as an investment.
I also described our investment in Discovery in last year's co-investor letter. Now, as planned, Discovery has successfully merged with Warner Brothers and has an even more attractive library of content that they will now market globally via subscriptions and advertising. Further, Warner Brothers Discovery is not only a distributor of entertainment but also a very potent producer of attractive content that also other distributors license.
There are few management teams as focused, disciplined and committed to delivering promised results as Discovery's. In recent years, Discovery generated $2.5 - $3 billion annually in free cash flow with approximately $11 billion in revenue. Now Discovery management has the potential to bring the same effectiveness to Warner Brothers, which generates no free cash flow on approximately $40 billion in revenue.
Market participants see an entertainer on the decline. I see a significantly undervalued business, led by a well coordinated, talented and motivated team with a very good track record that knows where the entertainment market is heading and is energetically setting the right course. Today, they have an even better hand in terms of content, diversification and synergy.
Wix.com (Wix) is the world leader in website creation and also supports their commercialization. I know the company well, as well as its closest competitor Squarespace, because we compared both for the RICHTWERT website and ended up designing the website with Wix because it provides the more flexible platform.
Both Wix and Squarespace are very good companies that enjoy tailwinds in an increasingly digital world. Besides these two, there is a substantial do-it-yourself market in which websites are created via Wordpress. Since Wordpress requires a lot of technical expertise and requires third-party service providers for support, I expect both companies to gradually gain more market share and be successful for many years.
Market participants take a pessimistic view of the company because the current economic development is uncertain. I view the future more positively for Wix especially since the company's services are very affordable and the company operates with a proven freemium business model where customers can create websites for free and only pay when they do not want ads on their website or whent they wish to benefit from other valuable value-added services such as marketing, e-commerce and appointment booking.
Innovation in Dining
Just over one-tenth of our capital is dedicated to companies that are changing the way we source and prepare food. These include our investment in HelloFresh, the world's leading provider of meal-kits (cooking boxes), which delivered nearly one billion meals last year and grew its revenue by 60%. In the following interview, I discuss the investment thesis for HelloFresh.
Additionally, we are indirectly invested in the leading food delivery business in Brazil, the number 1 or 2 food delivery business in India, the two leading food delivery businesses in China and the leading food delivery firm in the rest of the world.
Since the turn of the year, investors have been mostly selling growth companies that were highly valued and not yet profitable, and this is even more true for those that benefited from COVID. HelloFresh was neither unprofitable nor highly valued, but the stock fell first as fears about Omicron grew (even though a dangerous Omicron would have helped demand for HelloFresh meal-kits) and then fell further as it became clear that Omicron was not that dangerous thanks to vaccines, as investors thought that now demand for meal-kits would fall. Yet the lockdowns had been over for a long time and HelloFresh had proven that they also grow fast when we start shopping and eating out again.
As explained in the interview above, I expect HelloFresh to thrive even without COVID because they make our lives easier as well as more enriching in a sustainable way, while enjoying cost advantages and still being at the beginning of their mission. In 5-10 years, we will look back and probably wonder how we bought and prepared food before. Also, I am not yet sure the last word has been written on Corona.
Other Portfolio Companies
The remainder of our portfolio is invested in Tesla, auction platform, digital payment, and e-learning providers, some of which enjoy little popularity with investors, but all of which have solid competitive advantages and should enjoy considerable tailwinds for a long time.
Stocks Are Only a Means To an End - It Is the Companies that Count
I am well aware that large share price drops are emotionally challenging and I am very grateful for the trust you have placed in me. I hope that the details on our portfolio companies will illustrate to you what you own and allow you to look to the future with confidence and patience.
Recently, I read this year's annual report of Berkshire Hathaway, led by Warren Buffett, and discovered a passage that describes very well the attitude with which I invest for us: “Please note particularly that we own stocks based upon our expectations about their long-term business performance and not because we view them as vehicles for timely market moves. That point is crucial: Charlie and I are not stock-pickers; we are business-pickers.”
I have tried to put myself in your shoes and share with you the facts that I would want to know if our roles were reversed. Please do not hesitate to contact me with any questions or suggestions. I value you very much as partners and am very happy to assist you!
Respectfully with my best wishes,
Bahram Assadollahzadeh, CFA
May 2022