2017 Year End Investment Letter
Our investment process will focus in its entirety on being highly selective. There will be times when we make individual investments that perform poorly. Ideally, we will not stick by these poor investments under false hope that things will simply improve. There will also be times when our portfolios are out of favor for being less thematically enticing than the leading stocks of the month or quarter. What should never occur under the Ballina Capital, LLC investment process is to find we have validated a thesis that closely resembles that of Steinhoff International ("Steinhoff").
If you are not familiar with the story, Steinhoff is a retail holding company listed in South Africa that disclosed accounting irregularities in December of 2017. In the days and weeks that followed, increasing chaos and crises engulfed the company as the company found it difficult to validate the existence of certain assets belonging to subsidiaries. This made it increasingly difficult to retain the existing credit agreements with banks that provided liquidity for the firm. The stock has lost roughly 95% of it’s previously held level while the company tries to gain some relief from its creditors.
Fortunately, Steinhoff did not appear in Ballina investment screens. It did not possess the quantitative metrics that we find to be common for investment candidates that can outperform over longer than a two-year time horizon. Steinhoff did possess some attractive financial metrics during the second half of 2017. For example, the long term average Return on Equity on a reported basis was above 10%. On valuation grounds the stock appeared to be trading in the low teens on price to earnings ratios. Additionally, the company had started to trade at lower Enterprise Value to Sales ratios than it was accustomed to. But on metrics that can possibly substantiate and/or separate the valuable from the transitory value – such as Tangible book value or Free Cash Flow Yield – Steinhoff was either nonexistent or weak (see below). The business had become very acquisitive and therefore had acquired large amounts of goodwill in recent years, making tangible book value small or incalculable. These metrics being in aggregate so unattractive, meant that Ballina did not have to employ its fundamental research tools to discover that the Steinhoff empire was lacking.
We live in a period of unprecedented monetary stimulus, often by untried or untested methods. The cost of capital, often largely driven by the cost of debt, for many businesses is rendered to be very low (attractive to them). There are, and perhaps will continue to be for some time, management teams that are willing to take on excessive risks, lever up and expand their businesses without the normal due diligence from the marketplace. As an ironic twist in the case of Steinhoff, the European Central Bank owned bonds issued by Steinhoff that they were forced to sell at a deep loss. Their capital base can absorb such a hit. The capital bases of Ballina’s clients are not intended to absorb such damage. We will remain vigilant that for as long as the current cycle continues, Ballina strategies will not seek value in the overly aggressive and financially dubious.
Strategy Performance
International All-Cap Value returned 2.49% (gross basis, 2.4% Net) in December 2017 versus 2.07% for the benchmark.
Global Small Cap Value returned 2.51% (gross, 2.43% Net) in December 2017 versus 1.35% for the benchmark.[1]
[1] Benchmark for Global Small Cap Value comprised of 50% weight iShares Russell 2000 Index (IWM) and 50% weight Vanguard FTSE All-World ex-US Small-Cap ETF (VSS)
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