Quarterly Report 4Q2021

Review

In the fourth quarter, the strategy was able to consolidate the solid progress it made for the first nine months of the year. Its compound return over time is highly competitive, especially when viewed in the context of the era taking hold since the bursting of the sub-prime bubble in 2008. During this time, monetary conditions around the world have been more expansionary than anyone would have dared to predict, bringing about big consequences for government finances, interest rate levels and the overall dynamics shaping financial markets. But as history goes, the specific forces that prevail during a certain period rarely continue forever. We are convinced that the long-running investment approach we adhere to robustly prepares the strategy for a life after “infinite money.”

Outlook, thoughts and issues

Sidestepping the nominal asset trap, part II

Continuing our discussion from the previous quarter, this time around we would like to delineate what thoughts are going into our positive selection process when it comes to the question how we guard against the devaluation of money. Here, the safe and careful approach is to borrow concepts from the fixed-income market, as its pricing mechanism is especially sensitive to the loss of purchasing power over time. Two specific approaches stand out for us, namely (1) “short duration” strategies and (2) “floating rate note (FRN)” structures. Both are ideas that can be readily applied to equity selection.

First, a short duration strategy in effect attempts to push the pay-off profile as close to the present as possible. For us, this means looking for aspects such as high recurring cash generation which allow the company to spend sufficiently on capex to stay competitive while at the same time being able to pay a generous dividend and/or engage in share buybacks. For the shareholder, such actions reduce the erosion of the time value of money farther into the future. Industry examples that come to mind are “utility-like” businesses such as electricity, heating and water providers, telecom services, as well as basic commercial banking and insurance operations. Also attractive in principle are consumer staples such as food and other consumables, provided they can be purchased at attractive prices.

While most large, well-known companies in this space do not pass muster in this regard as they tend to be viewed and used by the market as “growth-bonds,” our portfolio selection attests to the fact that we are able to find lesser-known and thus neglected names in this field at solid bargain levels.

Second, the concept of an FRN appeals to us because of its capacity to readily adjust in real terms the cash flow streams that will accrue further in the future, thereby in essence inflation-protecting the so-called “terminal value” component in our discounted free cash flow model. The main way to accomplish this is to own businesses that enjoy a high degree of bargaining power in their role and position within the overall supply chain.

Characteristically, these may be firms with outstanding service/product consistency as well as brand recognition, thereby exerting favorable terms and condition on both suppliers and buyers. Examples are retailers such as select supermarkets, department stores and franchise chains that possess valuable shelf space and/or can rely on recurring impulse purchases. Another example are businesses that are in a powerful bargaining position mainly relative to their suppliers, such as large, well-connected commodity traders as well as wholesalers of partially processed materials and semi-standardized manufactured goods. Another group of companies with FRN features are those whose bargaining power extends mostly downstream, i.e., vis-à-vis their buyers. Some of them benefit from high switching costs due to the complexity of the products they offer, particularly when they also require a high degree of after-sale support and maintenance. These include building installations and maintenance (such as air conditioning and filtration systems, piping, and elevators); manufacturing and servicing of turbines (such as those used in electricity generation equipment and aircraft engines); and industrial pumps (for basic resource processing, energy production, chemical- and desalination plants, among other applications). Another type of business enjoying high switching costs relates to the provision of services involving access-rights to scarce loading and unloading facilities in prime locations, as encountered in the case of certain multi-modal, integrated logistics and transportation services.

Having summarized a major part of our favorite sectors and industries for long-term investment, the decisive test in our work is whether we can buy specific equities at significant discounts to our conservative estimate of intrinsic value. And this brings us to the highly appealing and perhaps surprising conclusion: currently we can choose from a broad and deep pool of investment opportunities in these preferred areas, which may be due in large part to most market participants being focused on other trades which we think are too expensive, too complicated to analyze or otherwise unattractive and hence uninvestable for us.

Sincerely,

Gregor Trachsel,
Chief Investment Officer SG Value Partners AG