It’s been another turbulent year for the world economy, but overall we believe we can look back at the year 2012 with a smile and reasonable confidence for the future. The year started with the “usual” optimism and confidence in a speedy recovery followed by a sharp reversal, for the most part caused by recurrent trouble in Europe, a mild slowdown in the US and a deceleration in Asia.
In our opinion, none of those factors managed to derail the US economy from its growth path, although these factors did succeed in temporarily depressing asset prices, creating interesting buying opportunities of which we took full advantage.
Europe is far from being past its troubles, which are structural rather than contingent at their core. We believe the European Central Bank has acted appropriately by standing behind the Euro and declaring its conditional support of member countries. These actions have contained the acute part of the crisis and, we believe, returned a minimum of stability to the system. However, core issues such as the productivity gap between North and South, declining competitiveness vis-à-vis US and Asia, and adverse demographics are likely to take years to address, if not decades.
The outlook is decidedly better for the US in our opinion. Despite the lingering aftereffects of the housing bubble and related financial crisis, the situation on the ground keeps improving steadily, albeit at a frustratingly slow pace. GDP growth has been a respectable 2.2% in 2012 with steady decreases in unemployment and low inflation.
We believe that the US economy is capable of eventually generating significantly faster growth rates, thanks to a unique combination of creativity, entrepreneurial culture, sound legal system, meritocracy and a system of government that, eventually, can get things done. In addition to this, we believe that the future of developed countries lies in the so called “knowledge economy” (rather than in low-level manufacturing) where the US is uniquely positioned to thrive and excel in the long run.
For this potential to be fully unleashed again, we believe a few hurdles need to be overcome. First, private as well as public finances must be stabilized and be firmly put on a sustainable course. Second, we believe the real estate sector, with all its potential to generate employment and economic activity must be allowed to return to a normalized level.
Third, we believe the government and its decision-making system must avoid excessive polarization and seek a commonality of goals. All of the above is attainable and indeed have seen encouraging signs in the last few months. Again, while we do not believe in the predictive power of short-term economic forecasts, I can’t help but be optimistic for our 2013 outlook, especially given the recent management of the “fiscal cliff.”
Although we did achieve what we see as respectable gains for the year, I would not describe our 2012 performance as exemplary. The year started extremely well, despite a correction in May. Unfortunately, part of that gain has diminished due to temporary adverse developments in some of our portfolio companies as well as general unease about the handling of the fiscal cliff.
In 2012, we opened a number of new positions to take advantage of new opportunities, as well as to invest new contributions. At Zanshin Capital we focus on acquiring shares in sectors where we believe fear, uncertainty and pessimism create a dislocation between the stock price and the intrinsic value of the underlying company.
The EU crisis represented what believe was an ideal opportunity: despite the seriousness of Europe’s economic troubles, we reckoned that some European multinationals, selling a majority of their non-discretionary products outside of the EU, were unlikely to suffer significantly from the crisis, despite their stock prices being severely depressed as wary investors stayed away indiscriminately from all things European.
We acquired Sanofi Aventis (SNY), a French pharmaceutical company, in the portfolio. The company has been in our sights for a long time, but only the EU crisis has allowed us to acquire its stock at a more favorable cost basis. Pharma stocks represent a conundrum: on the one hand, we believe they are poised to benefit from important long-term demographic trends (aging of the world population and increasing use of Western medicine from emerging countries). On the other hand, many firms suffer from decreasing pipelines of new drugs to replace expiring patents. Our solution was to focus on companies where we believed the “patent cliff” was limited and the company was on track to address the situation. We're hopeful that Sanofi will prove to be a good example.
Most of Sanofi's patent challenges are behind it and we believe its focus on vaccines, emerging markets and biotechnology (they have recently acquired Genzyme, a leading biotech firm) show that they have the right strategy in place to leverage those demographic trends. The market showed significant enthusiasm for the stock in 2012.
Our acquisition of Total SA (FP:EN) shares follows a similar line of reasoning. The company sells a non-discretionary commodity (oil) and it has been trading at very low multiples due to the EU crisis. Although we believe marketing and refining margins may suffer as the EU recession unfolds, we also believe its core Exploration & Production profits are unlikely to be hit and are actually expected to increase significantly given Total’s recent massive investments in new oil wells around the world.
