Value investing puritanism and Skarbiec Holding

Every community has its conventions. Despite value investing circles ostensibly being collections of misfits and mavericks, practitioners tend to operate within frameworks which I believe too narrowly define the job of investors.

Two common tenets of value investing are that one should only buy a company if you’re willing to hold it for the long term, and that short term price movements are impossible to anticipate.

For most stocks, for most value investors, most of the time, I completely agree.

Value stocks historically have outperformed growth stocks despite growing materially slower. The reason, explained nicely in this GMO piece, is that a simple value strategy earns more in current income and will harvest rebalancing returns by buying low and selling high. A growth strategy will do the opposite, earning lower income today and paying a rebalancing carry, the sum of which tends to outweigh the higher growth. On balance it leaves value strategies slightly more profitable over time, notwithstanding long periods of drawdown versus growth like the one we’re currently in.

Value investors are warehousing boredom and retailing excitement. Because they typically invest into short term headwinds of poor sentiment, momentum and often company results, short term share price movements are rarely on the side of the value investor.

The successful implementation of the traditional value strategy requires investors to have the wherewithal and patience to see an investment through the valley of boredom to the excitement on the other side.

Trying to add short term price predictions to the equation is unlikely to benefit this strategy most of the time. In fact it’s probably a terrible idea on average, and in that sense I agree with the general rule of focusing on the long term.

These rules make perfect sense within the quite efficient, large-cap, developed market universe that most value funds operate within. These rules are necessary as part of an overall value strategy that delivers reasonable outperformance over long enough time frames within that universe.

But the question of when it’s acceptable to speculate on short term price movements gets to one criticism I have of fundamental investment styles, which is that they tend to focus on business analysis to the exclusion of investment meta-analysis.

I believe too many fundamental investors invest like they play golf. They work on their swing, play their own game and hope to see their name at the top of the scoreboard at the end of the day.

But investing is not like golf. It’s more like tennis or martial arts where you are directly interacting with an opponent. You must be conscious of and reactive to their actions. A successful strategy doesn’t exist in a vacuum. It is only successful if you are reacting more appropriately to your competitors’ actions than they are to yours.

Value investing is only successful because it’s a reaction to today’s ecosystem of investors, most of whom are too focused on growth, short-term results and the new and shiny. The tenets of long-termism were created for and are effective within this specific environment. But it’s not universal.

Value investing wouldn’t work in a world where most investors were overly conservative and overweighted the value of assets and historical earnings. There would be less rebalancing return to harvest and the price paid for historical earnings would be higher. In that world, investors wouldn’t be valuing growth highly enough, and the investor who accepted lower earnings today in exchange for higher future growth would have the advantage.

(Given growth is currently showing the largest outperformance over value in history, you could argue that we are living in my counterfactual world today. That world probably existed in the early 2010s when quality and growth were not afforded large enough premiums. But the virtues of growth and quality are not lost on anyone today. The years of undervaluing growth and quality were the aberration, and I believe time will show today’s growth and quality stock valuations to be way overblown.)

So if our value strategy is specific to certain conditions, is it not possible that in another environment, short term price speculation could be part of a rational and considered value investing strategy?

I think so. As a value investor it feels shameful to admit. That’s probably part of the reason it’s underutilised. As value investors we’re also used to getting our investment wisdom from famous value investors, who are typically operating within that large-cap, developed market universe in which short termism doesn’t work.

So where might conditions support profitable price speculation? Well, the obvious answer is the opposite of where it doesn’t work which points towards small caps outside the most well studied markets. That’s no surprise and not particularly interesting; of course we’d expect more inefficiency in these markets.

We want to do better than that though, and this is where the meta-analysis begins.

It’s accepted that fundamental analysis can shed light on whether one company is likely to outcompete its competitors. Business and competitive analysis is what most value investors spend all day doing.

But competitive analysis can and should be turned upon our real competitors, other investors. To successfully speculate we still need to be ahead of the crowd. What can I learn about them and can I increase my probability of a good result by analysing them?

You first have to realise who you’re up against. When you’re speculating in developed markets your competitor is Rentec. Forget about it. But when a Polish white-collar employee-cum-part-time investor is the marginal price setter on the microcap you’re looking at, you might be in business.

That tells us that competitors might be more prone to mistakes. The next step is understanding specifically what behaviour you're attempting to exploit.

Asbis (WSE: ASB), an electronics distributor, is one example of rank inefficiency in Polish small caps, which showed the inability of the market to properly respond to even publicly reported quarterly information. I bought it at zł8 in January 2021 when it had a market cap of zł450m against 9 month year-to-date earnings of 180m, up 120% Y/Y.

The market in this case hadn’t paid attention to either quarterly results or earnings guidance. It took the release of the full year results in late February for the price to more than triple.

