Quarterly letter 4Q2019

Theme and Background

This section discusses how Azvalor adhered to its value investing principles in 2019, a year when its performance lagged behind the benchmark. The market environment exhibited irrational characteristics: investors favored narratives and future technology stories while ignoring actual asset earnings, putting value investing under relative pressure. The author argues that such market distortions are unsustainable and that supply-side realities and undervaluation will eventually reassert themselves.

Core Thesis

The author’s core investment argument is: Rationality and logic will ultimately prevail, and the current market’s overvaluation of narratives and neglect of value are temporary. Counterintuitive judgments include:

• The market rewards “narratives over valuations,” but the author believes this trend will end due to “force majeure” (e.g., commodity surpluses or shortages).
• Financially constrained industries such as coal, oil extraction, and uranium mining face supply-side realities and undervaluation that are unsustainable, potentially serving as sources of future returns.
• Volatility is not the same as risk; patience is the price of future compounding growth.

Key Arguments and Data

• Performance Data: Azvalor International posted a 2019 return of 5.5%, and Azvalor Iberia returned 1.9%, both lagging their respective benchmarks.
• Long-Term Performance: The report mentions cumulative returns since the fund’s inception at the end of 2015 but does not provide specific figures (the original text only references comparisons to benchmarks without listing tabular data).
• Evidence of Market Distortion: Capital continues to flow into Tesla, technology companies, and private equity, while industries such as coal, oil extraction, and uranium mining face financial constraints, leading to supply-side imbalances.
• Logical Reasoning: The author argues that “the realities of science, geology, and depletion” are reflected in supply outcomes and low valuations, and that this imbalance cannot persist indefinitely.

Companies/Assets Involved

• Tesla: Representing the market’s enthusiasm for narratives and future technology, it continues to secure new financing.
• Coal, Oil Extraction, Uranium Mining: Financially constrained industries that the author believes offer potential sources of future returns due to their low valuations and supply-side realities.
• Azvalor Itself: The management team (five partners) all invest in their own funds and have committed to keeping assets under management below €2.5 billion to maintain flexibility.

Investment Insights

• Contrarian Allocation to Overlooked Industries: Investors should focus on supply-constrained, deeply undervalued sectors such as coal, oil extraction, and uranium mining, which may see value recovery due to supply-demand imbalances.
• Distinguish Volatility from Risk: Current market volatility presents an opportunity for patient investors, not a risk. The author advises investors to avoid chasing narrative-driven hot assets (e.g., Tesla) and instead hold financially constrained real assets.
• Long-Term Holding: Patience is the price of future compounding growth; short-term underperformance should not shake confidence in value investing principles.

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Theme and Background

This chapter discusses how passive investing and ESG standards distort capital market pricing, thereby creating value investing opportunities. The author argues that the current market exhibits severe valuation divergence, with the gap between popular and out-of-favor sectors further amplified by capital flows and ESG biases.

Core Thesis

The author's central judgment is: Passive investing and ESG standards are systematically undermining the price discovery mechanism, causing capital misallocation, but this precisely creates a "sweet spot" for contrarian investors. The counterintuitive point is that the author believes ESG's "good intentions" have led to irrational capital exclusion of industries such as energy and mining, which are crucial for economic development in less developed regions.

Key Arguments and Data

1. Passive Investing Distorts Pricing:

• In 2019, nearly one-third of the S&P 500's gains came from just six stocks.
• Outperforming the index requires overweighting high-valuation stocks, which contradicts Azvalor's investment principles.
• Capital flows matter more than valuations, making "violent mis-pricings" inevitable.

2. Unintended Consequences of ESG:

• Environmental (E): The "stigmatization" of mining and energy companies suppresses capital inflows, leading to future supply shortages. Modern mining projects actually include strict remediation and reclamation requirements, with a net positive impact on regional economies.
• Social (S): Energy and extractive industries create jobs and wealth in remote areas. Specific cases:
• Agnico Eagle's investment in Nunavut, Canada, accounts for 25% of the province's GDP.
• Exxon's Stabroek field and Tullow's Orinduik field discoveries in Guyana could bring over 10 billion barrels of liquid hydrocarbons to a country with a per capita GDP of only $1,000 in 2004.
• Governance (G): Azvalor has consistently emphasized alignment of interests between shareholders and management, investing only in companies with rigorous compliance procedures and filtering out "promotional small-cap companies" that abuse minority shareholder rights.

3. Market Structure: The pursuit of low volatility and long duration in a low-interest-rate environment has further inflated valuation multiples.

