Below you find an overview of the current portfolio as of March 31, 2014:
|#||Investment||Currency||Purchase Price||Current Price||Gain/Loss1||Portfolio Share|
|8||City of London||GBP||2.41||2.55||9.3%||4.1%|
1) Performance in EUR inc. dividends/interest
From a relative perspective the portfolio suffered from the large cash position during the quarter. The portflio’s benchmark (Euromoney Smaller Europe exc. UK Weight 70%; Euromoney Smaller World Weight 30%) increased by a sensational 7.5% against a not so sensational 1.6% increase of the virtual portfolio.
Eurozone small cap equities continue to be one of the best performing market segments. Since the end of 2012 the Euromoney Smaller Europe (Exc. UK) Total Return Index has increased by 48%. The index consists of more than thousand companies in 15 different countries with an average market cap of EUR 850 m. So it provides a pretty good approximation for this market segment. Sometimes it can be frustrating to watch the prices reaching one all time high after the other and at the same time to reject investment ideas given that they simply do not match the investment criteria.
These criteria are pretty straight forward. An investment opportunity needs to deliver a margin of safety based on a conservative estimation of intrinsic value. For the estimation of intrinsic value I am using either a normalized free cash flow or a sum-of-the parts approach. Apart from that, a company I want to invest in should meet a couple of preconditions:
– Generating sustainable returns on invested capital
– Management needs to be capable and willing to allocate capital in shareholders’ best interest
– Relatively low level of financial leverage
– Relatively high earnings-quality (identifying any red flags in the financial statements)
Despite the recent market increases, for me it is essential to control emotions and to stick to my disciplined absolute value approach.
While Fairfax’s insurance business performed very well in 2013 (with a combined ratio of 92.7%), the investment return was negative (for the third time since the company’s inception in 1986). This was mostly due to the equity hedges in place which cost the company approx. USD 2 bn (realized and unrealized), but also due to a decline in the fixed income portfolio.
In his letter to shareholders, Prem Watsa once again states the reasoning for Fairfax’s defensive investment strategy. They continue to worry about the consequences of the massive fiscal and monetary stimulus not only in the Western world, but also in China. From their perspective, debt to GDP ratios are at a very high level and they forecast significant deleveraging yet to come. In addition, speculative excesses and once again the built-up of additional vast financial leverage will eventually cause tremendous instability, ultimately leading to a deflationary environment.
I think they have a point here. Looking at the US and Europe there is still a large employment gap in place. At the same time many jobs that are created are being filled by over-qualified labour no longer able to wait for compensation levels similar to what they had before. Thus, people need to shift down the way they life or how they expect to live. As a consequence, the willingness to save increases, leaving less resources for consumption. In the case of China, the booming economy fuelled by overinvestment has not only created speculation and large amounts of uncontrolled credit but also a tide of inflation (price/wage spiral). At the same time cost of living outpaces wage increases. Once the Government reduces credit and fights speculation, it risks a deflationary collapse. Eventually this process will not be started by the Government, but by the market when the speculative capital leaves. As a side effect of this scenario commodity price will obviously collapse.
Ned Goodman of Dundee Corp. is also worried by the unintended consequences of stimulus. However, his conclusion is quite the opposite. From his perspective, in order to handle the elevated debt levels and to prevent a market collapse the Fed and other central banks will continue to monetize Government debt and other types of debt (i.e. mortgages) and keep interest rates down. This will ultimately lead to money debasement in the Western world. At the same time he is very bullish on the rise of the middle class in the emerging markets leading to continuation of the secular trend in commodity prices.
Due to their contrary views, Fairfax and Dundee have allocated their capital to different types of assets as you can read in the two initial write ups here and here. While I do not know, whether both will be wrong or whether one of them will be right, I am comfortable to own these companies for the following reasons:
Both provide an attractively priced hedge for two different tale risk scenarios. In addition, both of them Prem Watsa and Ned Goodman proved in the past that they have an edge in the allocation of capital and I expect them to do so in the future. Apart from that, I believe that the risk of a permanent loss of capital is limited, as both companies own a variety of high quality businesses which should perform relatively well regardless of the actual economic environment.
Finally, KBG closed the BHF transaction at the end of the first quarter. The purchase price has been further reduced to EUR 340 m or 0.69x book value. After a capital increase RHJI’s share in KBG decreased to 65.8% while the balance of 34.2% is now being held by three co-investors. The value of RHJI’s 100% stake in KBG that existed prior to the BHF acquisition was adjusted downwards from EUR 320 m to EUR 294 m or 0.69x book value (EUR 194 m based on the new 65.8% share) for the purpose of the transaction. From that perspective the deal has been unfavourable for shareholders as the downward adjustment required a larger cash payment from RHJI than what the company would have had to pay based on KBG’s original valuation to complete the transaction.
91% of BHF Bank are now being held by KBG. 9% have been acquired directly by RHJI. To satisfy the EUR 30.6 m equity consideration for the 9% stake, RHJI has issued 5.5 million additional shares. This has resulted in a revised total share count of 91.0 million shares and Deutsche Bank becoming a significant shareholder with an approximate 6.0% stake in RHJI. The new shares were issued at EUR 5.56 which is substantially above the current share price leading to an additional source of discount of the transaction of approx. EUR 9.7 m. So this is generally favourable for RHJI’s shareholders. However, for some reason management plans to allocate the discount across RHJI and its co investors on a pro rata basis resulting in a reduction of RHJI’s ownership in KBG to 65.13%, with the offsetting increases being reflected in the individual co-investors’ stakes.
Why are they doing this? Management is actually planning a further simplification of the structure. Following the completion of the BHF acquisition, they are now discussing with the co-investors the future conversion of their interests in Kleinwort Benson Group into RHJI shares. From that perspective, treating the co-investors equally as if they were shareholders might make sense and might be even value enhancing for RHJI’s existing shareholders once the structure has been simplified. However, currently it is clearly reducing RHJI’s net asset value. Based on my estimation, since my original write up RHJI’s NAV decreased by 7.3% to EUR 4.8 per share.
With the completion of the BHF transaction a return of the company’s former large cash pile to shareholders is off the table now. For RHJI’s activist investors the investment case has now changed and it will be interesting to watch whether they will sell their shares. Recently, Third Avenue Management, another non-activist but very respectable firm, reduced its holding in RHJI. Apart from that, there is Deutsche Bank which based on the management’s information already announced that their stake in RHJI is not a strategic investment.
RHJI’s management will present indications for financial targets at the next investor’s call on May 15th 2014. They will have to be very precise in explaining to investors how they will turn the combined entity into a private bank that earns an acceptable return on equity. I will then try to come up with a conclusion whether RHJI’s management still matches my investment criteria.
Portfolio Transactions in Q1 2014
Just for your information below you can find the quarterly portfolio transactions for the virtual portfolio:
|Item||Date||Amount in EUR|
|Passat||1/2/2014 to 2/14/2014||-60,963|
|Magix||1/2/2014 to 2/6/2014||-77,235|
|City of London||1/22/2014||-100,000|
|Olympic Entert.||1/16/2014 to 1/17/2014||-300,000|
|Miba||2/14/2014 to 3/31/2014||-104,175|
|City of London Dividend||2/28/2014||13,350|
|TMW Weltfonds||3/17/2014 to 3/26/2014||-279,116|
|Interest on cash||12/31/2013 to 3/31/2014||17,906|
The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!