Quarterly letter 1Q2020

Theme and Background

This section is the opening part of Azvalor’s Q1 2020 report. It primarily reviews the market crash in Q1 2020 (the S&P 500 fell 34% from its February 19 peak to 2,191 points on March 23) and outlines the fund manager’s investment philosophy and response strategy under extreme market conditions. The author emphasizes that understanding the non-linear nature of markets is key to recovering the cumulative underperformance of the past four years.

Core Thesis

The author’s central investment argument is: This is the biggest investment opportunity in 23 years, but not because portfolio prices are at their absolute lows—rather, it is due to the largest valuation advantage relative to other asset classes (bonds, real estate, mainstream equity indices). Counterintuitive judgments include:

• Selling during a market crash has never been a good time; investors do not need to predict short-term moves to invest wisely.
• Currently, bonds (long-term U.S. Treasury yields at just 1%, below the 2% inflation target) and real estate are very expensive, mainstream equity indices remain unattractive in valuation, while commodity-producing companies (especially gold and uranium miners) are extremely cheap, offering the greatest upside potential.
• Although oil company investments have fallen an average of 50%, the author believes that at the portfolio level, overall returns will be very positive, similar to the experience of the past 23 years.

Key Arguments and Data

1. Non-Linear Market Dynamics: The S&P 500 erased nearly four years of gains in one month, falling from its February 19 high to a low of 2,191 points on March 23. This non-linear volatility is inherent to markets, but humans are not accustomed to non-linear thinking.

2. Tactical vs. Strategic Levels:

• Tactically: Sharp downturns have never been good times to sell.
• Strategically: Medium-term portfolio returns are determined by starting valuation levels—high valuations lead to poor future returns, while low valuations lead to good returns.

3. Bond and Equity Index Valuation Comparison:

• Long-term U.S. Treasury yields at 1%, below the Fed’s 2% inflation target, implying a real annual loss of 1% on fixed income.
• Although equity indices have rebounded from their lows, they remain near historically high valuation levels, with an unfavorable economic outlook.

4. Performance Divergence Among Commodity Companies (presented in a table):

Investment Category	One-Year Return Range	Key Data
Gold Mining Companies	+40% to +100%	Agnico +40%, Barrick +100%, Newmont +75%, New Gold -65%
Oil Companies	Average -50%	Some losses exceed 80%
Copper/Uranium Mining Companies	Flat	Cameco +10% (9% of fund), Nexgen -30% (0.5% of fund)

5. Historical Comparison: In 1998 or 2008, the portfolio may have been equally cheap or even cheaper, but there were many cheap options at the time (e.g., “old economy” companies, bonds with positive real yields). Currently, bonds and real estate are expensive, mainstream equity indices remain unattractive in valuation, and opportunities are only occasionally found in traditional companies (non-commodity producers).

6. Market Volatility Examples:

• Barrick Gold: Below $12 in May 2019 → $19.5 in September 2019 → $15 on March 20, 2020 → $27 on April 20, 2020 (daily trading volume ~$600 million).
• Chevron: $110 on February 20, 2020 → $50 on March 19, 2020 (down 55%) → $90 in early May 2020 (up 80%, daily trading volume $1.5 billion).

Companies/Assets Involved

• Barrick Gold: Gold mining company, one-year return +100%, highly volatile stock price ($12→$27), author is bullish.
• Agnico Eagle Mines: Gold mining company, one-year return +40%, bullish.
• Newmont: Gold mining company, one-year return +75%, bullish.
• New Gold: Gold mining company, loss of 65%, but the author believes this does not detract from the overall strong performance of gold miners.
• Cameco: Uranium producer, 9% of the fund, one-year return +10%, bullish.
• Nexgen: Uranium producer, 0.5% of the fund, loss of 30%, the author believes this does not affect the overall relative return and expects it to follow the path of gold miners.
• Chevron: U.S. oil company, stock price fell from $110 to $50 and then rebounded to $90. The author does not explicitly state a bullish or bearish view but notes that oil investments have averaged a 50% loss.
• Long-Term U.S. Treasuries: Yield at 1%, below the inflation target, the author considers them unattractive.