Companies/Assets Involved

Company/Asset	Role	Key Data	View
Agnico Eagle	Case company	Investment in Nunavut accounts for 25% of the province's GDP	Positive case, illustrating mining's economic contribution to impoverished regions
Exxon (Stabroek field)	Case company	Could bring over 10 billion barrels of liquid hydrocarbons to Guyana	Positive case, illustrating the value of energy development for low-income countries
Tullow Oil (Orinduik field)	Case company	Same as above	Same as above
Energy, mining, and shipping sectors	Main portfolio allocation	Currently account for the majority of Azvalor's portfolio	Bullish, considered a "market sweet spot" with both fundamental support and inefficient pricing driven by psychological biases

Investment Implications

• Short passive investing and the ESG consensus: Investors should avoid high-valuation stocks favored by capital flows and instead turn to sectors shunned by ESG labels and passive indices (energy, mining, shipping).
• Focus on supply-side realities: Capital exclusion driven by ESG will lead to future supply shortages, benefiting holders of existing production capacity.
• Distinguish individual cases: ESG assessments should be based on the actual impact of specific projects on local societies, rather than blanket exclusion of entire industries. Resource development projects in less developed regions may have significant positive socioeconomic externalities.
• Stick to contrarian investing: The current market treats volatility as risk, but the real risk is permanent capital loss. Low-valuation, high-volatility cyclical assets provide a margin of safety.

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Theme and Background

This chapter focuses on the performance of Azvalor’s investment portfolio in the energy, uranium, and coal sectors. In 2019, these sectors faced overall pressure, but the management team believes there is a severe disconnect between market pessimism toward traditional energy and supply-side realities, which instead creates contrarian investment opportunities.

Core Thesis

The author’s core investment argument is: Current market valuations for oil, coal, and uranium have excessively priced in negative expectations, while structural supply shortages (insufficient capital expenditure, declining reserve replacement rates, and financing difficulties due to ESG constraints) will drive a significant rebound in these asset prices in the future. Counterintuitive judgments include: 1) Passive investment and ESG strategies have led to unprecedented risk in mainstream indices, while risk in the traditional energy sector has actually decreased; 2) Coal demand will continue to grow, driven by India and Southeast Asia, rather than simply declining; 3) Uranium inventories are about to be exhausted, triggering a supply shortage.

Key Arguments and Data

Oil Sector:

• In 2019, estimated growth in crude oil liquid demand fell from 7% to 1.0%
• Upstream oil and gas capital expenditure remains extremely low, 50% below pre-2014 levels
• Although 2019 was a major discovery year (12.2 billion barrels, including natural gas), liquid consumption alone was about 35 billion barrels, with persistent under-replacement of reserves
• Global refining capacity increased by 2 million barrels per day, and Chinese imports also grew
• For shale oil: the best drilling activity decreased by 30%, and the inventory of drilled but uncompleted wells (DUCs) is being depleted
• Natural decline rate is about 3 million barrels per day, which will push oil prices higher
• WTI crude oil rose 34.1% in 2019, outperforming the S&P 500 total return (31.5%)
• The entire U.S. energy sector’s market capitalization is equivalent to that of Apple alone

Coal Sector:

• Global coal production in 2019 was flat at 5.45 billion metric tons of coal equivalent (Mtce), with India and Southeast Asia growing at high single-digit compound rates
• According to Glencore, coal currently accounts for 26% of energy supply, potentially falling to 22% by 2030, but total tonnage will still grow
• Financing costs for coal projects exceed 30%, and capital shortages will lead to supply gaps
• Consol Energy has the lowest unit cost in the U.S. (unique longwall mining capability), with production for 2020 and part of 2021 already sold forward at high prices

Uranium Sector:

• Nuclear power generation is expected to grow at a 2% compound annual growth rate, with installed capacity reaching 569 GW by 2040 (a 50% increase from current levels)
• Nuclear power accounts for 10% of global emission-free electricity generation (second only to hydropower at 18%)
• Energy equivalent of one nuclear fuel pellet: 564 liters of oil, 1,000 kg of coal, or 481 cubic meters of natural gas
• The world’s largest wind farm (375 square kilometers) generates 1.75 MW per square kilometer, while the largest nuclear plant generates about 2 GW per square kilometer—an efficiency gap of 1,100 times
• Nuclear plants consume approximately 170 million pounds of U3O8 annually, with current primary supply at 120 million pounds and secondary supply at 20 million pounds, with the gap filled by inventories
• 70% of global primary uranium production is sold below cost, and the incentive price for new investment is at least three times the spot price

Comparative Data Table:

Metric	Oil (Tullow)	Coal (Consol)	Uranium (Cameco)
2019 Portfolio Drag	-4.8%	-4.6%	-1.6%
Core Valuation Metric	Market cap $975M, FCF $150M (at oil price $60)	Lowest unit cost in the U.S.	Owns the best mining rights in North America
Bear Case Valuation	P/E 6.5x (at oil price $60)	2020/2021 production locked in at high prices	70% of production below cost
Base Case Valuation	P/E 2.5x (at oil price $75, FCF $400M)	Competitor bankruptcies will cede market share	Incentive price ≥3x spot

