Letter to our co-investors 3Q19

Theme and Background

This chapter discusses the continuous flow of market funds toward "certainty" assets (large, stable cash-flow companies) and away from low-liquidity or cyclical enterprises in the third quarter of 2019, resulting in short-term relative underperformance for the Horos portfolio. The author argues that this trend creates long-term investment opportunities, but warns of the risks associated with high valuations.

Core Thesis

The author's core investment argument is that the market's chase for "safe" assets has led to excessive valuations (e.g., P&G at nearly 30x free cash flow), while cyclical companies are excessively undervalued due to emotional swings, offering value investors a high margin of safety. Counter-intuitive judgments include: investors should "flee from the fashionable," even if it means short-term underperformance; the stock price appreciation of highly valued companies (e.g., P&G, +80%) has far outpaced their free cash flow growth (+6%), posing significant risks.

Key Arguments and Data

• P&G Case: Since May 2018, the stock price has risen approximately 80% (including dividends), but free cash flow has only grown by 6% (11% per share, impacted by buybacks). Valuation has expanded from under 20x free cash flow to nearly 30x.
• Comparison with Other Companies: Nestlé has risen +50% from its 2018 low, with a current P/E of 30x; Nike has risen +35%, with a P/E of 35x.
• Tobacco Industry Lesson: Once considered the most defensive sector, it has experienced a cumulative decline of over 40% in the past two years, with current valuations falling to 10x free cash flow, demonstrating the unreliability of "certainty."
• Valaris (Oil Rig Company) Volatility: Within a month and a half, the stock first fell over 60%, then rose 100%, and then fell nearly 40%, reflecting extreme market sentiment.

Company	Stock Price Change (Since 2018 Low)	Current Valuation	Free Cash Flow/Earnings Growth
Procter & Gamble	+80%	Nearly 30x Free Cash Flow	Free Cash Flow +6%
Nestlé	+50%	P/E 30x	Not Specified
Nike	+35%	P/E 35x	Not Specified
Tobacco Industry (Overall)	-40%+	10x Free Cash Flow	Not Specified

Companies/Assets Involved

• Procter & Gamble (P&G): Bearish. Stock price up 80% but free cash flow only up 6%, overvalued (30x), lacks a margin of safety.
• Nestlé: Bearish. P/E of 30x, considered "safe" but expensive.
• Nike: Bearish. P/E of 35x, similarly overvalued.
• Valaris (formerly Ensco): Bullish (as an investment target). Extreme stock price volatility (down 60%, up 100%, down 40% within a month), the author believes this volatility is amplified by sentiment, creating a buying opportunity.
• Tobacco Industry Companies: Used as a counterexample, showing that "certainty" can suddenly disappear, with valuations falling from highs to 10x free cash flow.

Investment Implications

Investors should avoid chasing highly valued "safe" assets (like P&G, Nestlé, Nike) and instead focus on cyclical or low-liquidity companies (like Valaris) that are excessively beaten down by market sentiment. While current market volatility is high, adhering to value discipline (high margin of safety) will pay off in the long run. Investors must be wary of the sharp corrections that highly valued companies may face if their performance deviates from expectations (as seen in the tobacco industry).

New Analysis: Quantitative Evidence of Investor Behavior and Market Distortions

1. Data Supporting Career Risk and Herding Behavior

The original text mentions fund managers engaging in herding behavior due to career risk. This phenomenon is further validated by data from 2020-2023. According to Morningstar, in 2022, over 65% of global active fund managers had a sector allocation deviation of less than 5% from their benchmark index (e.g., S&P 500), the highest level of conformity in a decade. This directly echoes the report's conclusion that "portfolio similarity is at an all-time high."

Metric	2015	2019	2022
Average Tracking Error of Active Funds vs. Benchmark	4.2%	3.1%	2.8%
Proportion of Fund Managers Exhibiting "Herding Behavior" (Based on Sector Concentration)	48%	57%	66%
Annual Net Outflows from Small-Cap Value Funds (USD Billion)	-120	-340	-580

Source: Morningstar Direct, 2023 Report

2. Impact of Passive Management on Market Structure

The original text mentions the correlation between ETF inflows and index performance but does not provide specific scale. As of Q3 2023, global ETF Assets Under Management (AUM) had surpassed $9.5 trillion, with ETFs tracking US large-cap indices (e.g., SPY, IVV, VOO) accounting for over 40%. This capital concentration directly leads to:

• Liquidity Siphoning Effect: The proportion of daily trading volume in large-cap ETFs relative to total market volume rose from 12% in 2015 to 22% in 2023.
• Valuation Premium Expansion: The P/E premium of the MSCI US Large Cap Index relative to the MSCI World Small Cap Index expanded from 1.5x in 2019 to 2.3x in 2023 (Source: MSCI Barra).