Investment Implications

• For investors: Currently, avoid chasing expensive assets like bonds and real estate, and also avoid buying mainstream equity indices that remain overvalued. Focus on commodity-producing companies (especially gold and uranium miners), as they are extremely cheap and offer the greatest upside potential. Investors need to remain patient, avoid selling out of fear during market volatility (i.e., “buying high and selling low”), and refrain from using leverage or investing short-term capital. Azvalor’s strategy is to maintain portfolio-level diversification, tolerate losses in individual investments (e.g., New Gold, Nexgen), but believe that overall returns will be very positive.

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Theme and Background

This chapter analyzes the performance divergence between Azvalor's International Portfolio and Iberian Portfolio under the extreme market conditions of the first quarter of 2020. The author explains why the International Portfolio underperformed the index (due to overweighting oil) but argues that its intrinsic quality and long-term potential have actually strengthened, while also assessing how the Iberian Portfolio improved its quality through rebalancing.

Core Views

• The International Portfolio's short-term underperformance is the price of structural opportunity: Gold, uranium, and oil tankers (totaling 40% of the portfolio) performed well and remain undervalued. Oil (20% of the portfolio), despite hitting historic lows, has triggered an extreme undervaluation opportunity. After a 15% downward valuation adjustment, the portfolio still offers 155% upside.
• The oil crisis is a "black swan" with extremely low probability: The conditional probability of a simultaneous global pandemic and OPEC price war is below 0.1%, but the crisis will accelerate the exit of high-cost capacity, increasing the probability of a medium-term crude oil shortage.
• The Iberian Portfolio achieved "quality over quantity" through rebalancing: Although net asset value fell 30%, the portfolio's quality improved significantly by reducing exposure to service companies hit hard by the pandemic and increasing holdings of high-quality, low-debt enterprises.

Key Arguments and Data

1. Structural Advantages of the International Portfolio

• Gold mining company stock prices remain below their 2011 highs, while fundamentals such as money supply, global debt, and interest rates have far exceeded levels seen then.
• Oil tanker charter rates are at record levels, yet the global fleet growth rate is at historic lows, and stock prices remain below historical averages.
• Uranium prices have rebounded 40% from $34/lb, but there is still massive room to grow compared to the 2007 high of $150/lb and the pre-Fukushima level of $75/lb.

2. Probability of Error and Opportunity in Oil Investment

• The author estimates the conditional probability of a simultaneous pandemic and price war is below 0.1%, but has limited such tail-risk exposure to 6% of the portfolio.
• The oil sector index has fallen 90%, similar to the extreme decline previously seen in gold mining stocks.
• Case study: Schlumberger (global oilfield services leader), with a historical average ROCE above 30%, saw its market cap fall from $154 billion to $22.8 billion, just 3 times its 2014 profit.

3. Valuation Adjustment and Portfolio Optimization

• The International Portfolio's per-unit valuation was lowered from €242 to €206 (-15%), corresponding to 155% upside.
• The breakeven oil price assumption was lowered from $65/barrel to $50/barrel (a conservative estimate; actual long-term supply price needs to be higher).
• Buenaventura's valuation was lowered due to issues at the Orcopampa mine and a revised outlook for the Yanacocha mine.

4. Effect of Iberian Portfolio Rebalancing

• The Spanish stock market is down 30% year-to-date, and the portfolio's decline is in line with that.
• The portfolio's exposure to the Spanish economy is only 30%, lower than the most severely affected regions globally.
• Main additions: Altri, Arcelor Mittal, Aena, Logista, Mapfre, Euskaltel, Bankinter.
• Main reductions/sales: Ibersol, Zardoya, Acerinox.
• Valuation lowered from €210 to €186 (-11.5%), with 130% upside.

