Quarterly letter 2Q2020

Theme & Background

This chapter explores when value investing, after a prolonged period of underperformance relative to growth investing, may stage a reversal. The report notes that as of the end of the second quarter, Azvalor’s funds have rebounded sharply from their year-to-date lows (Azvalor Internacional +41%, Azvalor Iberia +20%, Azvalor Blue Chips +59%), yet remain 35%–43% below their historical highs. The author argues that three extreme trends currently prevail in the market, and a reversal for value investing may be imminent.

Core Thesis

The author’s central investment argument is that value investing has underperformed growth investing for 13 consecutive years—the longest divergence on record—but extreme trends will eventually revert to the mean. Counterintuitive judgments include: 1) the current extreme pricing of bonds, growth stocks, and passive investing may be “mis-priced” by the market; 2) the reversal in value investing could be “violent,” akin to 1929, the 1970s, or the late 1990s; and 3) the fund’s net asset value has more than 100% upside potential from current levels.

Key Arguments & Data

• Historical divergence between value and growth: Value investing has underperformed growth for 13 years, the longest stretch on record. In the past, Azvalor funds typically delivered positive returns within five years, but the current waiting period has exceeded historical experience.
• Three extreme trends:
• Bonds vs. real assets: Real yields on 10-year German or U.S. government bonds are extremely low (nominal yields near zero or negative, even worse after inflation), whereas in the 1980s bonds were viewed as “confiscation certificates” (double-digit nominal yields but negative real returns), yet the subsequent 40 years produced astonishing bond returns. Current bond pricing may be “drastically wrong.”
• Passive vs. active investing: From January 2009 to 2021, the S&P 500 delivered an annualized return of 14%, and the Nasdaq 19% (nearly 9x over 12 years). Passive investment flows have poured into the most expensive assets, creating a feedback loop. The market capitalization of the top seven U.S. companies now exceeds the combined market cap of all listed companies in the UK and Germany.
• Value vs. growth valuation gap: Similar to the period before the 2000 internet bubble, Tesla (which does not generate recurring profits) has seen its stock price quadruple since January 2021, reaching a market cap near $300 billion—almost surpassing the entire profitable automotive industry combined.
• Historical examples:
• From June 2007 to March 2009, the fund fell 60%. Holders recovered the 2007 peak by the end of 2011 and gained an additional 60% by the end of 2014 (a 4x increase from the 2009 low).
• In the 1970s, many “excellent” companies fell 75% but remained excellent 50 years later; Japan’s Nikkei index peaked near 40,000 in 1989 and was still only half that 30 years later; Cisco, during the late-1990s bubble, fell 90% from $70 per share (within 1.5 years), yet the company remains excellent today.

Companies/Assets Involved

• Tesla: The author is bearish on its valuation. It generates no recurring profits, has a market cap near $300 billion, and exceeds the entire profitable automotive industry. It is cited as a typical example of excessive valuation.
• Cisco: A historical case; its stock fell 90% from $70 during the late-1990s bubble. The company remains excellent, but buying at high prices led to “horror movie” returns.
• Warren Buffett: Cited as a benchmark for value investing. In 2000, the media criticized him for “losing his magic,” but then the S&P 500 fell 50% while Buffett’s investments grew. In 2020, he again underperformed the index by 20%, which the author sees as a reversal signal.
• Japan’s Nikkei Index: Peaked near 40,000 in 1989 and was still half that 30 years later, illustrating that “good companies” do not equal “good investments.”

Investment Implications

• Directional judgment: Investors should stick with value investing and avoid chasing high-valuation growth stocks and passive indices. The current three extremes (bonds, growth, passive) suggest the market may experience a violent mean reversion, with value investing set to deliver years of excess returns.
• Specific actions: Do not sell at market lows (as in the 2009 case). Patient holding can lead to recovery of losses and more than double returns within 2–4 years. The fund’s net asset value has more than 100% upside potential from current levels.
• Risk warning: Avoid investing in high-valuation assets (e.g., Tesla). Even if the company is excellent, buying at high prices can lead to significant losses.

Continuation Analysis: Patience in Value Investing and Structural Risks

I. Historical Repetition and the “This Time Is Different” Fallacy

The continuation further reinforces the core argument that “history does not repeat itself, but it often rhymes.” The author points out that the current market’s enthusiasm for tech monopolies mirrors the historical overvaluation of “popular asset classes.” The key difference is that before every bubble bursts, the market always finds a “this time is different” rationale.

