The Benefits of Patience

Deep Value Strategy 4Q 2019 Letter

The Deep Value strategy had a strong finish to the year, building upon an inflection in investment performance seen in the middle of August. For the fourth quarter, the Deep Value Strategy was up more than 40%, significantly higher than the overall market. For the year, the Strategy was up 64.6%, nearly double the S&P 1500 Value Index and the overall market. While the Strategy is focused on generating long-term returns for our clients, we are fortunate to sometimes have strong positive performance over a shorter time period.

As we highlighted in our Q3 letter, we saw numerous low valuation securities during the summer that were being significantly overlooked in the marketplace. Excessive marketplace geopolitical and economic fears weighed on near-term perceptions, leading to crowding in stability and longer duration equities. The end result: the great divide and a Value investors delight!

Over the years, we have found staying disciplined and patient will eventually be rewarded in the marketplace. The more out of favor a value opportunity becomes, it’s our experience the greater the likelihood of an attractive long-term reward/risk opportunity being present. Companies that are undergoing turnarounds can sometimes be fertile hunting ground for attractive mispriced opportunities. Uncertainty usually runs high, as share prices are typically at multi-year lows, creating a large price to value divergence. The marketplace tends to focus on the recent past operating challenges with the share price reflecting limited-to-no value for future improvement and long-term cash flow and earnings power of the enterprise.

Corporate turnarounds are challenging; a good number stall out and are not successful. However, over the past 25 years we have taken notice of some items that seem to reappear in the successful ones. We favor underlying business with sizable revenue and asset base, good market presence and strong brand awareness. The hiring of a new CEO from outside the company with a strong operational track record more often than not increases probability of success. We have found it can be challenging sometimes for an internal leader to take a fresh perspective and make needed structure changes. A business that has strong cash generation and an improving balance sheet are a big plus. Non-core or hidden company assets also provide another margin of safety as monetization can unlock equity value and also provide incremental proceeds to accelerate the turnaround. We have also found that greater rigor on capital allocation for the benefit of shareholders increases the likelihood of future improvement in return on capital. In these types of situations being early as an investor is always a risk. However, with great uncertainty comes the potential for very attractive long-term returns. Patient investors have the potential to benefit not only from a return to normalized earnings and free cash flow but also the potential for significant valuation expansion.

Avon Products (AVP) was one of the top contributors last year as the stock was up more than 250%. Jan Zijderveld joined the company in early 2018, bringing a strong operational track record with him from Unilever. Jan realized early on that the company had underinvested and misallocated capital for years, yet Avon remained a company with significant global infrastructure and strong brand awareness. Jan recruited new management/talent from outside leading consumer global companies (Unilever, Herbalife & P&G). He focused on opening up the company and laying the ground work for a successful turnaround. Jan had his team dramatically streamline infrastructure, drive gross margin improvement through new product innovation, eliminate less profitable products, monetize underutilized assets, enhance IT infrastructure and reinvest back into the business, including extensive training for their sales reps. The 3-5 year plan supported a return to historical margins and significant improvement in future earnings and free cash flow. With the stock price near a 70-year low, it reacted favorably to signs of the turnaround taking hold as operating margins began to expand each quarter. In May 2019, the share price recovery accelerated further as Natura announced their interest to acquire Avon. Natura provides an opportunity to further accelerate Avon’s turnaround effort with significant global IT expertise, greater operational efficiencies and further investment capability. The combined entity has the ability to transition to a global social selling company which could have favorable long-term impact on revenue, earnings and cash flow.

The Deep Value Strategy was also favorably impacted during Q4 and 2019 by Maxar Technologies (MAXR). The company continues to make significant strides in improving its operational execution, streamlining its operations and deleveraging the balance sheet. During the quarter, Maxar completed a debt refinancing, eliminating any near-term maturity risk. Maxar also completed a real estate sale lease back transaction for $300M and sold their MDA (Canadian operation) for $765M. The proceeds from both transactions are being used to significantly reduce the company’s debt leverage further unlocking equity value. A successful upcoming launch of Legion constellation has the potential to generate significant future free cash flow and improve the company’s return on invested capital. Maxar remains an attractive holding as the share price remains at a meaningful sum of the parts discount to peers and a significant discount to its long-term intrinsic value.

Our largest laggard during the fourth quarter was Tutor Perini (TPC), which was down 10%. Tutor Perini had a set-back late in the year, as their joint venture lost a court case regarding previously completed work for the Washington State Department of Transformation. A successful trial outcome would have led to meaningful cash collections over the next couple of years. The company will file an appeal and it will likely be a couple of years for future resolution. Recent results indicated that Tutor’s civil division backlog remains strong, and upcoming projects will be at margins significantly higher than the corporate average. We continue to believe that the company should see EPS in excess of $3/share over the next couple of years and the potential to generate $500M of free cash flow supported by additional collection efforts. We also see meaningful debt reduction over the coming years that has the potential to unlock significant equity value. With Tutor Perini‘s market price is at a significant discount to book value, we believe the share price has the ability to more than double over the next couple of years.

During the 4th quarter, Signet Jewelers (SIG) was the only new portfolio holding. The company is the world’s largest retailer of diamond jewelry with more than 3,000 stores primarily under name brands of Kay Jewelers, Zales, Jared and Piercing Pagoda. The company had a series of bad press releases and operational issues over the past couple of years, leading to significant share price weakness, down more than 80% from $150 in 2015. A new management team has been in place and the company is in the middle of a multi-year transformation. The 3-year program has focused on outsourcing their credit operations, enhancing system and Omni-channel capabilities, launching new products, reducing costs by closing unprofitable stores, and adding new higher margin service categories to their stores. A new merchandise head and CFO appear to be making a positive impact on enhancing product mix and focusing on working capital management. The company’s $2B+ in inventory provides a margin of safety and there should be ongoing opportunity to reduce inventory over the coming years to further enhance free cash flow. Recent holiday sales trends indicate that the transformation program is starting to get traction and improve top line trends.

It is interesting to note Tiffany’s acquisition by LVMH. Signet Jewelers has seen some significant challenges over the last couple of years, and is not as profitable as Tiffany, however when you look at the two company’s side by side, there is a very significant valuation discount in Signet shares.

Side-by-Side (as of 12.31.19)

Signet’s current share price reflects limited success in their transformation plan. Given their significant revenue base and trough margins, share price potential for Signet could be significant on further improvement in business results. As an example, Signet’s share price could double from current levels and it would still be at 40%+ valuation discount to the market and 60-70%+ discount to Tiffany’s take-out price. Signet share price reflects very low expectations and could end up being a hidden gem!

We believe the Deep Value Strategy has significant embedded return potential. The holdings are collectively more than 30% below their 52-week highs while the market is not far from its all-time highs. With an earnings yield approaching 20% and greater than 30% free cash flow yield, the portfolio is at a significant valuation discount to the overall market. We think clients are getting an opportunity to participate in very attractive future returns over the coming years. If we see further improvement in low valuation securities, history has shown that the Deep Value Strategy will be a likely a significant beneficiary.