Quarterly letter 3Q2017

Theme and Background

This chapter is Azvalor’s quarterly letter to investors on the occasion of its second anniversary. It primarily reviews fund performance, explains the current underperformance relative to the benchmark, and reaffirms its deep value investment philosophy. The market backdrop is characterized by the prevalence of global index investing, with massive capital flows blindly into index constituents, while Azvalor focuses on undervalued companies that are overlooked or troubled by the market.

Core Thesis

The author’s core investment argument is that, despite Azvalor’s underperformance relative to the benchmark since 2017, the potential for future returns has not diminished; on the contrary, market volatility has created opportunities. The counterintuitive judgment is that the current underperformance is a normal part of a contrarian investment strategy, not a sign of strategy failure. The author emphasizes that through a rigorous research process and a “margin of safety” mechanism, the fund is capable of outperforming the market over the long term.

Key Arguments and Data

• Performance Review: The Iberian portfolio has achieved a cumulative return of +30%, and the International portfolio +20%; both have risen nearly +50% from their lows in January 2016, are at historical highs, and no investor has experienced negative returns.
• Future Potential: The Iberian portfolio is expected to have 55% upside, and the International portfolio 85%.
• Market Structure Comparison: There are over 1 million global indices, while the total number of listed companies is only about 43,000 (Bernstein data), of which only around 3,000 have the lowest liquidity. Index investing leads to blind capital inflows into index constituents, whereas Azvalor only invests in undervalued companies that have undergone rigorous screening.
• Investment Process: By analyzing historical financial statements, adjusting public data to assess “true” profitability, and comparing key metrics with competitors; building conviction through field research (companies, competitors, suppliers, customers) and discussions with industry experts.
• Error Management: Using a “margin of safety” (sufficient undervaluation) to buffer analytical mistakes; decisively selling if the investment thesis is entirely wrong.

Companies/Assets Involved

• Azvalor Iberian Portfolio: Cumulative return +30%, expected upside 55%.
• Azvalor International Portfolio: Cumulative return +20%, expected upside 85%.
• Azvalor Itself: The authors (Fernando and another) had increased their investment in the fund at the time of writing, indicating alignment of management’s interests with those of investors.

Investment Insights

• Adhere to Contrarian Strategy: Current underperformance relative to the benchmark is normal; investors should remain patient rather than chasing index investing.
• Use Volatility to Add Positions: When holdings decline due to market sentiment, if the investment thesis remains unchanged, take the opportunity to increase positions.
• Strict Discipline: Continuously review the investment thesis; if an error is identified, cut losses decisively rather than holding on stubbornly.
• Long-Term Perspective: Azvalor recommends a minimum investment horizon of five years; short-term performance fluctuations should not interfere with judgment.

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Theme and Background

This chapter focuses on the portfolio adjustments and valuation changes of the Azvalor Iberian and International portfolios in the third quarter of 2017. The report notes that market volatility—particularly the Catalan independence crisis in Spain—has created new investment opportunities, leading to a significant expansion in expected upside for both funds while cash ratios declined.

Core Views

• Iberian Portfolio: The author believes the fund is currently in its "largest gap between price and value" since inception, making it the most attractive. The estimated fair value per share is €200, implying a 55% upside from the current market price of €130.
• International Portfolio: The author argues that most European stocks are overvalued, as investors are forced into equities due to low bond yields, creating a dangerous combination of "high P/E ratios and high earnings." In contrast, the International portfolio trades at 8x earnings, significantly reducing risk.
• Contrarian Judgment: The author disagrees with the view that "only a recession can cause both earnings declines and valuation contractions simultaneously," arguing that even a modest earnings decline (-20%) and valuation contraction (to 14x) could lead to a 35% drop in stock prices.

Key Arguments and Data

1. Iberian Portfolio Cash and Valuation Changes:

• Cash ratio fell from 22% at the end of Q2 2017 to 15% at the end of Q3, and further to 5% at the time of writing.
• Expected upside increased from 40% in June 2017 to the current 55%.
• If the stock reaches €200 per share in 3 years, the annualized compound return would be 15%; if achieved in 5 years, it would be 9%.

2. International Portfolio Adjustments and Valuation:

• Sold 11 companies in Q3 (including Samsung, Ryanair, Vivendi, etc.), and bought or increased holdings in Cameco, Grupo México, Norilsk Nickel, Consol Energy, Eurocash, and Range Resources.
• Expected upside is 87%, corresponding to €225 per share.
• Top 10 holdings account for 57%, top 20 for 80%; commodity-related assets account for 63% (copper, nickel, uranium, gold, oil, and gas), with the remaining 32% in other undervalued companies.

3. European Market Risk Example (Table Format):

Scenario	Earnings (€ million)	P/E Ratio	Valuation (€ million)	Stock Price Decline
Current Expectations (2018)	110	17x	1,870	-
Earnings down 20%, valuation contracts to 14x	88	14x	1,232	-35%
Recession scenario (earnings down 40%, valuation to 10x)	66	10x	660	-65%

4. Defensive Logic: The author believes that traditional "moat" companies are facing accelerated erosion from "disruption," while resource-based companies in the International portfolio (e.g., copper mines) are difficult to replicate and trade at 8x earnings, significantly reducing risk.

