Annual Letter 2018

2019/01/03

Dear partner,

 

The second half of 2018 was nothing like any market participant had expected, the S&P 500 dropped from 2,704.95 to 2,454.37 points or -9.2%. Year to date the S&P lost 7.5% or -5.3% with dividends reinvested. Here at Lembirik Group, we had a loss of 10.27% (No fees are charged this year as we failed to beat the market). Since the inception of the partnership (18 months ago), we returned 14.73% after fees compared to 0.07% for the general market.

 

As a general partner, I will not blame our shortcomings on tariffs, interest rates, elections or value investing as other managers do. Like I mentioned before, we do not comment on interest rates or any macro-economic factors. We spend our time searching for undervalued securities (this is a decent environment for that) and hold them until they reach their intrinsic value. Hence, what they say on the business news or what the Federal Reserve does is irrelevant to us. As for value investing, many research attest that value stocks outperform growth stocks over the long term. Just look at Warren Buffett’s track record when in doubt!

 

People tend to panic when their plans do not go as anticipated. An investor must have a sound judgment and the right temperament to make money in this business. The stock market is there to serve us, not to instruct us. This is the reason we are not running a mutual fund. We carefully select our partners who share this philosophy of long-term thinking.

 

We are in this for the long term. Market gyrations are inevitable and there is no need to get excited or depressed about their sequence of occurring. My promise to you is that in the long term, we will achieve higher returns than those of the general market.

 

We ended the year with value type holdings. Our largest holdings are Kors (now called Capri Holdings after they acquired Versace), Ford Motors, Foot Locker and Fossil. We added two stocks to our portfolio and we will discuss them with you in due time. On the other hand, if we were holding any FANG stocks (Facebook, Amazon, Netflix and Google) I would be worried. Even though they lost a combined $715 billion in market value, they are still overvalued in our opinion. The rout may not be over!  

 

A case in point:

 

We purchased Michael Kors (now Capri) at an average price of $32.73 per share, their sales per share were $28.84, cashflow per share: $4.96 and earnings per share: $3.29. Fast forward 18 months later, the company increased sales/share, cashflow/share and EPS by 9.2%, 10.7% and 20% respectively. Meanwhile the market cap has increased by only 7%. Talk about efficient markets!

 

On the other hand, let’s take Facebook for instance. Wildly regarded as a great company, 92% of analysts covering this stock have a “Buy” recommendation.

Looking at their latest annual report for fiscal year 2017, one can see that the net cashflow from operations was $24.2 billion and net income was $15.9 billion.

Part of the difference was a non-cash compensation expense of $3.7 billion. At the same time, stock option exercises resulted in pre-tax expenditures of $359 million. In addition, 43 million restricted stock units (RSUs) were issued to employees and management during the year for a value of $6.76 billion. Consequently, on a pre-tax basis, in 2017, FB expended over $7 billion in employee compensation. Since the IRS treats these expenditures as an operating expense, Facebook received a reduction in 2017 tax liability of $5.8 million.

 

Under current accounting procedures, the $7 billion pre-tax expenditure for stock options is captured primarily within the financing activities of the statement of cash flows. Only the reversal of the deferred tax asset resulting from the option exercise and issuance of RSUs stays within the operating activities section.

 

Now, to get a real picture of FB’s financials, we must subtract the stock option compensation from the statement of cash flow and add back the excess tax benefit resulting in a cash flow from operation of roughly $17 billion (30% reduction) and a drop of free cash flow from $17.5 billion to roughly $10 billion.

 

This is a reason we shy from FANG stocks, they are run for the benefit of insiders instead of their owners: shareholders. When share repurchases are massive and the share count keeps rising, that’s a clue. In a recession or a bear market, stocks of such companies will suffer.

 

FIRST REALIZED LOSS:

 

On June 19th 2017, we bought shares in MANNING & NAPIER INC (ticker symbol MN); an investment management firm offering mutual funds and a variety of consultative services, at an average price of $4.25. Their track record at money management is below average at best, but what caught our attention was that the whole company was selling for a quarter of their net asset values, basically paying 25¢ for a dollar bill. There was a hitch though: their capitalization structure is very complex.

The stock is separated into two classes: A and B. Class A stock holds 100% of the economic rights of Manning & Napier, Inc. (the reason they consolidate the financial results), but only 49.8% of the voting rights the other 50.2% of the voting rights are held by William Manning via 1,000 shares of Class B shares. What’s interesting is that Manning & Napier INC has only 17.8% ownership of Manning and Napier Group, LLC (the money maker we thought we were getting).

 

Not to bore you with too much accounting. As shareholders of class A, we have only a 17.8% claim on the $160 million of equity we thought we had as a margin of safety the rest belongs to the Manning and Napier Group, LLC. Therefore, the adjusted book value was $28.5 million (17.8% X $160) and we ended up paying over 2$ for a dollar bill! Including dividend our realized loss was 25%.

 

This mistake was in the category of value play: companies selling for less than their net assets. A portfolio containing several of these stocks should yield a good rate of return over time. Our livelihood though is companies with high return on capital; those are the stocks we make exceptional returns from. They were few in 2018, hopefully the coming year will provide more prospects.

 

RELOCATION TO USA:

 

As I discussed with every partner, because of all the interests we received from the United States, Lembirik Group is relocating south of the border. I am thankful to all my partners who elected to remain in the partnership. I will keep you apprised of all developments. The business structure is changing from a limited partnership to an LLC (limited liability company) yet the agreement will remain the same.

 

Please do not hesitate to contact me should you have any questions or concerns, I will be reaching out shortly to inform you of the development of the new LLC. Meanwhile, your quarterly statement was sent few days ago.

 

Best regards,

 

 

S. Mehdi Lembirik

 

Managing Partner,

Lembirik Group Investments®