"There are two times in a man's life when he should not speculate:
when he can't afford it and when he can." - Mark Twain
Dear RICHTWERT Partners and Co-Investors,
2020 was a memorable year in many ways. The coronavirus pandemic unfortunately cost millions of lives and brought large parts of the global economy to a standstill. US and global GDP fell by more than 3%, more than at any time in the last 60 years. The U.S. stock index S&P 500, on the other hand, gained more than 18% in the same period, once again demonstrating short-term market forecasting to be pointless.
We also experienced some of the best as well as the worst in human potential. My realization from this was that this difference is even greater than we think and can also have a much greater impact than we admit. Our society, for instance, is seething with tensions that I am convinced will increase. Globally, we face choices with far-reaching consequences. The more we acknowledge these differences in potential and the more we recognize their sources, the better we can nurture gifted people and task them with our toughest challenges to create a brighter future for all of us. You will find my thoughts on this in the section "What Kind of Society Should We Want? Is Inequality Good or Bad?”.
In last year’s co-investor letter, I described why our portfolio companies were well positioned to withstand the pandemic. Overall, they increased their intrinsic/business value by almost 17% in US dollars (USD) and the equivalent of 7% and 6% in Euros (EUR) and Swiss Francs (CHF). Since our firms benefit from crises, I expect continued business strength in 2021 and beyond.
However, our portfolio companies' market performance was only 8.8% in USD, 0.6% in EUR and 0% in CHF in 2020. The reason for this delta was that I shifted from companies that became more highly valued to ones that were more attractively valued while market participants continued to pay little attention to the latter despite their solid business performance and standing. You have often heard me say that short-term performance needs to be taken with a grain of salt and 2020 was no different. Just in the first 5 months of this year our portfolio’s market performance has gained approximately 20%. In the section "Business Performance vs. Market Performance", I provide more detail about our business and market performance, introduce you to three of our investments and reflect on the portfolio decisions I made on our behalf.
Since the outbreak of the global financial crisis in 2007-2009, governments and central banks have intervened even more than usual in the economy to mitigate the effects of crises and protect us from further ones. Their vigorous intervention has not only benefits but also significant costs and side effects such as distortions, exaggerations and risks in the capital markets. RICHTWERT's mission to "help people invest intelligently so they can live the lives they deserve" came about because I sensed that there would be a massive wealth transfer from savers to borrowers and investors and that the majority would eventually be forced to choose between very low returns and high risks. As you can see from the characterizations in the section "Where We Stand", risks are both widespread and significant.
Since the current situation requires an even higher level of differentiation in terms of investments, RICHTWERT's mission is even more relevant today. In the section "How We Are Positioned and What to Expect" I share how I have deployed our capital and what we can expect if I am mostly right.
As in every letter, I include a copy of our goals at the end so we can compare our results to our original goals.
What Kind of Society Should We Want? Is Inequality Good or Bad?
The massive support measures and their costs do not benefit and burden everyone equally. In a capitalist system, the more productive usually benefit from these measures at the expense of the less productive and the risk-takers at the expense of the risk averse. But the capitalists among us should not cheer too soon, because we all pay in the form of higher prices, soon also likely higher taxes and at some point, also higher interest rates - some more, others less.
I can understand that significant assistance was temporarily necessary but maintaining most of that for 12 years was selfish for the beneficiaries and irresponsible towards large sections of the population. The resulting enormous wealth transfer was unjust, and understandably has resulted in considerable tensions in our society around the world, which are repeatedly expressed in the form of populism and unrest, among other things. With the outbreak of the pandemic, governments and central banks now had no choice but to offer exceptionally strong support again, which in turn will significantly increase societal tensions.
How do we deal with the continuously growing inequality and the resulting tensions? The way we respond to these pressures has a big impact on where we end up. This is a challenge for us all and I would like to suggest three measures:
We must teach upcoming generations more about business and economics earlier so that they can take more personal responsibility and take better care of themselves. I myself wish I had learned much of this earlier.
We must also create intelligent long-term incentives so that decision-makers act less in their own self-interest and more for the good of society. That alone, for example, would go a long way toward ensuring that politicians support and regulate only as much as necessary and as little as possible.
