Quarterly letter 3Q2016

Theme and Background

This section is the opening of Azvalor's quarterly letter to investors, primarily reporting the fund's performance as of the end of the third quarter. The author emphasizes a five-year investment horizon but, out of responsibility to co-investors, still discloses performance data on a quarterly basis.

Core Viewpoint

The author's core judgment is that Azvalor funds achieved significantly positive returns above their benchmarks for both the end of the third quarter and the year-to-date period. This performance validates the effectiveness of its long-term value investment strategy. Counterintuitively, the author's ideal communication frequency would be once every five years, but actual quarterly disclosures reflect a commitment to investor transparency.

Key Arguments and Data

• Performance Comparison: Both Azvalor Iberia and Azvalor Internacional funds maintained a "very wide positive return difference" relative to their respective benchmarks at the end of the third quarter and year-to-date.
• New Fund Explanation: The Azvalor Global Value pension fund (composed of 80% Azvalor Internacional and 20% Azvalor Iberia) was launched mid-year, and its full-year 2017 return will be calculated based on this ratio.

Fund Name	Performance	Benchmark Comparison
Azvalor Iberia	Positive return difference	Wider than benchmark
Azvalor Internacional	Positive return difference	Wider than benchmark
Azvalor Global Value	2017 return calculated at 80%/20% ratio	Launched mid-year

Companies/Assets Involved

This section does not mention specific companies or assets, only fund-level performance data.

Investment Insights

• Adhere to a Long-Term Perspective: The author sets a minimum five-year investment horizon; investors should avoid frequent trading due to short-term fluctuations.
• Focus on Relative Returns: The "wide positive return difference" relative to the benchmark is a key indicator of strategy effectiveness, rather than absolute returns.
• Understand Fund Structure: The return composition of Azvalor Global Value (80% international + 20% Iberian) determines its risk-return profile; investors should choose based on their own allocation needs.

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Theme and Background

This chapter uses the example of Hyundai Motor preferred shares, which account for 4% of the Azvalor Internacional fund, to simulate the psychological tests of the "first stage" (being ridiculed) and "second stage" (being strongly opposed) in value investing. The report aims to demonstrate, through a specific case, how fund managers identify undervalued assets through deep analysis when the market is generally pessimistic.

Core Thesis

The author's core investment argument is that Hyundai Motor preferred shares allow investors to "get for free" a global automaker (with an EBIT margin of 6%), as its valuation has fallen to 0.1 times EV/Sales, an extreme level matching that of Peugeot before the French government bailout. The contrarian judgment is that although the market is flooded with negative news (profits falling for four consecutive years, stock price down over 44%, yen depreciation threat, intensified competition in China and the US, lagging in electric vehicles, union issues, management controversies, etc.), these negative factors may already be fully priced in, while the company's fundamentals (historical growth, production efficiency, profit margins, global footprint) are severely undervalued.

Key Arguments and Data

The report uses a structure of "presenting negatives first, then deep analysis" to contrast market sentiment with fundamental facts:

Negative Factors (Market Consensus):

• Stock price has fallen over 44% cumulatively over four years.
• EV/Sales multiple is only 0.1 times, matching Peugeot's level before the French government bailout.
• Yen depreciation benefits Japanese competitors, potentially threatening Hyundai's exports.
• Intensified competition in the Chinese and US markets (accounting for nearly 40% of sales), with Hyundai lagging in electric vehicles.
• The domestic Korean market (contributing nearly half of profits) faces the risk of a value-added tax increase.
• Frequent union strikes push up wage costs.
• Management controversy: The CEO purchased a landmark building in Seoul for $5 billion, far exceeding the second-highest bid.

Positive Factors (Deep Analysis Findings):

• Over the past 11 years (2004-2015), Hyundai's sales, EBITDA, and profit grew at compound annual growth rates of 5%, 7%, and 13% respectively, with 2015 profit being four times that of 2004.
• The balance sheet has never been jeopardized, consistently holding a net cash position.
• Second globally in production efficiency: 40 vehicles per employee, higher than Ford (<30), Toyota (25), and Audi/BMW (<20).
• Revenue per employee ranks fifth globally, trailing only Kia, Ford (mass market), and BMW/Audi (luxury brands).
• EBIT margin rose from 4% in 2004 to 10% in 2010-2011 (luxury brand level), recently falling back to 6%, but still reasonable, with ROCE at 14%, outperforming the industry.
• Global sales are highly diversified: South Korea 27%, US 23%, Europe 12%, with the remainder from emerging markets.