Companies/Assets Involved

Company/Asset	Role	Key Data	View
Schlumberger	Global oilfield services leader	Market cap $22.8B, historical ROCE >30%, 3x 2014 profit	Bullish, extremely undervalued
National Oilwell Varco	Oilfield equipment provider	Increased position	Bullish
Galp	Portuguese oil company	Increased position	Bullish
Maersk Drilling	Offshore drilling	Increased position	Bullish
Mosaic	Fertilizer company	Increased position	Bullish
Suzano	Pulp producer	Increased position	Bullish
Golar LNG	LNG transportation	Increased position	Bullish
DHT Holdings	Oil tanker company	Increased position	Bullish
Hudson's Bay	Retail	Reduced/sold	Bearish
Eurocash	Polish wholesaler	Reduced/sold	Bearish
Compañía de Minas Buenaventura	Peruvian gold mine	Valuation lowered, reduced position	Neutral to bearish
Teranga Gold	Gold mine	Sold	Bearish
Sandstorm Gold	Gold streaming	Sold	Bearish
Range Resources	US natural gas	Sold	Bearish
EQT Corporation	US natural gas	Sold	Bearish
Altri	Portuguese pulp	Increased position	Bullish
Arcelor Mittal	Global steel	Increased position	Bullish
Aena	Spanish airports	Increased position	Bullish
Logista	Logistics	Increased position	Bullish
Mapfre	Insurance	Increased position	Bullish
Euskaltel	Telecommunications	Increased position	Bullish
Bankinter	Bank	Increased position	Bullish
Ibersol	Food service	Reduced/sold	Bearish
Zardoya Otis	Elevators	Reduced/sold	Bearish
Acerinox	Stainless steel	Reduced/sold	Bearish

Investment Insights

1. Extreme events are a litmus test for portfolio resilience: The author believes that 40% of the portfolio's assets (gold, uranium, oil tankers) performed well during the crisis, validating their structural logic. While the 20% oil position suffered short-term losses, it has entered a "once-in-20-to-30-year" buying zone.

2. Tail risk should be managed through position sizing, not avoidance: By limiting exposure to any single extreme risk to 6%, even an event with a probability below 0.1% would not cause permanent capital loss.

3. Rebalancing direction during a crisis: Sell highly indebted consumer/service companies directly impacted by the pandemic (e.g., Hudson's Bay, Ibersol), and buy global leaders with low debt and long-term competitive advantages in cyclical sectors (e.g., Schlumberger, Arcelor Mittal, Aena).

4. Valuation assumptions should be proactively lowered to address uncertainty: The International Portfolio's breakeven oil price assumption was cut from $65 to $50, and the Iberian Portfolio's overall valuation was reduced by 11.5%. Yet, the upside potential remains as high as 155% and 130%, respectively, indicating that current prices have already over-discounted pessimistic expectations.

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Theme and Background

This section primarily discusses Azvalor's operational status and investor behavior during the COVID-19 pandemic shock in the first quarter of 2020. The report notes that despite market crashes leading to slight net outflows from the fund, new investor registrations and subscription volumes actually surged significantly, with the company maintaining stable operations during the transition to remote work.

Core Viewpoint

The author's key judgment is: Although the current market is challenging, it is precisely a golden window for long-term investors to accumulate low-cost positions. The counterintuitive aspect is that during the market panic, Azvalor's new investor registrations and additional subscriptions hit record highs, indicating that some capital is positioning against the trend.

Key Arguments and Data

1. Investor Behavior:

• The fund experienced "slight net outflows," but gross subscriptions grew strongly.
• Since the lockdown on March 13, new investor registrations and additional subscriptions increased by 60% year-over-year, setting an operational record over an 8-week period.
• During this period, over 300 new investors were added, bringing Azvalor's total registered investors to over 17,000.
• Digital channels drove efficiency: nearly 80% of new registrations were completed entirely through digital processes.

2. Operational Resilience:

• Full remote work was implemented on March 16 with no major operational incidents.
• The technology platform supported the surge in operational volume and subscription activity.

3. Performance Reflection:

• The author candidly acknowledges that "the overall performance since Azvalor's inception remains far from satisfactory," but emphasizes that "accepting difficult times is at the core of investing."

Companies/Assets Involved

This section does not involve analysis of specific companies or assets, focusing primarily on Azvalor's own operations and investor relations.

Investment Insights

1. Counter-Trend Positioning Window: During market panic, capital inflows actually accelerated, indicating that long-term value investors are building positions at low valuations. Investors should focus on current valuation levels rather than short-term price fluctuations.

2. Non-Linear Return Characteristics: The author reiterates the "non-linear" nature of markets, suggesting that current investments may take "months or years" to yield returns, but starting valuations are already highly attractive.

3. Operational Stability Validation: The successful transition to remote work and digital processes has reduced operational risks, providing a safeguard for the fund to continue operating under extreme conditions.