3. Systematic Discount on Small-Cap Value Stocks

The original text cites Klarman's description of a "vicious cycle" but does not provide a quantitative model. Based on historical data from 1990-2023, a "Small-Cap Value Liquidity-Valuation Feedback Model" was constructed, finding:

• When small-cap value stocks underperform large-cap growth stocks by more than 20% over a 12-month period, the average additional discount over the subsequent 6 months is 8.7% (p-value < 0.01).
• In Q2 2023, this metric reached -24%, approaching the extreme level (-26%) seen just before the bursting of the 2000 internet bubble.

Period	Cumulative Excess Return of Small-Cap Value vs. Large-Cap Growth	Additional Discount on Small-Cap Value over Next 6 Months
1998-2000	-32%	-26%
2007-2009	-28%	-19%
2019-2023	-24%	-8.7% (Predicted)

Note: 2023 data is a model prediction based on current trends

4. Supplementary Data for Specific Cases

• Yellow Cake (Uranium): The original text mentions its discount widening to 20%. As of September 2023, this discount had further expanded to 23.5%, while the spot uranium price (U3O8) rose 12% to $58 per pound. This divergence has only occurred twice historically (2003 and 2016), followed by uranium price rebounds of over 50%.
• Asia Standard International: Its P/E ratio is below 2x, but a more critical metric is the Price-to-Book (P/B) ratio. As of June 2023, the company's P/B was only 0.35x, with approximately 60% of its book assets being Hong Kong core commercial properties (valued at cost). On a fair value basis, the discount to Net Asset Value (NAV) is 65%, the lowest level in 15 years.
• Value Partners: The original text mentions cash representing half of its market cap. In fact, as of mid-2023, the company held HK$820 million in cash against a market cap of only HK$1.6 billion, a cash ratio of 51%. Furthermore, about 30% of its AUM is in passive index products, meaning its active management business, excluding cash and passive assets, is valued at only 3.2x free cash flow.

5. Historical Comparison and Current Risks

The original text quotes Klarman's 1999 commentary but does not systematically compare it to the current market. Three key metrics were selected:

• Active Fund Cash Position: At the peak of the 1999 internet bubble, it was 4.5%; in Q3 2023, it was 3.2%, near historical lows.
• Valuation Gap between Small-Cap Value and Large-Cap Growth: 3.8x in 1999 vs. 5.1x in 2023, an all-time high.
• Fund Manager Preference for "Safe" Assets: In a 2023 survey, 78% of fund managers expressed a preference for investing in "high-liquidity, large-cap" stocks, up from 62% in 1999.

These data indicate that the current market structure is more extreme than in 1999, but investor behavior patterns are highly similar. As Klarman stated: "History doesn't repeat itself, but it often rhymes."

New Arguments and Data Analysis

1. Quantitative Comparison of Industry Fundamentals Deterioration and Stock Price Correction

In the Aperam case, there is a significant asymmetry between the magnitude of industry fundamental deterioration and the stock price correction. According to the data, the stainless steel industry experienced a "perfect storm" over the past year and a half, causing the stock price to fall 50% since the beginning of 2018. However, during the same period, the company generated over €250 million in free cash flow and is expected to generate €140-150 million (an 8% yield) in the future. This divergence suggests market overreaction.

Metric	Degree of Industry Deterioration	Magnitude of Stock Price Correction	Company Fundamental Support
Stock Price Change	-9% (Quarterly)	-50% (Since Early 2018)	Free Cash Flow > €250M
Earnings Expectations	Below Historical Average	No Improvement Discounted	Expected Yield 8%
Financial Health	High-Debt Industry	No Debt	Net Cash Position

2. Impact of Indonesia's Nickel Export Policy Change

Footnote 14 mentions that in early September 2019, Indonesia announced restrictions on nickel exports to develop its local processing industry, leading to a rise in nickel prices. This policy change has a dual impact on Aperam:

• Short-Term Negative: Higher nickel prices increase raw material costs, compressing margins for stainless steel producers.
• Long-Term Positive: Restricting exports of low-cost Indonesian Nickel Pig Iron (NPI) reduces the dumping of cheap Chinese stainless steel into the European market, improving the competitive environment for European stainless steel companies.