Remaining in the oil sector, we also acquired shares of Halliburton (HAL) and, for some accounts, National Oilwell Varco (NOV). Our long-term assumption is that oil will get more expensive and difficult to extract, and therefore we believe companies that assist oil majors in the extraction process are likely to be long-term winners.
Halliburton is one of the pioneers in hydraulic fracturing and horizontal drilling, newly developed techniques to extract oil and gas from shale formations. Already dominant in the US, Halliburton is pushing to expand its activity overseas. National Oilwell Varco is primarily a one-stop-shop for oil drilling equipment. Around 90% of wells around the world carry its products, which tend to work best when integrated together. This generates a great deal of customer captivity and we believe has the potential to provide strong profitability over time.
We added some shares of Western Union (WU) in 2012, an interesting play. This 100+-year-old company is the market leader in money transfers around the world. While a great deal of transfers nowadays is performed between bank accounts, if either sender or receiver does not have a bank account little choice is left but Western Union (or one of its much smaller competitors).
The company is, therefore, primarily used by immigrant workers around the world for remitting cash to their home countries. On the plus side, most of its costs are fixed (corporate overheads, IT, advertising/marketing) so their unit cost decreases with revenue. Being the largest player therefore means having the lowest unit cost in the industry and the fattest profit margins. On the minus side, the company is perceived to be under threat from money transfers performed through smartphones: many people believe it is just a matter of time before WU’s business model becomes obsolete.
We have researched this company extensively and believe that WU will continue to thrive in the future. Our thesis is complex and too long to be described here in detail, but we believe that complex anti-money laundering regulations in place for international transfers make it likely that if a worldwide, smartphone-based system to transfer money is established, WU will probably emerge as the standard operating platform, given its ubiquity and experience with regulations.
The stock unfortunately dropped significantly during the 4th quarter due to reasons that we believe are short term, and we expect a recovery next year. Of course we keep WU under close observation at all times to make sure that our thesis still holds.
We acquired shares of Annaly Capital Management (NLY), a US Real Estate Investment Trust. Annaly’s business model is quite simple: they acquire mortgage backed securities (MBS) from Fannie Mae and Freddie Mac (with a US federal government guarantee and, thus, no credit risk) and use short term borrowing for financing, enjoying the spread between two.
Despite Annaly’s attractive dividend yield (13%) and talented management, I have to admit that acquiring Annaly has been a mistake. I never intended this as a long-term position, but thought it could have been a good place to park some cash waiting for better long-term opportunities.
Unfortunately, as part of its Quantitative Easing program, the Fed recently started buying MBS as well, thereby increasing the value of Annaly’s holdings, but compressing the spread for future investments and causing a moderate drop in share price. We still hold the stock, given its generous dividend yield, but we have earmarked it for sale as price recovers or better opportunities come along.
Teva Pharmaceutical (TEVA) shares, part of our portfolio since 2006, have not given us much gratification in 2012. The company is undergoing a period of transition as the new CEO, Jeremy Levin, took the helm at the beginning of the year. His strategy is sound in my opinion: aggressively cutting costs (to offset upcoming patent expirations), focusing R&D efforts on selected areas (e.g. central nervous system), pushing for emerging markets presence and developing innovative uses for existing compounds.
A great deal of skepticism and negativity has surrounded the stock lately, the recent struggle with Hamas being a factor too (Teva is an Israeli company and its foreign shareholders get anxious each time the geopolitical situation deteriorates in the Middle East).
The investments discussed are held in client accounts as of December 31, 2012. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.
Certain information contained in this presentation is based upon forward-looking statements, information and opinions, including descriptions of anticipated market changes and expectations of future activity. The manager believes that such statements, information and opinions are based upon reasonable estimates and assumptions. However, forward-looking statements, information and opinions are inherently uncertain and actual events or results may differ materially from those reflected in the forward-looking statements. Therefore, undue reliance should not be placed on such forward-looking statements, information and opinions