We must view and treat inequality in a differentiated way, because there are several types of inequality. Some are harmful to us, others are beneficial. For this, we need only look at the past year.
In 2020, we experienced some of the worst and best that humans can bring about. From people locking up their neighbors to protect themselves from infection to scientists discovering effective vaccines in record time. From people and governments who selfishly bought or stole vital supplies, to doctors and nurses who put their lives on the line, and companies that helped those in need even though they were not part of the pharmaceutical industry. From governments that could not even inform their citizens for months, let alone care for them, to a government that built hospitals for thousands in a matter of days. From businesses that had to close without a perspective of when or if they would be able to reopen, to companies that experienced massive growth due to the pandemic. From investors who were very short-term oriented and fearful at the beginning of the pandemic, to investors who have a time horizon of several decades toward the end of the pandemic and are suddenly investing or speculating in very risky ways.
A clear insight for me is that people generate inconceivable positive as well as negative performance. This divergence has much greater implications for all of us than we acknowledge. To ensure that adverse circumstances do not waste the potential of individuals with great potential, we must address the widespread inequality of opportunity wisely, urgently, and vigorously. Yet inequality of outcomes is both natural and necessary to our prosperity because it is often what creates the necessary incentives in the first place. This inequality has increased with technological progress and globalization and it will continue to do so.
If we aspire to quality of life and prosperity, we must not put unnecessary obstacles in the way of those who are highly capable. Instead, we should set the ground rules, entrust them with our most important challenges and reward them accordingly so that they can realize their full potential. For one thing, they will lift many with them into prosperity. For another, governments will then have the opportunity to redistribute this greater prosperity through sensible taxation to further reduce inequality of opportunity worldwide and to unleash the potential of even more highly talented people.
Let us wish for parents, teachers, leaders, politicians, and media who teach us to refrain from envy and protectionism and instead guide us to be more curious, imaginative, experimental, open-minded, tolerant, ambitious and more self-reliant.
Business Performance vs. Market Performance
In last year’s letter, I described why our portfolio companies are well equipped to withstand the Corona crisis and even profit from it. But the true test failed to materialize, because the U.S. Fed intervened very forcefully early on and, in addition to rock-bottom interest rates, virtually guaranteed almost all corporate liabilities. This proved hugely effective because it reduced the risk for market participants immensely from one day to the next, thus opening the floodgates of the capital market. Further, most governments stepped in supportively so that the worst economic effects of the Corona crisis did not materialize.
We at RICHTWERT also benefited from this in the short-term, but in the mid- and long-term it cost us for the time being, as our companies were unable to fully exploit their competitive advantages. However, we need not despair because anything that cannot go on forever will end. The opportunity for our companies will then possibly be all the greater.
Overall, our companies increased their intrinsic/operating value by almost 17% in USD and 6% and 7% in CHF and EUR, respectively. At RICHTWERT I only follow one strategy, so all portfolios are nearly equally invested. The difference stems from the fact that we were heavily invested in US companies while the dollar came under pressure last year. Due to the cost of hedging and the fact that most of our businesses operate internationally and thereby offer a natural currency hedge in the mid-term, I usually do not hedge currencies. In the short-term, our performance tends to fluctuate a bit more as a result, but this need not worry us as long-term investors in productive businesses in a globally interconnected economy.
The following chart shows the business and the market performance of our portfolio companies for the year 2020 independent of purchases and sales on my part. In addition, the colors of the bars show whether our firms were able to defend or extend their competitive advantages, which is necessary for long-term value creation.
In terms of business performance, those of our companies that provide e-commerce, cloud services, online gaming, and digital exchange between people and businesses, as well as Tesla, topped the list. They were followed by our investment and media businesses. As expected, our other financial services providers, which mainly provide credit/leasing, achieved the lowest increase in value in this environment. It was pleasing to observe that almost all our firms were able to increase their value even in the year of the pandemic. Since our businesses benefit from crises, I expect them to perform better in the coming years relative to what they would have done in the absence of the pandemic.