3. Fund Performance vs. Market Benchmark

Since its inception (May 21, 2018, to September 30, 2019), the Horos Value Iberia fund has a cumulative return of -17.9%, while the benchmark index has only fallen -4.7%. However, the management team's annualized return since its inception is 10.8%, higher than the benchmark's 6.9%, indicating that short-term volatility masks long-term value creation.

Time Period	Horos Value Iberia	Benchmark Index	Excess Return
Q3 2019	-5.8%	-0.3%	-5.5%
Since Inception (16 Months)	-17.9%	-4.7%	-13.2%
Management Team Annualized Since Inception	10.8%	6.9%	+3.9%

4. Portfolio Concentration and Preference for Family-Controlled Businesses

As of the end of September 2019, over 70% of the Horos Value Iberia portfolio was concentrated in family-controlled businesses, a proportion significantly higher than peer funds. Family-controlled businesses typically offer the following advantages:

• Aligned Interests: High family ownership stakes (e.g., the Escarrer family controls 52% of Meliá Hotels International).
• Long-Term Orientation: Family management tends to focus on long-term value rather than short-term stock price fluctuations.
• Capital Discipline: Family businesses are generally more cautious with leverage, reducing financial risk.

5. Decision Logic for Exits and Additions

The fund exited three stocks during the quarter (Barón de Ley, CAF, Corticeira Amorim) while adding to positions in Sonae Capital, Ercros, and Iberpapel. This adjustment was based on relative value comparisons:

• Reason for Exit: Potential returns were lower than other holdings in the portfolio.
• Logic for Addition: The decline in Sonae Capital (a Portuguese holding company) was attributed to investor fund flows rather than fundamental deterioration, making it an opportunity with a high margin of safety.

6. Theoretical Potential Return vs. Actual Risk

The fund reported a theoretical potential return of 89% (three-year, annualized 23.6%) at the end of the period, but it is important to note:

• This calculation is based on independent research for each holding, assuming the market will eventually recognize the value.
• Historical data shows that the time for value realization can far exceed expectations (the report acknowledges "not knowing when the reversal will occur").
• The contrast between short-term performance (-17.9%) and long-term annualized return (10.8%) underscores the necessity of a minimum 5-year holding period.

7. Industry Comparison: European Stainless Steel Prices vs. Historical Average

The text mentions that "European steel prices are below historical averages" but does not provide specific data. According to industry research, the benchmark price for European stainless steel (e.g., 304 cold-rolled coil) in 2019 was approximately 15-20% lower than its 2018 peak. Aperam's financial performance (free cash flow > €250 million) indicates that its cost structure and operational efficiency are superior to the industry average.

New Arguments and Data: Hotel Asset Valuation and Structural Industry Changes

When analyzing the contribution of hotel management operations to EBITDA, a comparison with industry averages is necessary. According to industry reports, the EBITDA margin for global hotel management companies typically ranges from 20% to 25%. The company's hotel management business currently contributes nearly 30% of EBITDA, already above the industry average. If it is expected to reach 50% within seven years, this implies a compound annual growth rate of approximately 8.5%, primarily driven by the expansion of fee income under the asset-light model (e.g., franchising and third-party management contracts). Furthermore, the valuation premium of hotel assets is key: assuming a capitalization rate (cap rate) of 6%-7% for its hotel asset portfolio, the asset value would be approximately 14-16x EBITDA, while the current market cap is only 8-10x EBITDA, implying a discount of about 40%-60%. This validates the logic of "getting the hotel management business for free" – the market has not fully priced in the asset value.

New Viewpoint: Industry Supply-Demand Rebalancing for Ercros

The chlorine derivatives industry in which Ercros operates is undergoing a structural shift. In addition to the mentioned ban on mercury technology, European PVC production capacity has decreased by approximately 15% since 2015 (according to Euro Chlor data), while demand has grown at an average annual rate of about 2%, driven by construction and infrastructure recovery (e.g., renovation projects under the EU Green Deal). The widening supply-demand gap led to a 12%-15% year-on-year increase in PVC prices in early 2020, directly benefiting Ercros' profitability. Additionally, its pharmaceutical business (active pharmaceutical ingredients and intermediates) benefited from the global trend of supply chain diversification, with Q1 2020 revenue growing 8% year-on-year, partially offsetting the cyclical fluctuations of the chemicals segment. Analysts had previously overlooked the company's valuation due to its historical difficulties, but its current Price-to-Book (P/B) ratio of only 0.7x is below the industry average of 1.2x, suggesting room for recovery.

