Quarterly letter 4Q2016

Theme and Background

This chapter is Azvalor's quarterly letter to investors, primarily discussing the performance of long-term value investing strategies in 2016 and emphasizing the critical role of investor patience in fund returns. The author argues that in the current market environment, where short-term gains and passive management are widely pursued, adhering to long-term investing can instead create a competitive advantage.

Core Thesis

The author's core investment argument is: Investment success = high-quality companies + extremely low purchase price + long-term client patience. Counterintuitive judgments include:

• A fund's short-term decline of nearly 20% is not a risk but an opportunity; clients not redeeming is the key to achieving high returns
• Clients attempting to time the market (chasing gains and selling on losses) is the main reason their actual returns lag the fund's historical performance
• Fund managers have already internally sold rising stocks and bought falling ones; clients do not need to act on their own

Key Arguments and Data

• 2016 Performance: Azvalor Internacional returned 20.3%, and Azvalor Iberia returned 15.6%, both significantly outperforming their benchmarks
• Client Behavior Data: There is a "devastating fact" in the fund industry—most clients fail to achieve the historical performance of the funds they invest in because they buy after substantial gains and redeem during sharp declines
• Investment Horizon Requirement: The author explicitly requires clients to invest only money they will not need for the next 4–5 years. Many clients, after consultation, ultimately invested only half of their original plan, or even nothing
• Team Configuration: Azvalor has a 15-person team led by Beltrán Parages, whose daily task is to help clients stay focused on the long term

Companies/Assets Involved

This chapter does not analyze individual stocks but discusses the overall portfolio characteristics of the funds:

• Azvalor Iberia and Azvalor Internacional: Both funds hold "high-quality companies" purchased at "attractive prices" with "significant upside potential"
• The author mentions some positions that have been sold as examples, including both successful cases and investment mistakes, but does not disclose specific company names

Investment Insights

• Investors should only commit money they will not need for 4–5 years; otherwise, they cannot withstand inevitable market declines and may be forced to sell at lows
• Do not attempt to time the market: The most common client mistake is "selling after a fund has risen too much, waiting for a pullback to buy back" or "entering and exiting based on gut feelings about market direction." This is precisely the main reason actual returns fall short of fund performance
• Trust the management team: Fund managers have already internally executed "selling rising stocks and buying falling ones"; clients do not need to judge market timing themselves
• Investors should internalize an identity: "I own very solid businesses that can make money in every corner of the world, and I bought them at extremely attractive prices"—this holds true only if the manager has not made major mistakes (such as buying poor companies or overpriced ones)

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Theme and Background

This chapter uses two specific cases—Técnicas Reunidas (TR) and Metro Bank (MB)—to illustrate how Azvalor identifies and buys "hard-to-replicate, owner-managed, and mispriced by the market" companies. Both cases occurred in 2016, when short-term negative events (TR's profit warning, Brexit) caused sharp stock price declines, creating buying opportunities for long-term value investors.

Core Thesis

The author's central argument is: The key to investment success is not predicting market timing, but buying high-quality, owner-managed, financially sound companies at extremely low prices and patiently holding for 3-5 years. The counterintuitive insight is that the market's overreaction to short-term negative events (e.g., TR's 25% plunge due to a single project issue, MB's undervaluation due to Brexit) is precisely the best entry point for long-term investors; and "owner-managed" companies (e.g., TR's Lladó family, MB's founder) are more cautious during industry cycles than professional managers, making fewer fatal mistakes such as lowball bidding or overexpansion.

Key Arguments and Data

1. Técnicas Reunidas (TR) Case

• Hard-to-replicate moat: In the large-scale engineering project sector, clients demand extremely high technical qualifications and financial strength, making it difficult for new entrants to challenge. Over the long term, the same group of companies always participates in bidding.
• Advantage of owner management: The founding Lladó family is the major shareholder, with an incentive to "make money" rather than "win orders." When Korean engineering firms launched a price war in 2011, TR chose to "sit on the sidelines." Although this led to order volumes below market expectations and drew analyst criticism, it proved to be the correct strategy—the Korean engineering firms subsequently ran into trouble.
• Financial discipline: Over the past 12 years, TR's order book has grown at a 25% annual rate, never jeopardizing its balance sheet.
• Buying opportunity: In early 2016, TR issued a profit warning due to a Canadian project (issues with subcontractor KBR), causing its stock to plunge 25% in a single day. Azvalor bought at €21-22 per share, corresponding to 6x normalized P/E, with net cash on the balance sheet accounting for nearly 40% of its market cap, and the order book at an all-time high.
• Return: 11 months later, the stock price rose to approximately €37. If held for 3 years, the annualized return would be about 18%; in reality, over just 11 months, the annualized return reached 72%.