Even more encouraging was that, on a weighted basis, just about half of our portfolio was able to extend its competitive advantages, about 40% of the portfolio was able to defend them, and only 11% lost competitive advantages. By the way, my assessment is strict because I expect especially our strongest companies to expand their competitive advantages not only against the broad set of competition but also against their direct competition. Alphabet and Facebook, for example, undoubtedly made gains against traditional media companies last year, but the comparison with other Internet platforms is more challenging.
As important as increasing business value is, it is only one side of the coin; the other is the price we pay for it. When it comes to investing, the key is to invest in those assets that will increase their value the most relative to their price. As you can also see from the chart, our firms’ stock performances ranged from -63% to +743%! It was therefore once again not a year for the faint-hearted! With this range of performance, some firms potentially become very cheap, and others may no longer be attractively valued. Hence, I decided to sell/reduce some of our investments and deliberately invested also in companies that grew more slowly in the short-term because in these cases the relationship between value and price was very favorable.
Compared to their business performance, our portfolio's market performance was meager last year (8.8% in USD, 0.6% in EUR and 0% in CHF). RICHTWERT partners & co-investors know from experience that such discrepancies have usually offered attractive opportunities. Indeed, our portfolio has achieved a price gain of roughly 20% between January and May 2021.
The main driver for last year´s delta between business and market performance was that I reduced or sold our investments in companies that I considered less attractive due to increased prices and invested the proceeds in businesses that in my view offered a better margin of safety as well as better profit potential. This included significantly increasing our already heavyweight investment in Grenke, which faced five simultaneous challenges in 2020. It also involved increasing our midsize investment in Wells Fargo. I considered both companies to be massively undervalued during 2020. The increase in Wells Fargo has already paid off and I strongly expect that we will also earn a lot from Grenke in due course - more details on Grenke in the next section.
Insights into three of our portfolio companies (Grenke, Discovery, Credit Acceptance)
In my letters to you, I provide insights about some of our investments so that
you can better assess what you actually own;
you can judge in a few years whether our performance was the result of luck or skill; and
you can learn more about investing from my mistakes and successes if you wish.
In view of current circumstances, I will report on Grenke first. Then I will introduce Discovery, one of our media companies, to you before explaining why I sold our investment in Credit Acceptance. Finally, I reflect on my other portfolio decisions.
Grenke is a specialized international provider of financial services for small and medium-sized enterprises. It generates the lion's share of its business by leasing companies all sorts of equipment they need. In addition, Grenke offers banking and factoring.
As a leasing provider, Grenke was affected firstly by increased defaults and delays in payment by customers due to the pandemic. Second, demand for leasing decreased because most firms refrained from investing for the time being. Third, Grenke was attacked by a well-known short seller and massively accused of having deceived and misled investors. The fact that this short seller had recently exposed Wirecard as a fraud had a strong effect and frightened most investors. As a result, Grenke had to undergo a thorough audit by three auditing companies at the same time to counter the allegations. This not only caused considerable additional costs but also inevitably diverted attention from the company's business activities during an economically delicate phase. It was thus the perfect storm!
In short, I considered and still consider most of the short seller's accusations to be nonsensical and, in part, negligent or fabricated. As the combined challenges caused Grenke's share price to fall far below its mid- and long-term value in a very short period, I took the favorable opportunity to significantly increase our investment in Grenke. The following is the detailed version for those who would like to learn more.
Crises are always part of investing. They can rarely be predicted, but you can certainly prepare for them. I invest in companies like Grenke, not least because they are well prepared for crises and because they profit from them. Grenke's business model is highly profitable because automation and economies of scale allow Grenke to offer leases that are unprofitable for competitors, and because Grenke can reliably predict the default probability of its receivables. Grenke can cope well with higher temporary default rates, firstly thanks to its high profitability and secondly because the company can be more selective in difficult times. In addition, Grenke is very solidly financed and broadly diversified both geographically and in terms of customers. Moreover, this is not the first crisis that Grenke has mastered, and unlike other crises, this time governments assured corporate aid from the beginning, which will indirectly benefit Grenke.
But what about the allegations?
Before I go into these, it is important to understand what short sellers do. Short sellers bet on falling prices and borrow securities, which they sell at the current market price, hoping to buy them back later at lower prices. I never understood why intelligent, experienced, and honest investors sell securities short because unlike ordinary investing, the potential for profit is limited (a security usually cannot be worth less than zero) and the potential for loss is unlimited.