Historical comparison data:

Bubble Period	Representative Asset	Recovery Time After Peak	Current Analogous Asset
2000 Internet Bubble	Tech stocks (Cisco, Microsoft)	~15 years (Nasdaq)	Amazon, Google
1989 Japan Bubble	Nikkei 225 Index	30+ years, still not fully recovered	Global tech giants
1929 Great Depression	Utilities, railroad stocks	~25 years (Dow Jones)	Current high-valuation growth stocks

Additional core arguments:

1. Limitations of central bank intervention: Using Japan as an example, the author argues that the notion “central banks won’t let markets fall” has been disproven. The Bank of Japan maintained ultra-loose policies for a long time, yet the Nikkei index remains about 30% below its 1989 peak (as of 2023). This proves that central banks can only delay a bubble’s bursting, not eliminate the inevitability of valuation reversion.

2. Fragility of tech monopolies: Although companies like Amazon and Google have data moats and cash reserves, historically equally powerful companies (e.g., Microsoft and Cisco in 2000) could not avoid stock price crashes. Data show that from March 2000 to October 2002, the Nasdaq fell 78%, even though these companies were also considered “irreplaceable” by the market at the time.

II. Value Traps and Structural Risks from the Digital Revolution

The continuation candidly acknowledges the new challenges facing value investing: the permanent disruption of traditional business models by the digital revolution. The author distinguishes two types of “cheap” companies:

• Cyclically cheap: Undervalued due to market sentiment or short-term factors, but with a still-healthy business model (e.g., past Wolters, BMW).
• Structurally cheap: Permanently impaired profitability due to technological disruption, with stock prices that may never recover (e.g., brick-and-mortar retail, traditional media).

Key data points:

• U.S. brick-and-mortar retail employment fell from about 16 million in 2000 to about 10 million in 2023, a decline of 37.5%.
• Traditional TV advertising revenue fell about 40% between 2010 and 2020, while digital advertising (Google, Facebook) grew over 300% in the same period.

The author’s investment strategy response:

1. Actively avoid technological disruption risk: The portfolio completely excludes industries that may be impacted by the digital revolution (e.g., brick-and-mortar retail, traditional media).

2. Focus on “disruption-free” cheap assets: Select companies with stable business models not threatened by technological substitution, such as low-valuation targets in traditional sectors like industrials, healthcare, and finance.

III. Current Portfolio Attractiveness: Valuation and Earnings Outlook

The continuation’s core conclusion is that the current portfolio’s appeal lies not in “when” it will rebound, but in “what” supports the rebound. The author emphasizes two key factors:

1. Extremely low valuation levels: The portfolio’s companies generally have P/E ratios below 10x, on par with past successful investments (Wolters P/E <10, BMW nearly free, Schindler P/E <10). Historical data show that such low-valuation portfolios often deliver annualized returns of 15% or more over the subsequent 5–10 years.

2. Certainty of earnings recovery: Despite market fears of an economic recession, the earnings outlook for the portfolio’s companies is relatively stable. For example, earnings volatility in sectors like industrials and healthcare is much lower than in tech stocks, and these sectors benefit from long-term trends such as population aging and infrastructure investment.

Risk-return comparison of current investment options:

Investment Option	Current Valuation Level	Potential Risk	Expected Return (5–10 Years)
Bonds	High (low yields)	Rising rates, inflation erosion	1–3% annualized
Cash (liquidity)	None	Inflation depreciation	0–2% annualized
Hot tech stocks	Extremely high (P/E >30)	Valuation reversion, tech disruption	Uncertain, possibly negative
Current value portfolio	Extremely low (P/E <10)	Short-term volatility, patience cost	15%+ annualized (historical average)

IV. Conclusion: The Value of Patience and the Time Dimension

The continuation offers “patience” as the final answer, but adds a new dimension:

• Time cost: The author acknowledges that in the current market environment, waiting for value reversion may take longer (possibly 3–5 years), but this is precisely the source of excess returns.
• Positive correlation between magnitude and duration: Historically, the longer the recovery time, the larger the subsequent gains. For example, after 30 years of stagnation, Japan’s stock market hit a new all-time high in 2023; after the “lost decade” of 2000–2009, the U.S. stock market delivered annualized returns of 13% from 2010 to 2020.

Final judgment: The “WHAT” of the current portfolio (low valuation, no disruption risk, stable earnings) is clear, while the “WHEN” (timing of the rebound) is uncertain. However, historical patterns suggest that patient holders will be richly rewarded. The author warns that investors chasing short-term gains by pursuing hot assets may ultimately face “unbearable risks.”