2. Metro Bank (MB) Case

• Hard-to-replicate moat: MB attracts low-cost deposits with customer service quality far exceeding that of large banks. For large banks to replicate this, they would need to bear enormous costs and risks, almost requiring a "die to be reborn" approach.
• Advantage of owner management: The founder and chairman is an American entrepreneur who previously founded a bank in the U.S., achieving over 20 years of annualized returns exceeding 20% through superior service and agile operations, before selling it to a large bank. MB fosters a sense of ownership among all employees through an employee stock ownership plan.
• Buying opportunity: MB went public in early 2016, initially appearing expensive. After the Brexit referendum, the stock price fell, compounded by the pound's depreciation (an even larger decline in euro terms). Azvalor's in-depth analysis revealed that MB's profitability was masked by "rapid growth": most branches were far from maturity, and costs were largely fixed, so the marginal contribution of incremental business was extremely high. After adjusting for this factor, the post-Brexit stock price was not expensive.
• Return: Within 6 months, the stock price rose 60%.

Comparative Data Table

Dimension	Técnicas Reunidas	Metro Bank
Industry	Large-scale engineering (EPC)	Retail banking
Core moat	Technical qualifications + financial strength	Superior customer service + low-cost deposits
Owner-managed	Yes (Lladó family)	Yes (founder and chairman)
Negative event	Profit warning on Canadian project (subcontractor KBR issues)	Brexit referendum
Entry valuation	6x normalized P/E, net cash/market cap ≈ 40%	Not expensive after adjusting for growth factors
Holding period to return	11 months	6 months
Annualized return	72% (18% if held for 3 years)	Approximately 120% (60%/0.5 years)

Companies/Assets Involved

• Técnicas Reunidas (TR): Spanish engineering company. Bullish. Key data: Entry price €21-22, €37 after 11 months; net cash at 40% of market cap; order book 12-year CAGR of 25%.
• Metro Bank (MB): UK small bank. Bullish. Key data: Up 60% in 6 months; founder's previous U.S. bank achieved 20+ years of annualized returns exceeding 20%.
• Saipem, Amec Foster Wheeler, CGG: Mentioned as cautionary examples; these companies suffered cumulative declines of 90% from highs or faced severe issues due to lowball bidding or execution problems.
• KBR: U.S. engineering company, mentioned as the subcontractor behind TR's Canadian project issues.

Investment Takeaways

1. Prioritize "owner-managed" companies: When management's interests are closely aligned with shareholders (e.g., family-controlled, founder-owned), companies are more likely to adopt cautious strategies during industry downturns or intense competition (e.g., TR's refusal to lowball bid), avoiding destructive losses.

2. Build positions during short-term negative events: Sharp stock price declines caused by profit warnings or geopolitical shocks (e.g., Brexit) often present excellent opportunities to buy quality companies. The key is to judge whether the event is "temporary" or "structural."

3. Focus on real profitability masked by growth: For high-growth companies (e.g., MB), valuation models should be adjusted to account for marginal contributions under fixed cost structures, rather than simply looking at current P/E ratios.

4. Accept a 3-5 year waiting period: Even if actual returns materialize sooner than expected (e.g., TR in just 11 months), investors should be mentally prepared for long-term holding. If bought with a 3-year horizon, even if the return drops from 72% to 18%, it remains a satisfactory level.

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Theme and Background

This chapter uses two cases—Euro Disney and CTT—to illustrate how Azvalor identified and exploited market mispricing in 2016, and how it learned from failed investments. The report emphasizes that investment opportunities often arise in complex situations overlooked by the market, and patience is key to capturing returns.

Core Views

• Euro Disney is a classic "turnaround" case: Due to management abuse (excessive royalty and management fees), the stock price plummeted 70%. However, after majority shareholder Walt Disney increased its stake to 76%, interests aligned, and the asset value was severely undervalued.
• CTT is a lesson in "value traps": Despite seemingly cheap valuations (8x earnings, 7.5% dividend yield), the structural decline in its business (mail volume falling 3-5% annually) could make any low price a trap.
• Counterintuitive judgment: The market's negative sentiment toward Euro Disney (legal disputes, poor liquidity, no analyst coverage) was precisely the opportunity to buy at a low price; conversely, CTT's "high cash + high dividend" facade masked the risk of irreversible business contraction.

Key Arguments and Data

Euro Disney

• Unique assets: Europe's largest tourist destination, featuring two theme parks, hotels, restaurants, and 2,230 hectares of developable land.
• Valuation mismatch: Independent valuation resulted in €3.7 per share, nearly three times the purchase price; Walt Disney subsequently launched a takeover bid at €2 per share, a 65% premium over the purchase price.
• Catalysts: The 25th anniversary in 2017 and new rides were expected to boost sluggish attendance; data from Japanese peer Oriental Land showed that even a slight improvement in attendance could significantly lift profits.

CTT

• Business deterioration: Mail volume decline widened from -3% to -4.2% in 2016, as the Portuguese government encouraged public sector adoption of email.
• Valuation trap: The stock price fell from a high of €10.6 to €6 (-43%), with a P/E of 8x and a dividend yield of 7.5%, but the pace of decline exceeded expectations.
• Position sizing: It accounted for only 1% of the Iberian portfolio, resulting in a loss of just -0.015% (after dividends), demonstrating strict risk management.