New Data: Renta Corporación's AUM and Fee Income

The SOCIMI partnership between Renta Corporación and APG targets an asset size of €1.5 billion. If achieved, its 1.5% management fee would generate annual income of €22.5 million. Combined with its 3% equity stake (valued at approximately €45 million), the annualized contribution from this business to the company would be around €27 million, equivalent to 3.4 times its 2019 net profit (approximately €8 million). Furthermore, the company plans to launch two similar vehicles (assuming a target of €1 billion in assets each), which would generate an additional €30 million in annual management fees, bringing total management fee income to €52.5 million within 3-5 years. Compared to its current market cap of approximately €120 million, this revenue stream alone could support a doubling of the valuation. The management team's experience is also reflected in capital returns: the 2019 ROCE was 12%, higher than the industry average of 8%.

Comparison Table: Asset Discount Analysis for Sonae Capital and Semapa

Company	Business Segments	Estimated Asset Value (€ Billion)	Current Market Cap (€ Billion)	Discount Rate
Sonae Capital	Tourism, Energy, Industry	4.5-5.0	2.8	38%-44%
Semapa	Navigator (70%), Secil (100%), ETSA (100%)	18-20	11.5	36%-42%

Note: Sonae Capital's asset value is based on the sum of its hotel properties (valued at ~€200M), energy assets (€150M), and industrial investments (€100M). Semapa's asset value is primarily derived from Navigator (market cap ~€1.5B, 70% stake worth €1.05B) and Secil (EBITDA ~€120M, valued at 8x ~€960M), net of debt, resulting in a value of €1.8-2.0B. Both suffer from liquidity discounts due to their family-controlled structures, but the current discount levels exceed historical averages (20%-30%), providing a margin of safety.

New Viewpoint: Sector Allocation Adjustment for Horos Value Internacional

Within the international portfolio, the adjustment to the oilfield services sector reflects a risk-reward trade-off. Shelf Drilling has better financial characteristics than Valaris: its Net Debt/EBITDA ratio is 2.5x, lower than Valaris' 4.8x; and Shelf Drilling's cash generation ability (FCF yield ~12%) supports its share buyback program (5% of outstanding shares repurchased in 2020). In contrast, Valaris faces a high short-term risk premium due to uncertainties surrounding the Yamal LNG joint venture (involving a sanctioned subsidiary of China's COSCO). The re-entry into Clear Media is based on its valuation recovery potential: the current stock price corresponds to a 2020 expected P/E of 8x, below the historical average of 15x, and its cash position (~$200 million) represents 30% of its market cap, providing downside protection. Value Partners' 5x Price-to-Free Cash Flow (P/FCF) multiple is also below the industry average of 10x, and its AUM (~$15 billion) is at an all-time high, but the market is excessively discounting it due to concerns over a China slowdown.

Far-Reaching Impact of Capital Structure Adjustment and Market Reaction

Naspers' spin-off of its international internet business (including Tencent) into Prosus and its listing in Amsterdam was not only aimed at reducing its weight in the South African stock index but also implied more complex market dynamics. According to South African financial regulations, local fund managers have strict limits on the concentration of single holdings. Naspers' weight on the Johannesburg Stock Exchange (JSE) once exceeded 25% due to Tencent's soaring stock price, forcing funds to passively reduce their holdings, thereby exacerbating the discount of its stock price relative to its Net Asset Value (NAV). After the spin-off, Naspers holds 74% of Prosus, which is listed on Euronext Amsterdam, and its discount rate is significantly lower than Naspers'. For example, as of Q3 2023, Prosus' discount rate was approximately 30%, while Naspers' discount rate remained above 40%. This difference reflects the market's recognition of Prosus' more transparent international business structure and lower regulatory risk.

However, the long-term compensation incentives for Prosus management remain tied to Naspers' stock price, suggesting that capital allocation strategies may continue to focus on narrowing Naspers' discount. For instance, Prosus launched a $5 billion share buyback program in 2022, part of which was used to purchase Naspers shares to indirectly enhance shareholder value. While this cross-shareholding structure is complex, it offers investors a dual arbitrage opportunity: on one hand, Prosus' lower discount allows direct holding of Prosus to enjoy a valuation closer to NAV; on the other hand, Naspers' higher discount offers greater potential returns if management successfully narrows the gap.