Thanks to this short seller attack, I now suspect that there are hardly any short sellers who are intelligent, experienced and honest. While I think short-selling can help keep managers honest and capital markets efficient, in practice short-selling is also abused to secure short-term profits by spreading panic, whether the accusations are justified or not. There is currently a significant, harmful gray area here that regulators should eliminate to protect firms and investors. But now to the allegations:
The short seller made the following allegations and wrote a 64-page analysis of his accusations:
Grenke's profits, balance sheet values (receivables) as well as cash are faked because the products Grenke leases (e.g. printers and copiers) have become obsolete and it cannot be that Grenke generates that much growth with these products. In addition, Grenke balances overpriced values of about 7500 Euro on average per printer or copier. The fact that Grenke is constantly raising expensive debt and equity capital, even though the company appears to have excess capital, is further evidence of the deception.
Grenke seriously neglects governance issues and defrauds investors by buying unattractive franchise companies owned by Grenke insiders at inflated prices for at least a decade, thus enriching insiders or people close to them at the expense of shareholders.
Grenke is an accomplice in fraudulent transactions in which dealers rip off customers with overpriced leases.
Grenke is negligent with internal controls at Grenke Bank, accepting customers who were blacklisted by BaFin and thus aiding and abetting money laundering.
After studying the short seller's analysis, I concluded that he was bending the facts and probably jumping to conclusions either negligently or maliciously based on potential fraud patterns only. Subsequently, Grenke also responded with press releases and an investor conference where they denied all allegations. On September 21, 2020, I shared my following assessment with RICHTWERT partners/customers:
Regarding the 1st accusation:
Grenke reported that the cash in question in fact exists and that 80% of it was deposited with the German Bundesbank.
Moreover, according to my analysis, Grenke has always been prudent and had consistently insisted on above-average equity capital to cope with planned expansions and to withstand potential crises. The company also demonstrated this during the global financial crisis between 2007-2009. In 2019, Grenke raised further equity to prepare for its planned expansion into the USA. Furthermore, at the beginning of 2020, Grenke Bank created incentives for private customers to secure funds in the form of bank deposits to be better prepared for the Corona crisis.
Both the equity and debt capital raises were always on attractive terms from the perspective of existing investors and made a well-thought-out impression. As far as I could see, there was no sign of expensive loans or any detrimental dilution of shareholders. Grenke's capital raises always made sense and were advantageous in the context of the leasing business and its expansion goals.
As for printers and copiers, the short seller either negligently or maliciously mixed facts from 2010 and 2019 to support his point. He also seems to have overlooked the fact that a lease can often include multiple printers and copiers. The percentage of leases with these items decreased from 31% to 18% during this time, and I believe the absolute growth is due to Grenke's regional expansion and market share gains.
Regarding the second accusation:
Grenke encouraged former Grenke managers to found franchise companies abroad with the aim of buying them in 4-6 years at predefined valuation criteria, provided they proved to be promising. In the last 12 years, Grenke paid about 100 million euros for acquired franchise companies. Today, these companies generate approx. 20% of Grenk's new business and achieve a total annual contribution margin that corresponds to the entire purchase price. To speak of overpriced purchases here requires a certain level of inexperience, imagination, or audacity.
It is probably correct that company founder Wolfgang Grenke, his family and persons close to him could have been advantaged by purchases of these franchise companies by Grenke AG, but as described next, I still think that there was no fraud here. After all, a potential conflict of interest is not necessarily proof of fraud.
In the last 10 years, Grenke generated nearly 800 million euros of profit. Towards the end of 2019, Grenke had a market capitalization of almost 5 billion euros. More than 40% of Grenke AG is owned by the family of founder and longtime CEO Wolfgang Grenke. It makes little sense to enrich oneself over 10 years at a purchase price of about 100 million euros in the company, in which one owns 40% of the shares worth almost 2 billion euros. This would only make sense if the company was actually a fraud and in reality, was not worth nearly as much. But then one would rather sell one's own overpriced shares instead of holding on to them long-term, as the Grenke family doe