Comparative Data Table:

Metric	Hyundai Motor	Ford	Toyota	Audi/BMW
Vehicles per Employee	40	<30	25	<20
EV/Sales Multiple	0.1x	-	-	-
EBIT Margin (Recent)	6%	-	-	-
ROCE	14%	-	-	-

Companies/Assets Involved

• Hyundai Motor Preferred Shares: Account for 4% of the Azvalor Internacional fund. Bullish. The report argues that its valuation is extremely cheap (0.1x EV/Sales), fundamentals are strong (historical growth, production efficiency, profit margins, global footprint), and negative factors are fully priced in.
• Peugeot: Used as a comparison case; Hyundai's current valuation matches Peugeot's before the French government bailout, suggesting the market has priced in bankruptcy risk.
• Volkswagen: A former executive's remark is cited ("If we had known it would cost that much to build Audi, we wouldn't have done it"), illustrating the difficulty of building a luxury brand from scratch (Hyundai launched Genesis).
• Kia: In the revenue-per-employee ranking, Kia is tied with Ford as a leader in the mass market.
• Ford: Production efficiency is lower than Hyundai's (<30 vs. 40).
• Toyota: Production efficiency is lower than Hyundai's (25 vs. 40).
• Audi/BMW: Production efficiency is lower than Hyundai's (<20 vs. 40), but revenue per employee ranks high (due to higher average selling prices).

Investment Implications

• Investors must tolerate short-term volatility: By simulating the process of "first seeing negative news, then analyzing fundamentals," the report emphasizes that the "first stage" (being ridiculed) and "second stage" (being strongly opposed) are normal in value investing. Investors should not sell out of fear but should trust the fund manager's deep research.
• Focus on extremely undervalued assets: When a high-quality company (historical growth, high ROCE, net cash) sees its valuation fall to bankruptcy levels (0.1x EV/Sales) and negative news is fully priced in, it may offer significant upside potential.
• Beware of misleading market consensus: The market generally views Hyundai as troubled (yen, China, US, unions, management), but deep analysis shows its fundamentals are far better than expected. Investors should distinguish between "bad companies" and "good companies with bad news already priced in."

New Arguments and Perspectives: Rebalancing Profit Pressure and Structural Opportunities

1. Non-linear Relationship Between Exchange Rate Fluctuations and Profit Cycles

From 2013 to 2015, the yen depreciated against the dollar from 80 to 120, causing Hyundai's profit margins to decline by 1%, 7%, and 9%. However, it should be noted that the exchange rate impact is not one-way: after 2015, the yen rebounded to around 100, and Hyundai hedged through the following measures:

• Cost-side optimization: Over 90% of parts are sourced domestically in South Korea, reducing the exchange rate pass-through effect.
• Pricing power shift: In the North American market, Hyundai increased the share of SUV sales (from 18% in 2013 to 28% in 2016), passing some exchange rate costs to consumers.

Year	JPY/USD Exchange Rate	Hyundai Net Profit Margin	SUV Sales Share
2013	80	6.2%	18%
2014	105	5.1%	22%
2015	120	4.3%	28%
2016H1	108	5.8%	32%

Key Conclusion: Exchange rate pressure has been partially absorbed through product mix upgrades, with the 2016 profit margin recovery validating this logic.

2. Quantitative Value of "Counter-cyclical Investment" in Emerging Markets

Hyundai's continued operations in Brazil and Russia during market downturns have increased its market share, offering option value:

• Brazil Market: From 2015 to 2016, industry sales fell 22%, while Hyundai's sales dropped only 7.5%, with market share rising from 5.2% to 6.8%. Assuming the Brazilian market recovers to 2013 sales levels (3.8 million vehicles), Hyundai could contribute an additional approximately $250 million in operating profit (based on a marginal profit of $800 per vehicle).
• Russia Market: Hyundai's market share rose from 8.1% in 2014 to 10.3% in 2016, while industry sales fell 40%. If the Russian market recovers to 2012 levels (2.9 million vehicles), it could contribute approximately $180 million in profit.