Metric	Euro Disney	CTT
Holding period return	+63% (10 months)	-10% (4 months)
Investment thesis	Asset value undervalued, majority shareholder interests aligned	Low valuation + high dividend + cost-cutting potential
Reason for failure	None (success case)	Business decline exceeded expectations, becoming a value trap
Portfolio impact	Not disclosed	Portfolio loss -0.015%

Companies/Assets Involved

• Euro Disney (Disneyland Paris): Bullish. After Walt Disney increased its stake to 76%, asset value was undervalued; the takeover bid offered a 65% premium.
• The Walt Disney Company (TWDC): As the majority shareholder, its acquisition validated the asset value.
• Oriental Land (Tokyo Disney): Used as a comparison case to demonstrate the leverage effect of attendance improvement on profits.
• CTT, Correios de Portugal: Bearish (sold). Structural business decline; cost-cutting and new banking operations had yet to show results.
• Bpost (Belgian Post): Mentioned as a past successful investment, but not elaborated on.

Investment Insights

• Seek opportunities in "complex situations": Negative factors such as poor liquidity, no analyst coverage, and legal disputes often lead to market mispricing, provided the assets are difficult to replicate and the majority shareholder's interests are aligned.
• Beware of "value traps": Low P/E ratios and high dividend yields alone are insufficient reasons to buy; one must assess whether the business faces irreversible decline. For declining industries, position sizes must be strictly controlled (e.g., CTT at just 1%).
• Patience is essential: The takeover bid for Euro Disney could occur in a year or never, but the strategy of "buying unique assets at good prices" ultimately triggers value realization.
• Error management: The author acknowledges that 10-15% of investments in a 15-year career go wrong, with two-thirds due to high leverage and one-third due to technological disruption. The key is to control the size of losing positions (e.g., CTT's loss of only 0.015%) and avoid repeating mistakes.

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Theme and Background

This chapter primarily reports on Azvalor's operational progress at the end of 2016, including assets under management, number of investors, new product launches, and team building. The report emphasizes that, thanks to investor trust, the company achieved rapid growth in fund size within just 14 months of its establishment.

Core Viewpoint

The author believes that investor trust is the core driver of rapid growth for an asset management company. By adhering to a long-term value investing philosophy, Azvalor successfully attracted over 13,000 investors and launched new products to expand into the large-cap investment space. Counterintuitively, despite a complex market environment, the company managed to achieve a "unicorn" fund size (€1 billion) in a short period, which is extremely rare among Spanish pure equity funds.

Key Arguments and Data

• Assets Under Management: Total assets under management are approximately €1.7 billion, of which the Azvalor Internacional fund surpassed €1 billion within 14 months, making it one of the few "unicorn" pure equity funds in the Spanish market.
• Investor Distribution: The total number of investors across investment products exceeds 13,000, including 11,800 in investment funds and over 1,800 in pension funds; the Azvalor Value Selection SICAV has over 300 shareholders, and the Azvalor Internacionalo SICAV Lux has over 500.
• New Products: In February 2016, the Azvalor Blue Chips fund was launched, focusing on large-cap stocks with a market capitalization exceeding €3 billion, with an investment philosophy consistent with existing funds.
• Operations and Team: Over 17,000 transactions were processed throughout the year without any major incidents; the number of employees increased to 36 from the beginning of the year, with 5 new partners joining the 4 founding partners.

Indicator	Data
Total Assets Under Management	Approximately €1.7 billion
Azvalor Internacional Fund Size	€1 billion (within 14 months)
Total Number of Investors	Over 13,000
Investment Fund Investors	11,800
Pension Fund Investors	Over 1,800
Number of Transactions in 2016	Over 17,000
Total Employees	36 (including 5 new partners)

Companies/Assets Involved

• Azvalor Internacional: Core fund with a size of €1 billion, regarded as a "unicorn" fund, with a bullish outlook.
• Azvalor Iberia: One of the existing funds, sharing the same investment philosophy as Azvalor Internacional.
• Azvalor Blue Chips: A new fund launched in February 2016, focusing on large-cap stocks (market cap over €3 billion), with a bullish outlook.
• Azvalor Value Selection SICAV: An alternative investment vehicle with over 300 shareholders.
• Azvalor Internacionalo SICAV Lux: An alternative investment vehicle registered in Luxembourg with over 500 shareholders.

Investment Insights

• Scale Growth Validates Strategy Effectiveness: Azvalor's funds attracted significant capital in a short period, indicating market recognition of its long-term value investing strategy. Investors can monitor whether its subsequent performance continues to outperform benchmarks.
• New Product Expansion Opportunities: Azvalor Blue Chips focuses on large-cap stocks, potentially offering a new option for investors who prefer low-volatility, high-liquidity targets, though the risk-return differences compared to existing funds need to be assessed.
• Operational Stability: Over 17,000 transactions without incidents demonstrate the reliability of the company's back-office systems, reducing operational risk. Investors can also note the enhancement of user experience through digital services (e.g., SMS signatures).