Quarterly letter 1Q2019

Theme and Background

This chapter primarily discusses the current extreme valuation divergence in global stock markets, as well as Azvalor Fund's investment strategy and portfolio attractiveness in this environment. The author argues that although the overall market (especially U.S. stocks) is at historically high valuations, there is unprecedented polarization within the market, creating opportunities for active stock selection.

Core Thesis

The author's core investment argument is: The current market is expensive overall, but Azvalor's portfolio is extremely cheap, with a massive attractiveness gap between the two. The counterintuitive judgment is that while overall market valuations (e.g., Shiller CAPE at 29x) suggest near-zero real returns over the next 10 years, bottom-up stock selection can still uncover cheap assets with significant upside potential. The author explicitly rejects short-term market predictions, emphasizing long-term holding (minimum 5 years) and the difficulty of "market timing."

Key Arguments and Data

1. Overall Market Overvaluation:

• The Buffett Indicator (total U.S. stock market capitalization/GDP) is at an all-time high.
• The S&P 500's price-to-sales ratio has exceeded or matched the level of the 2000 dot-com bubble.
• The Shiller CAPE ratio is approximately 29x, far above the historical average of 16x.
• Historical data (1881–2017) shows that starting from a CAPE of 29x, the expected real annualized return over the next 10 years is near 0% (rising only with inflation).

2. Extreme Market Valuation Divergence:

• The P/E gap between the most expensive 20% of U.S. stocks and the cheapest 20% is at its widest since 1951.
• The divergence in price-to-book ratios between U.S. and European markets peaked in 2000 and currently, with the ratio of high- to low-valuation stocks fluctuating between 3x and 20x (since 1990).

3. Attractiveness of Azvalor's Portfolio:

• The potential upside for the International Portfolio and the Iberian Portfolio is 119% and 80%, respectively (based on company-level valuations).
• Stocks in the portfolio have fallen approximately 50% cumulatively from their 2011 highs, while the S&P 500 has risen about 60% (1.6x) over the same period.
• Valuation comparison between the portfolio and indices (original table data):

Metric	International Portfolio	Iberian Portfolio	S&P 500	Stoxx 600
P/E	7.8x	8.2x	19.5x	15.5x
P/B	0.7x	0.7x	3.2x	1.7x
Dividend Yield	4.1%	4.7%	1.9%	3.3%

4. Reasons for Extreme Divergence:

• The rise of passive investing (ETFs, etc.).
• Financial repression (negative bond yields) forcing capital into "quality" stocks as substitutes.
• Central banks (e.g., the Swiss National Bank) directly purchasing stocks.
• Technological disruption causing many companies to trade at depressed valuations for "the right reasons."

Companies/Assets Involved

• Azvalor International Portfolio: Buys stocks that have fallen 50% cumulatively from their 2011 highs, currently with a P/E of 7.8x, P/B of 0.7x, dividend yield of 4.1%, and potential upside of 119%.
• Azvalor Iberian Portfolio: P/E of 8.2x, P/B of 0.7x, dividend yield of 4.7%, and potential upside of 80%.
• S&P 500: P/E of 19.5x, P/B of 3.2x, dividend yield of 1.9%, considered expensive by the author.
• Stoxx 600: P/E of 15.5x, P/B of 1.7x, dividend yield of 3.3%, slightly cheaper than U.S. stocks but still not cheap.
• Swiss National Bank: Cited as an example of a central bank purchasing stocks.

Investment Implications

• Avoid broad market indices: Current U.S. stock valuations (29x CAPE) imply historically low expected returns (near 0% real annualized over the next 10 years); investors should avoid passive index tracking.
• Focus on extremely undervalued individual stocks: Market polarization is at historical extremes, and cheap companies (P/E 7–8x, P/B 0.7x) offer significant margin of safety and upside potential, though risks of structural decline or technological disruption must be monitored.
• Beware of the "market timing" trap: Holding cash may seem to offer option value, but history shows timing is extremely difficult; investment opportunities can disappear within months (e.g., the International Portfolio rose 100% in 9 months in 2009).
• Bond markets pose greater risks: Negative-yielding sovereign bonds are considered the "biggest valuation bubble in history," posing more danger to savers than stocks.

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Theme and Background

This chapter primarily reports on Azvalor's internal operational developments, including receiving a workplace award, team personnel changes, and the operational progress of a new fund. Although this information does not directly involve market analysis, it reflects corporate governance, talent reserves, and internal alignment of interests, offering reference value for assessing the firm's long-term execution capability.

Core Viewpoints

The author (Azvalor management) emphasizes that internal governance and team building are the cornerstones of investment success. Key judgments include:

• Consecutive certification as a "Best Workplace" indicates that the company culture helps attract and retain talent.
• The new fund has entered a stable operational phase ("cruising speed") and has lowered the minimum investment threshold to broaden investor participation.
• Employees continue to increase their holdings in the fund, reinforcing the "skin in the game" principle and demonstrating internal confidence.

Key Arguments and Data

• Award: For the second consecutive year, Azvalor received the "Best Workplace" certification from the international organization Great Place to Work (in the 50-500 employee category) and ranked first in the "Better For Business" category.
• Team Changes: Analyst Jorge Cruz left to join Saudi Aramco (the world's largest oil company); new analyst Philip Ngotho, CFA, joined from ABN Amro (Amsterdam), bringing 7 years of experience, and has been responsible for the mining sector since May 6.
• New Fund Progress: Established at the end of last year, the fund currently has approximately €15 million in assets, is fully invested, and has entered stable operations. The minimum investment amount has been reduced from the original standard to €5,000, consistent with other funds.
• Internal Investment: Employees increased their contributions to the fund in the previous quarter, making the employee collective the fund's largest investor.

Companies/Assets Involved

Company/Asset	Role	Key Data	Viewpoint
Azvalor itself	Fund manager	Certified as Great Place to Work for two consecutive years; employee collective is the largest investor	Positive: Internal governance and interest alignment are strengthened
Saudi Aramco	Competitor (talent outflow)	Jorge Cruz joined its Saudi headquarters as an engineer	Neutral: Personal career choice, not a negative reflection on Azvalor
ABN Amro	Talent source	Philip Ngotho previously worked there for 7 years	Positive: Introduction of an experienced analyst
Azvalor New Fund	Product	Approximately €15 million in assets; minimum investment reduced to €5,000	Positive: Has entered stable operations; lower threshold broadens the investor base

Investment Implications

• Positive Internal Signals: Employees increasing their fund holdings indicate a high degree of alignment between management and investor interests, which can reduce agency risk in long-term investing.
• Manageable Talent Flow: Despite the departure of one analyst, the newly added Philip Ngotho brings extensive experience in the mining sector, potentially enhancing the fund's coverage in resource-related sectors.
• Improved Accessibility of the New Fund: The reduction of the minimum investment to €5,000 provides a lower barrier for small and medium investors to participate in Azvalor's strategy, potentially attracting more capital inflows.
• Overall Assessment: Azvalor's operational stability and internal governance quality support the execution of its long-term value investment philosophy. However, attention should be paid to potential liquidity or cost efficiency issues arising from the new fund's relatively small size (€15 million).