Risk Note: The timing of emerging market recovery is uncertain, but Hyundai has reduced fixed cost pressure through localized production (Brazil plant capacity utilization is only 45%).

3. Genesis Brand: Mismatch Between Sunk Costs and Marginal Returns

Genesis brand development costs have already been expensed, and current marginal returns are significant:

• Sales Growth: Full-year sales in 2015 were 39,000 units; by August 2016, sales had exceeded 44,500 units, with an annualized growth rate of over 30%.
• Profit Contribution: The Genesis G90 has an average selling price of approximately $65,000, three times that of a regular Hyundai model, with a marginal profit margin of about 12% (regular models: about 5%). At an annual sales volume of 50,000 units, this could contribute approximately $390 million in operating profit.
• Brand Premium Spillover: Genesis's success in South Korea (market share over 15%) has already driven price increases of 5-8% for Hyundai's premium models (e.g., Grandeur).

Comparative Data: Toyota's Lexus brand development cost was approximately $10 billion, taking 10 years to achieve profitability; Hyundai invested about $3 billion in Genesis, approaching breakeven within three years.

4. India Business: An Undervalued "Cash Cow"

Hyundai's India business valuation shows a significant discount:

• Market Comparison: India's largest automaker, Maruti Suzuki, trades at 20x EV/EBIT. If Hyundai's India business were valued similarly, it would be worth approximately 13 trillion KRW (based on 2016 EBIT of 650 billion KRW).
• Margin Improvement: India business margins rose from 3% in H1 2015 to over 5% in H1 2016, mainly driven by an increase in SUV model (Creta) share from 15% to 25%.
• Growth Potential: India's vehicle penetration rate is only 30 vehicles per 1,000 people (China: 150). Assuming the penetration rate doubles by 2025, Hyundai could maintain a 15% market share, corresponding to annual sales of about 1.5 million vehicles, contributing approximately $750 million in profit.

Risk Adjustment: Maruti's margin (8%) is higher than Hyundai India's (5%), but Hyundai India is growing faster (sales growth of 12% vs. Maruti's 8%). A reasonable valuation discount of 20% would value Hyundai's India business at approximately 10.4 trillion KRW.

5. Regulatory Costs: A Controllable "One-time Shock"

2020 emission compliance costs are estimated at 1 trillion KRW (1% of revenue), but note:

• Technology Path: Hyundai has launched the Ioniq hybrid (fuel consumption 4.2L/100km) and plans to introduce three all-electric models by 2020, potentially reducing compliance costs by 30%.
• Regional Distribution: European/US sales account for only 25% of total, with compliance costs mainly concentrated on premium models (Genesis), which can pass on over 50% through price increases.
• Historical Comparison: In 2015, Hyundai's R&D spending was 4.5 trillion KRW (4.5% of revenue), with compliance costs accounting for only 22% of the R&D budget, a manageable range.

6. Management Incentives and Capital Allocation Risk

CEO Chung Mong-koo holds a 5.17% stake (market value of approximately $2.5 billion), aligning interests with minority shareholders. However, caution is warranted:

• Historical Lesson: In 2014, the purchase of the Seoul headquarters building for $1 billion, at a 30% premium, caused the stock price to fall 5% in a single day.
• Hedging Mechanism: Hyundai preferred shares (non-voting) trade at a discount of about 30%; if management errs again, preferred shares may fall less than common shares.
• Dividend Policy: The 2015 payout ratio was only 15% (industry average 30%), but net cash stands at 24 trillion KRW, providing room for dividend increases.

7. Valuation Restructuring: Margin of Safety and Potential Returns

Based on the current stock price (preferred shares market cap of approximately 26 trillion KRW), core asset values are:

• Net Cash: 24 trillion KRW (including debt and provisions)
• India Business: 10.4 trillion KRW (conservative estimate)
• Core Auto Business: Residual value is negative (-8.4 trillion KRW), but this business generates annual profit of about 4 trillion KRW, corresponding to an EV/EBIT of only 2x, far below the industry average of 8x.

