Mutoro Group Partners, LP
"Men may not get all they pay for in this world, but they must certainly pay for all they get." – Frederick Douglass
Dear Partner,
The Fund was down 4.14 per cent for the first half of 2017. While I am not pleased with this result, I think it is temporary, and I remain focused and optimistic about the long-term. In general, I try not to react too positively or negatively to short-term results if the facts do not warrant it, especially given the difficulties this market environment presents to our investing approach. Let us review our approach as we look back on the quarter.
In my first quarter letter, I wrote, “I think we should have more capital invested, ideally in companies with attractive economics and available at attractive prices.” In the second quarter, I focused on searching for these companies as we are unlikely to generate the returns we would like without being more invested than we are at present. (Cash is still the majority of our holdings and does not earn anything; however, it allows us to take advantage of those opportunities that do pass our screens.) With the continued ascension of public equity prices almost across the board in the United States, there are fewer attractive opportunities to put our capital to work given our investment philosophy, my standards for what constitutes a margin of safety, and the industries in which I feel comfortable making investment decisions. Not every business I come across is expensive. However, significantly fewer are attractively priced than in recent years, and many mediocre companies are priced as if it were only a remote possibility that they could fail or stumble. While being more invested presents a challenge, it is one I am eagerly attacking. Rather than reducing the margins of safety we demand, I spent more time looking abroad than previously, including in Europe and East Asia. I found many good businesses. Most were not available at discounts to their intrinsic values such that purchasing them would be advantageous to us, even if I overestimated their prospective earning power. Just after quarter end, however, I found an opportunity I thought compelling, and I bought a stake in the business for our portfolio. We can call this Company E—it is listed on the Hong Kong Stock Exchange, and I will likely describe it in greater detail in future letters.
In my first quarter letter, I also wrote, “I am searching for [attractive opportunities], while also reducing our exposure to those businesses we have which may no longer be worth owning for the long run.” I then described selling, after two years, the vast majority of our holdings in Company A. I sold this position because of what I judged to be irredeemable problems with its relatively fixed cost structure and melting revenue. Happily, we had purchased our stake in Company A so cheaply that we were able to profit from the sale even though its business prospects have not developed as anticipated. This quarter, we also sold our position in Company D, which I once described as a “highly innovative technology business.” Unfortunately, Company D showed a deterioration in its competitive position and cash flows, risking our margin of safety. Before I explain why I sold Company D, we should review why we sell shares at all. We sell a position for one of two reasons: Either (1) we need the cash for something else more attractive, or (2) it is not worth what it is selling for. With Company D, the latter was my motivation. While I would prefer for all of our investments to turn into long-term holdings that significantly compound our capital over time, I feel no regret in cutting them. Long-term investing does not mean sitting on your hands when the facts behind your thesis change or when you learn of new facts that cast a new light on your old thesis. Rather, it means using long-term thinking to inform decisions in the near-term. Let us explore how long-term thinking informed our decisions regarding Company D.
Company D is a global information technology business that has successfully evolved through its long history. But not without fits and starts. It has experienced some challenging periods exiting traditional profit centers, whether through selling off divisions or allowing an attrition in sales. The most recent exit being its transition away from the business of selling hardware to corporations and governments and providing services and software to support that hardware. We initially bought shares of Company D in 2015 amounting to nearly 10 per cent of our portfolio (and also bought long-dated call options equal to one per cent of our portfolio). At the time, I thought the market was underappreciating Company D’s probability of success in transitioning to new business. I estimated the company was available at a roughly 40 per cent discount to the bottom range of my appraisal of its probable value, or 60 cents to the dollar. Moreover, the company had a four per cent dividend yield and an aggressive share buyback program, which were likely to increase our purchase discount and the per share value of the business over time. The company’s market capitalization at the time was just over eight times its most recent three-year average earnings, a lower multiple than it had 10 years earlier in 2005, despite a better business mix and a solid balance sheet. While Company D was significantly bigger than most companies I currently consider investing in, at its price, it presented such a high probability of capital preservation and meaningful upside that I thought it remiss to exclude it from our universe of investment ideas. In other words, the margin of safety in the company’s equity price and strengths favored the probability of gains versus the potential for loss over time. Its strengths included its unequaled research productivity, diversified customer base, recurring revenue, trusted brand name, and superior management and balance sheet.
While I was right that our margin of safety in Company D was large enough that we were likely to make money, I erred in weighing Company D’s financials too heavily versus the changing competitive dynamic of its industry. With some notable exceptions, over time, a company’s competitive positioning usually determines its financials, and not the other way around. At the time of purchase, I knew that Company D’s old business lines had declined because its customers have embraced what is called ‘public cloud computing.’ Instead of buying and running their own computing, storage, and networking machines, customers now pay as they go for on-demand computing power housed at off-site data centers managed by outside companies. Company D is making good progress transitioning into this new line of business; however, it is unfortunately not as big nor growing anywhere nearly as fast as its main competitors, who are cash rich and well-managed. In this situation, there is a risk of a race to the bottom, whereby leaders attempt to take or keep market share by offering supplementary services at continually lower prices and margins. The risk is significant: Building data centers and the services around them takes massive upfront fixed investments, yet the marginal cost of providing services to the next customer that comes along is significantly smaller. Industry leaders thus offer lower prices that stifle the growth of new entrants or smaller competitors. For example, Amazon Web Services has seen its year-over-year quarterly revenue growth fall for eight quarters in a row as it cut prices to fend off rivals. As of May, the company claimed to have cut prices at least 51 times since its launch. Company D has no particular competitive advantages in a race to the bottom versus its competition, whose parent companies have other non-cloud business lines that remain healthy.
To counteract such practices, Company D could offer more differentiated or highly-valued services at higher prices. This is easier said than done. Despite an impressive collection of patented technologies around artificial intelligence and data analytics, it became unclear to me what Company D’s comparative advantages are versus its competition. Furthermore, whatever those advantages are and however profitable they may be, it is unlikely they will in time maintain Company D’s intrinsic value at a range satisfactorily above our cost of ownership. Meanwhile, its average earning power continues to decline. It may very well stabilize or grow again, but the odds are currently not favorable. Despite this and the mistakes I made in my analysis, we sold our position at a profit (though a lower price than where it finished last year, contributing to our lower returns this quarter). Where one erroneously assesses something’s long-term value, a large enough margin of safety becomes the difference between realized profits and losses; and thankfully we had one. Keeping track of what you own is as important as finding new investment opportunities. I will continue to track Companies A and D to determine whether the expected value of investment is likely to change in our favor.
The chart below indicates our cash position at the quarter end, which does not include the approximately 10 per cent of capital allocated toward Company E:
Portfolio Holdings
Thank you for your partnership and your continued confidence and trust. I cherish it and will continue to strive to earn it. Please feel free to call or write me if you have any questions or need further clarifications on any matter discussed above.
Sincerely,
Godfrey M. Bakuli
Managing Partner