Companies/Assets Involved

Company	Role	Key Data	View
Tullow Oil	Oil producer	Medium-term production guidance of 70,000 bpd, core NAV at 50% discount, non-producing assets (Uganda, Kenya, Guyana) valued at zero by the market	Bullish: Dividend cut is the right decision, producing assets sufficient to recover initial investment
Kosmos Energy	Deepwater oil	Similar to Tullow, benefiting from deepwater drilling demand	Bullish (indirectly mentioned)
Geopark	Latin American oil	Same as above	Bullish (indirectly mentioned)
Consol Energy	Coal producer	Lowest unit cost, PAMC longwall capacity, 2020/2021 production locked in forward	Bullish: Will benefit from competitor bankruptcies and supply cuts
Cameco	Uranium mining	Largest uranium miner in North America, owns the best mining rights	Bullish: Extremely undervalued, increasing importance of source origin
Kazatomprom	Uranium (Kazakhstan)	Jointly restricting supply with Cameco	Bullish (indirectly mentioned)

Investment Implications

1. Go long on traditional energy supply shortages: Structural underinvestment in capital expenditure and declining reserve replacement rates in oil, coal, and uranium present opportunities. Investors should focus on survivors with the lowest costs and strongest balance sheets (e.g., Consol, Cameco).

2. Capitalize on ESG-driven irrational selling: ESG constraints force funds to sell assets like coal, creating a transfer of value from short-term investors to long-term contrarians. Azvalor views this selling as a "de facto value transfer."

3. Beware of passive investment risks: The author argues that current mainstream index valuations are at historical highs, with potential for zero long-term returns, while the risk-reward ratio for the traditional energy sector is more favorable. Investors should distinguish between volatility (short-term price fluctuations) and risk (permanent capital loss).

4. Focus on the uranium supply gap: Growing nuclear power demand + inventory depletion + 70% of production at a loss suggest significant upside for uranium prices and uranium stocks. Cameco, as a high-quality Western producer, may see its origin value further highlighted.

5. Patience is key: Azvalor emphasizes that contrarian investing inevitably involves volatility, but the portfolio’s liquidity is at historically optimal levels, and implied default probabilities in corporate debt markets are far lower than the pessimism reflected in stock prices, providing a margin of safety for patient holders.

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Theme and Background

This section focuses on Azvalor's operational progress in 2019, changes in investor behavior, and analysis of portfolio performance. The report emphasizes that despite the fund's short-term relative underperformance, improved operational efficiency and investor trust remain the core pillars of the company.

Core Views

The author believes that the majority of positions in the current portfolio have achieved positive returns, while the few loss-making positions are concentrated and viewed as temporary opportunities. Citing research from Tweedy Browne, the report notes that 80-90% of the fund's returns come from 2%-7% of holding periods, making patience key to long-term returns. Counterintuitively, despite lagging relative performance in 2019, the company gained 1,100 new investors while also experiencing its first significant investor outflows.

Key Arguments and Data

• Operational Efficiency: In 2019, 12,000 operations were processed with only 1 client complaint; over 90% of additional operations were completed via SMS-authenticated digital channels; periodic investment transactions exceeded 1,000.
• Website and Content: The website received 2.2 million annual visits with a user base of only 600,000; the YouTube channel AzvalorYou had over 235,000 video views and a total watch time of 3.5 million minutes.
• Investor Behavior: Gained 1,100 new investors; experienced first significant investor outflows.
• Portfolio Performance:
• Among current and historical holdings exceeding 50 positions, total positive returns in 2019 were 20%.
• Over 20 stocks returned more than 40%, and 9 returned more than 60% (some were sold at a profit).
• 22 positions were negative, collectively dragging the fund down by 15 percentage points, with 4 positions accounting for 80% of the negative returns.
• Charity Projects: Donated 509,000 euros to 23 projects via the Davalor platform, benefiting 92,000 people.

Indicator	Data
Total Operations	12,000
Client Complaints	1
Digital Channel Processing Ratio	>90%
Periodic Investment Transactions	>1,000
Annual Website Visits	2.2 million
YouTube Views	>235,000
Total Watch Time	3.5 million minutes
New Investors	1,100
Positive Return Holdings	>50
Total Positive Returns	20%
Stocks with Returns >40%	>20
Stocks with Returns >60%	9
Negative Return Holdings	22
Total Negative Return Drag	15 percentage points
Main Loss Sources (4 positions)	80% of negative returns
Charity Donations	509,000 euros
Beneficiaries	>92,000 people

Companies/Assets Involved

• Azvalor International: The subject of analysis; most holdings in the portfolio have positive returns, with a few concentrated losses.
• Tweedy Browne Company LLC: Its research "What Has Worked in Investing" is cited to demonstrate the uncertainty of return distribution over time.
• Davalor / África Directo: A charity collaboration platform used to support social projects such as education and healthcare.

Investment Insights

• Persist with Contrarian Holding: Current loss-making positions are concentrated and viewed as temporary; investors should avoid selling due to short-term volatility and wait for value to return.
• Focus on Return Distribution Over Time: The majority of the fund's returns are concentrated in very few holding periods, making patience a necessary condition.
• Operational Efficiency Improvement: Digitalization and automation reduce operational risk and support long-term scale expansion.
• Divergence in Investor Behavior: An increase in new investors indicates sustained long-term trust, but the first significant outflows suggest a need to focus on client retention.