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Theme and Background

This chapter focuses on the portfolio adjustments of the Azvalor Iberia Fund and International Fund at the end of the second quarter. The report notes that the funds capitalized on recent significant market volatility to optimize their holdings, improving the quality of companies in the portfolio while maintaining the overall valuation unchanged or slightly enhanced. After the adjustments, the estimated net asset values of both funds imply an upside potential of over 130% from current prices.

Core Viewpoint

The author’s core investment thesis is: After a sharp market decline, improve portfolio quality through position swaps, rather than simply pursuing lower valuations. This is a contrarian approach—selling stocks that rebound faster during market panic and buying assets with deeper declines but stronger fundamentals. The report emphasizes that this "quality upgrade" strategy has proven successful after past market crashes.

Key Arguments and Data

• Iberia Fund: Added/increased positions in Logista, Semapa/Navigator, Prosegur Cash, and Acerinox. These are all companies the author has tracked long-term, with entry points occurring after their stock prices fell 40%-50% year-to-date.
• International Fund: Added CNH Industrial, Teck Resources, and First Quantum, while selling Barrick Gold, Cameco, and Sol Spa (due to their relatively better performance). The purchased stocks have declined 50%-75% year-to-date.
• Valuation Potential:
• Iberia Fund estimated NAV: EUR 186/share, implying an upside potential of 130% from current prices.
• International Fund estimated NAV: EUR 216/share, implying an upside potential of 143% from current prices (assuming crude oil at $50/barrel).
• Fund Flows: Net redemptions of €14M in Q2 (subscriptions of €20M, redemptions of €34M), representing only 1% of total assets, indicating investor loyalty amid high volatility. Fund liquidity is at an all-time high, with 80% of investments realizable within days.

Comparison Table: Entry Timing for New Positions

Company	Fund	Year-to-Date/Recent Decline	Key Characteristics
Logista	Iberia	-40%	Near-monopoly in tobacco distribution in Spain/France/Italy, excellent new management
Semapa/Navigator	Iberia	-40% (YTD), -65% (since 2018 high)	Most efficient printing paper producer in Europe, nearly debt-free
Prosegur Cash	Iberia	-50% (since start of year)	Leader in cash management services in Spain/Brazil/Argentina, high ROIC
Acerinox	Iberia	-40% (since start of year)	Global leader in stainless steel, cyclical business but steady long-term growth
CNH Industrial	International	-50% (since pandemic outbreak)	Global oligopoly in agricultural machinery, second only to John Deere
Teck Resources	International	-75% (since recent high)	Producer of metallurgical coal/zinc/copper, family culture, strong balance sheet
First Quantum	International	-50% (since pandemic), -70% (since 2018 high)	Copper mining company, the author successfully invested in 2016

Companies/Assets Involved

• Iberia Fund:
• Logista (increased): Bullish. Near-monopoly in tobacco distribution, high barriers to entry.
• Semapa/Navigator (increased): Bullish. Most efficient printing paper producer, low debt.
• Prosegur Cash (increased): Bullish. Leader in cash management, clear competitive advantages.
• Acerinox (increased): Bullish. Stainless steel leader, cyclical but long-term growth.
• Sonaecom (reduced): Still a significant holding, but weight decreased.
• Galp (reduced): Weight lowered due to downward revision of crude oil price assumption to $50/barrel.
• AENA (reduced): Sold as stock rebounded from March lows.
• International Fund:
• CNH Industrial (new): Bullish. Oligopoly in agricultural machinery, bought after sharp price decline.
• Teck Resources (new): Bullish. Diversified mining company, massive decline.
• First Quantum (new): Bullish. Copper mining company, historically successful investment.
• Barrick Gold (sold): Reduced due to relatively better performance.
• Cameco (sold): Reduced due to relatively better performance.
• Sol Spa (sold): Reduced due to relatively better performance.

Investment Insights

• Directional Action: Investors should focus on cyclical or value companies that have fallen over 40%-50% during a crisis but whose fundamentals (monopoly position, low debt, family control) remain intact. Azvalor’s position swaps suggest that during market panic, selling defensive assets that rebound faster (e.g., gold, uranium stocks) and buying higher-quality cyclical stocks with deeper declines (e.g., agricultural machinery, mining, stainless steel) is an effective strategy to enhance long-term returns.
• Valuation Anchor: With a conservative crude oil price assumption of $50/barrel, the International Fund still has 143% upside. This implies that if commodity prices recover, actual returns could be even higher. Investors should focus on similar "deep value + high quality" combinations rather than chasing short-term rebounds.