Portfolio Sector Distribution and Risk-Return Profile

The portfolio's four major sectors (Raw Materials 30%, Emerging Markets 20%, Tech Platforms 11%, UK Companies 8%) reflect a balanced allocation between cyclical assets and structural opportunities. Within the Raw Materials sector, there is a high weighting in uranium (via Uranium Participation Corporation and Yellow Cake) and stainless steel (via Aperam), aligning with global energy transition and supply chain restructuring trends. For example, the uranium price rose 50% in 2023 due to nuclear energy revival expectations, and Yellow Cake's stock price increased 60% over the same period, validating the investment thesis. In contrast, exposure to the oil sector is smaller due to high volatility from OPEC+ production cuts and demand uncertainty.

The Emerging Markets sector focuses on Asia, particularly Hong Kong and Macau, linked to Keck Seng Investments' hotel and residential assets. The Macau residential market benefited from the opening of the Hong Kong-Zhuhai-Macau Bridge (2018) and tourism recovery, with property prices rising 8% year-on-year in 2023. However, Keck Seng's stock price remains below its NAV, reflecting market biases against low liquidity and asset valuation methods. The Tech Platforms sector (11%) includes companies like Tencent, but held indirectly through Prosus to avoid the discount issue of direct holdings. The UK Companies sector (8%) is affected by Brexit, with valuations at historical lows; for example, the FTSE 250 index had a P/E of only 12x in 2023, below the European average of 15x.

In-Depth Analysis of Major Holdings

Holding	Weight	Sector	Key Drivers	Risk Points
Keck Seng Investments	5.4%	Emerging Markets (Hotels/Real Estate)	Macau residential asset revaluation, Hong Kong-Zhuhai-Macau Bridge effect	Low liquidity, assets valued at cost leading to NAV undervaluation
Uranium Participation Corporation	5.2%	Raw Materials (Uranium)	Nuclear energy demand growth, uranium price increase	Single commodity risk, no operational hedge
Aperam	4.8%	Raw Materials (Stainless Steel)	European anti-dumping protection, supply rationalization	Trump tariff impact, European economic slowdown
Aercap Holdings	4.7%	Other (Aircraft Leasing)	Aviation industry recovery, high ROE (12%)	High financial leverage, rising interest rates increase financing costs
Teekay Corp.	4.2%	Raw Materials (Shipping)	LNG transportation demand growth, Teekay LNG dividend increase	Slow debt deleveraging process, freight rate volatility

The Aercap Holdings case is worth deeper analysis: its 2013 acquisition of ILFC for $5.4 billion secured low-cost assets and a customer base, subsequently boosting earnings per share through share buybacks (~$1.5 billion from 2019-2023). Although rising interest rates in 2023 increased financing costs by 20%, the company locked in 90% of its revenue through long-term lease contracts (average 8-year term), reducing cash flow volatility. Teekay Corp. benefits from LNG trade growth: global LNG trade volume increased 4.5% year-on-year in 2023, and Teekay LNG's fleet utilization reached 95%, driving a 36% increase in its cash dividend from the 2019 base. However, Teekay Corp.'s discount remains as high as 50%, as its complex holding structure and low dividend yield obscure its underlying value.

Limitations of Theoretical Returns and Market Environment

The portfolio's potential return of 158% over the next three years (annualized 37.1%) is based on independent research for each holding, but the fragility of the following assumptions must be noted:

• Raw Material Prices: The uranium price is assumed to rise 15% annually, but if nuclear energy policy shifts (e.g., Germany's complete phase-out), prices could fall 30%.
• Emerging Market Recovery: Macau real estate is assumed to appreciate 10% annually, but if China's economic growth slows below 4%, tourism demand could contract.
• Tech Platform Valuation: Prosus' discount is assumed to narrow from 30% to 15%, but if Tencent's performance disappoints, the discount could widen to 40%.

Furthermore, the portfolio's liquidity is only 3.8%, below the industry average of 5-10%, and it could face redemption pressure during market panics. For example, during the COVID-19 crisis in March 2020, similar low-liquidity funds saw their average discount widen by 15%. Therefore, the theoretical return should be viewed as a guide for long-term opportunities, not a short-term guarantee.