Companies/Assets Involved

• Iberian Portfolio New Additions/Increases:
• Almirall, FCC, Jeronimo Martins (new purchases)
• Técnicas Reunidas (increased holdings)
• International Portfolio Sales: Samsung, DEA, FFP, Thyssen, Savills, Amsterdam Commodities, Dassault Aviation, Fairfax India, Ryanair, Vivendi, Via Varejo (profit-taking)
• International Portfolio Purchases/Increases:
• Cameco (uranium), Grupo México (copper), Norilsk Nickel (nickel), Consol Energy (coal/natural gas), Eurocash (Polish retail), Range Resources (oil and gas)
• Overall View: Bullish on the newly added/increased holdings; believes the sold companies have delivered good returns; bearish on European stocks overall.

Investment Implications

• Iberian Market: The Spanish stock market is currently undervalued due to political turmoil. Investors can focus on buying opportunities created by the Catalan crisis, particularly the newly added companies in the portfolio such as Almirall and FCC.
• International Market: Avoid high-valuation European stocks and shift toward low-valuation (8x P/E) assets with "non-replicable" characteristics, such as resource companies (copper, nickel, uranium, oil and gas). Commodity assets provide a margin of safety in the current cycle.
• Risk Warning: Be wary of the "high earnings + high valuation" combination in European equities. Even a moderate adjustment could lead to a significant decline (-35%), with a recession scenario potentially causing a 65% drop.

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Theme and Background

This chapter focuses on the quarterly adjustments to Azvalor's Blue Chips portfolio, asset allocation recommendations, and a review of the company's operations on its second anniversary. The author aims to explain changes in the portfolio's holdings, its positioning differences from the International portfolio, and reiterate the investment philosophy and team progress.

Core Views

• The Blue Chips portfolio is positioned as a large-cap fund, with significant overlap with the International portfolio in stocks with a market cap exceeding €3 billion, but it lacks exposure to small- and mid-cap stocks (such as Danieli, Sol, ITE Group, etc.). The author expects that if these small- and mid-cap stocks perform as anticipated, the Blue Chips portfolio's long-term returns will lag behind the International portfolio, though its short-term performance may surpass it.
• Asset allocation recommendation: The authors (Fernando and Álvaro) personally allocate 10-20% of their total investment to the Blue Chips portfolio and advise investors to allocate 20% to Iberian, 60% to International, and 20% to Blue Chips.
• Company operational milestones: On its second anniversary, AUM reached €1.7 billion, with over 16,000 clients, a team of 37, and plans to announce new partner names.

Key Arguments and Data

• Portfolio adjustments: Fully sold Dassault Aviation, Alphabet, Franco Nevada, and Samsung (due to achieving good returns); newly purchased Tenaris and Barrick Gold; reduced Vivendi (due to strong performance); increased holdings in Buenaventura, Cameco, Consol Energy, Grupo México, and Range Resources.
• Concentration: The top ten holdings account for 60%, reflecting a highly concentrated strategy.
• Scale and growth: AUM grew from zero at inception (2015) to €1.7 billion (+€1,700 million), with over 16,000 clients.
• Team and governance: Currently 37 professionals and 9 partners, with plans to add new partners.

Companies/Assets Involved

Company/Asset	Role	Key Data	Bullish/Bearish
Dassault Aviation	Fully sold	Exited after achieving good returns	Bullish (profit taken)
Alphabet	Fully sold	Same as above	Bullish (profit taken)
Franco Nevada	Fully sold	Same as above	Bullish (profit taken)
Samsung	Fully sold	Same as above	Bullish (profit taken)
Tenaris	Newly purchased	Specific amount not disclosed	Bullish (new position)
Barrick Gold	Newly purchased	Same as above	Bullish (new position)
Vivendi	Reduced	Partial profit-taking due to strong performance	Bullish (but weight reduced)
Buenaventura	Increased	Specific amount not disclosed	Bullish (added position)
Cameco	Increased	Same as above	Bullish (added position)
Consol Energy	Increased	Same as above	Bullish (added position)
Grupo México	Increased	Same as above	Bullish (added position)
Range Resources	Increased	Same as above	Bullish (added position)
Small- and mid-cap stocks (Danieli, Sol, ITE Group, Sprott, Ophir, Eurocash, Odet, Serco)	Only in International portfolio	Not covered by Blue Chips	Bullish (expected to perform well)

Investment Implications

• Implications for investors: The author recommends allocating the majority of funds (60%) to the International portfolio, as it contains more small- and mid-cap value stocks with expected higher returns; the Blue Chips portfolio serves as a large-cap supplement, suitable for investors with lower risk tolerance. Investors should focus on Azvalor's concentrated holding strategy (top ten account for 60%) and the potential for excess returns from small- and mid-cap stocks.
• Implications for holdings: New purchases of Tenaris (industrial pipes) and Barrick Gold (gold mining) indicate a bullish view on the resources/commodities sector; the reduction in Vivendi suggests partial profit-taking after a price increase, rather than a bearish view on fundamentals.