Another example is Eurotel (WSE: ETL), which historically paid dividends of around zł2 per share but which was skipped in June 2020 as Covid was really taking off. Despite announcing great full year results in March 2021, including record profits and around zł10 per share of excess cash, it took until the announcement of a zł6 dividend in mid April to drive the price 50% higher.

And that’s not it. I own two more Polish small caps which had huge pops on the announcement of large dividends which couldn’t have been more obvious given strong profits, a huge pile of cash, and a long-established policy of high dividends.

This is clear evidence of an inefficient market which responds too late to news which is either public, or easily forecastable. I’m anticipating this to happen again and that’s part of a current investment case of mine.

I don’t believe that many value investors would be comfortable with this thinking. But I increasingly believe that this kind of analysis, this meta-analysis of thinking not just about companies and their competitors, but about other investors who are your competitors, is as much as half the game.

That brings us to Skarbiec Holding (WSE: SKH), a Polish fund manager which is the subject of my current price speculation. It’s a zł240m (US$60m) business which manages about zł6bn in assets, of which around zł2bn is in equity-focused funds and the balance in bonds. The first 9 months of results are out, and I’m forecasting full year NPAT of roughly zł50m and a cash balance of zł130m for the year to 30 June 2021.

Earnings from 2016-2020 averaged zł23m, with their better years the result of a huge bet on the growthiest of tech stocks. Skarbiec’s main growth fund, which accounts for more than half of their equity-focused FUM, has smashed its index and kept 25% of the outperformance. That was the primary contributor to this year’s record profits, with huge performance fees earned in H1.

Now, they disclose enough for someone to have easily calculated this in advance by piecing together fund information which discloses performance fees, fund sizes and recent performance versus benchmarks. It took me an hour or so while checking whether performance fees will be earned during H2 (unfortunately not).

But no one did the work. No one noticed until the announcement of the H1 results sent the price up from zł30 to over zł45.

Importantly, this is not what happens in developed markets. The prices of listed fund managers respond rapidly to every announcement of fund flows. The information feeds directly into sophisticated investors’ models and the market reacts swiftly. This is clearly not happening with Skarbiec.

I consider this strong evidence that I’m competing with unsophisticated investors. Let’s now turn to Skarbiec’s likely dividend given the examples I cited above.

After Skarbiec’s last large dividend payout of zł30m in late 2018, zł30m was left in the bank. Some regulatory changes pushed back the next dividend of zł22m to mid 2020 but it was canned as Covid took off. Given the current cash balance of zł130m, there’s around zł100m of excess cash. Even assuming management keep more in the kitty than prior years, it easily leaves room for a zł60m dividend — 25% of the current market cap.

Assuming zł60m is paid out, you’d still be left with zł70m of cash and a business with five year average earnings of ~zł33m (2017-2021) and trailing 12m earnings of zł50m. Assuming the price adjusts down ex dividend the market cap would be just zł180m, putting it on around 2x trailing earnings ex cash.

Now that sounds extremely cheap, and that was indeed my first reaction.

The bear case though is that when earnings once again become a factor in valuing tech companies, performance fees will dry up and funds will flow out of their largest fund. Sustainable profits are probably more like zł15m if their growth fund underperforms over the coming years (my base case expectation), and it’s a long way down for investors extrapolating zł30-50m in annual profits.

Furthermore their active management fees could be at risk in a world rapidly moving towards low cost ETFs. They only average around 40bps but that’s with about 60% of their assets in bonds earning close to zero. Fees cap out at 2.5% p.a. + 25% for the aforementioned growth fund, though scaling down with higher balances.

For all those reasons today’s price is not nearly as cheap as it first looks. Using a 15% cost of equity on zł15m of earnings plus zł130m of cash gets you to the current market cap. A further run up in tech stocks for even one or two years could add materially to this valuation. But with a high probability of a tough road when tech eventually corrects, if you forced me to hold the stock for five years I’d say it’s only mildly cheap today if you’ve got a high hurdle rate, though I’d still be an owner.

But I also put a high probability on Skarbiec’s share price increasing materially in the next couple of months once it has reported huge full year profit growth and declared what I think will be a very large dividend.

For those reasons I have pushed Skarbiec to an uncomfortably high portfolio weighting ahead of its upcoming earnings announcement, far in excess of what I'd own if I were buying for the long term.

Now I don’t want to suggest this is how I invest all the time. This is the first short term price speculation that I’ve ever engaged in, and I don’t anticipate doing this regularly. But overweighting a moderately cheap stock for a month or two when it’s highly likely the market will overreact seems a low risk gamble with a lot of upside.

Leaving the constraints of traditional value investing has opened up many opportunities that I once would have steered clear of. I was once a value investing puritan but not any more, and I’m a better investor for it.