Emerging Value Q2 Letter: Middle East Is Imploding; Short Poorly Designed ETP

August 2, 2017

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By VW Staff. Originally published at ValueWalk.

Emerging Value Capital Management letter to investors for the second quarter ended June 30, 2017.

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Dear Partners and Shareholders,

For the second quarter of 2017, Emerging Value Capital Management fund returned an estimated +5.1% net to investors. Stock markets worldwide were up with the All Country World Index (ACWI) and the HFRI Equity Hedge Index up +4.3% and +2.3% respectively.

Since inception (10/15/2008), Emerging Value Capital Management Fund returned an estimated +138.5% (net to investors). During this same time period the MSCI All Country World Index (ACWI) and the HFRI Equity Hedge Index returned approximately +120.0% and +60.2% respectively.

Emerging Value Capital – Q2 Market & Portfolio Overview:

Tensions between North Korea and the US flared as the rogue state accelerated its development and testing of various missile systems, including those that could, hypothetically, strike the US and its allies with a nuclear war head. With diplomatic efforts showing no results, president Trump must either accept the new military capabilities of North Korea or else launch a massive air-strike which would likely lead to war involving the US, North Korea, South Korea, Japan and possibly China.

We continue to think that a full scale war is an unlikely scenario, but must admit that the probability of such a war has significantly increased. If a war broke out, North Korea would lose and its regime would likely topple, but not before it could cause great damage and loss of life to South Korea. There is also a small risk that North Korea strikes with various weapons of mass destruction.

To protect our portfolio from this risk, we established an 11% short position in EWY, the South Korean ETF. We are still net long South Korea, via our Preference Shares Basket and our investment in Samsung Electronics, so this is only a partial hedge. Even in a scenario of all-out war on the Korean peninsula, we are confident that the US and South Korea will win decisively and will recover from any temporary damage. Therefore, in the unlikely event that war breaks out, our plan is to wait for the Korean stock market to drop, then remove our hedge and wait for the recovery.

We made few changes to our portfolio in Q2 because we like what we own and did not find much that is better to buy. We did re-establish investment positions in General Motors and Fiat Chrysler when their stocks temporarily declined due to slightly disappointing monthly car sales numbers. Both companies are exceptionally cheap and have much improved business operations. While we agree that self-driving electric cars pose a long term threat to their business models, we do not think this threat is imminent.

We also increased our short positions in USO (United States Oil Fund) and UNG (United States Natural Gas Fund). These poorly designed ETF’s continuously lose value verses their underlying commodities due to management fees, trading costs and futures contracts roll-decay. We think that Oil (WTI) around $50 per barrel and Natural Gas (Henry Hub) around $3 per Million Btu have little fundamental upside, which makes holding these short positions, while the ETF’s decay, low risk.

Below, we will go into greater detail on some of these positions. For now, however, we think it is important to point out that our top 10 longs make up over 79% of our long exposure. As of quarter-end, we were 99% long and 30% short. Our overall net exposure level of 69% reflects the compelling bargains we are finding in global stock markets combined with our short and hedge positions.

Thoughts on Global Investing:

The number of trouble spots around the world continues to increase. A decade ago it looked like the world was entering a new era of global trade and world peace. Europe was uniting, emerging markets were rapidly developing, China was a benign and peaceful emerging superpower and Russia was joining the west. Today the trend has reversed. Europe is struggling to hold together, Russia and China have become belligerent powers, South American economies have imploded, Africa is undergoing Islamisation and the Middle East (excluding Israel) is in shambles.

If these were all temporary issues, they might have created compelling investment opportunities. But sadly, with few exceptions, we think these issues are permanent and getting worse.

Therefore, it is critical that we carefully pick and choose those countries in which we invest our capital. We continue to conclude that the US, Israel, and South Korea are the three countries were most of our capital should be invested. All three are true capitalist democracies, enjoy favorable demographic trends, and are the world leaders in technological innovation – the driving force behind today’s economic growth. Two of the three (Israel and South Korea) also offer plenty of cheap stocks.

The following table shows how our capital is allocated geographically.

Our main contributors in Q2 – 2017:

Main contributors to Emerging Value Capital Management returns in Q2-2017 include: Hilan, Israel Discount Bank and our basket of Korean Preference Shares. Below are short discussions of these positions. We had no significant detractors from performance in Q2.

Hilan

Hilan is Israel’s leading payroll processing and HR service provider. US investors might think of it as the “ADP of Israel”. The company provides an array of solutions for organizations: payroll, human resources, time & attendance and pension administration. Hilan possesses the most advanced and comprehensive system of its kind in Israel, rendering services to about half of the mid-size and large businesses in Israel.

Payroll processing and HR services is a predictable, slow growth business which generates a lot of recurring free cash flow, requires minimal capital investments, is recession resistant, and provides a high return on capital invested. Customers are very “sticky” since it would require a lot of time, effort, and expense to switch service providers.

Leveraging its existing customer relationships, Hilan has expanded into software services and IT infrastructure services. These newer segments are more competitive and lower margin than payroll & HR, but do provide more rapid growth. Hilan is a cheap, high quality business trading about 10 times our estimate of 2018 operating earnings with a 2.8% dividend yield.

Israel Discount Bank

Israel Discount Bank (IDB) is the third largest bank in Israel. Operationally, it is the least efficient major bank in Israel. Its employees belong to a fairly militant union and they make cost cutting and operational improvements an always difficult undertaking. As a result IDB suffers from a bloated cost structure and earns sub-par returns on equity (ROE). When we invested, sustainable ROE was below 6%.

IDB continues making slow progress with its multi-year strategic cost reduction program. Based on this program, 350 redundant employees have already retired from the bank and 650 additional

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