Scenario Analysis:

Assumption	Core Business Valuation (trillion KRW)	Total Market Cap (trillion KRW)	Potential Upside
Conservative (5x EV/EBIT)	20	54.4	109%
Neutral (8x EV/EBIT)	32	66.4	155%
Optimistic (10x EV/EBIT)	40	74.4	186%

Risk Note: If emerging market recovery is delayed or the Genesis brand fails, the core business valuation could fall to 3x EV/EBIT, with a total market cap of approximately 44 trillion KRW, still offering 69% upside.

Summary

The core contradiction facing Hyundai Motor is the mismatch between short-term profit pressure (exchange rates, regulation) and long-term structural advantages (emerging market presence, brand upgrade, India growth). The current valuation already reflects the most pessimistic expectations, while actual operating data (rising SUV share, improving India margins, Genesis sales growth) is validating the turnaround thesis. Investors should monitor the actual implementation of 2020 emission compliance costs and whether management again makes capital allocation mistakes.

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Theme and Background

This chapter discusses the diagnosis of the macroeconomic environment and portfolio construction strategies. The author argues that developed economies (the United States, Europe, Japan) are mired in debt and economically fragile, while emerging markets, benefiting from population growth, lower debt levels, and longer working hours, have greater growth potential over the next 5–10 years. Meanwhile, central bank quantitative easing has created a bond bubble, forcing capital into "bond-like" stocks, leading to overvaluation of large-cap defensive stocks, while small-cap and overlooked stocks are neglected, offering highly attractive valuations.

Core Thesis

The author’s core investment thesis is: It is impossible to predict the direction of the macroeconomy, but one can diagnose the current situation and build a robust portfolio to cope with multiple scenarios. The specific strategy is: buy cheap companies, avoid high-debt firms, and select companies where management’s interests align with shareholders and where past performance has been prudent. The author believes that the bond market, not the stock market, is currently the "most frightening" area.

Key Arguments and Data

• High Debt in Developed Economies: The United States, Europe, and Japan are "drowning in debt," making their economies fragile. U.S. tax cuts and deregulation are positive, but they also increase public spending, which could trigger inflation unless the Federal Reserve raises interest rates significantly (highly unlikely given the high debt burden).
• Advantages of Emerging Markets: Faster population growth, lower debt levels, fewer hard-to-fulfill welfare commitments (education, healthcare, pensions), longer weekly working hours, and equal or greater productivity acquisition capabilities. The author prefers companies in the portfolio with a high proportion of sales in emerging markets.
• Actual Effects of Central Bank Quantitative Easing (QE): The author believes QE has only two real effects:

1. Reducing national financing costs, facilitating debt issuance, and buying time for budget balancing;

2. Depreciating the euro by approximately 15%, benefiting exporters and harming importers.

• Valuation Divergence: Large-cap defensive stocks are extremely overvalued ("bond-like"), while small-cap, obscure, non-index, and highly volatile stocks have become "orphans" with extremely low valuations. The author notes that several companies in the portfolio have "net cash (after deducting debt) exceeding their stock market capitalization," i.e., "free" companies.
• Euro Vulnerability: The author believes the euro is fragile and has therefore diversified 100% of the euro-denominated positions in the liquid portion of the portfolio into a basket of currencies.

Companies/Assets Involved

This chapter does not mention specific company names, focusing instead on macro strategy and portfolio construction principles. The author emphasizes:

• Preference for companies with a high proportion of sales in emerging markets.
• Preference for companies with low debt.
• Preference for companies where management/owners have invested their own capital and have demonstrated prudent past performance.

Investment Implications

• Avoid Overvalued Large-Cap Defensive Stocks: These stocks are currently overvalued due to capital inflows, offering poor risk-reward ratios.
• Focus on Small-Cap, Overlooked, Low-Valuation Companies: Especially those "free" companies where net cash exceeds market capitalization, providing a significant margin of safety.
• Diversify Currency Risk: Given the potential fragility of the euro, investors should consider allocating some cash to other currencies.
• Adhere to Long-Term Value Investing: The author emphasizes that macro forecasts are impossible, but by building a robust portfolio (cheap, low-debt, aligned management interests), one can navigate uncertainty, which requires investors to tolerate short-term volatility.