First Half 2023 Letter: Builders with a Sense of Urgency

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Dear GreenWood Investor:

Our performance thus far in 2023 has been decent. We have performed in line or above global indices as of July in all of our funds and composites, but as we can no longer discuss individual fund performance according to updated marketing regulations, investors should please see our Results page for more details. Past quarterly letters are still available for investors, however, you must now certify your accreditation in order to access the Letters page.

Given nearly all of the performance this year for global indices has been driven by a few large fad stocks, we are pleased with this performance, as we have zero exposure to the current frenzy. However, we’re still very far from satisfied. Our portfolio directly contradicts the fads of the day, and our holdings remain exceptionally cheap while fundamental results nearly across the board are accelerating.

These results have been largely driven by our three coinvestments, all of which significantly outperformed the market this year — validating our efforts to “triple down” on our coinvestments late last year. These remain our largest positions and we are confident their best days lie ahead.

Builders Getting Assertive

“People pay to see others believe in themselves.” -Kim Gordon

However, we are also finding tremendous pockets of value outside the most fashionable fads of the market today. This is particularly the case for owner operators, or Builders as we term them, which have actually performed in line, or modestly worse than indices for the last decade.

Borrowing a snippet from our recently completed white paper on Builders, or companies where insiders (executives & board members) own over 20% of the company, we can see rolling 5-year performance has been mediocre since 2019. That means outperformance has been muted since 2014 from this asset class. However, the long-term out-performance remains substantial.

Exhibit 1: Builder Rolling 5-year Outperformance

Source: GreenWood Investors, Data from CapIQ

When looking at the trailing 5-year performance, one may wonder, is investing in owner operators a broken strategy?

Quite the contrary, we believe. Just like the late 1990s, the Builders underperform late cycle valuation bubbles. Frankly, that’s not a time in the market we’d expect to be outperforming substantially, particularly if we remain diligent value investors. However, this class has reliably outperformed in downturns, and has also rocketed out of these corrections.

These Builders are getting increasingly assertive in regards to their own capital structure. Few have been as assertive as two of our core non-coinvestment positions: RH and Bolloré. In the past 8 months, RH has already repurchased 22% of its shares outstanding. While recent earnings have been hit recently by the slowdown in the luxury housing market, both the company’s opportunistic repurchase activity, and forward indicators suggest the lull is now behind the company.

CEO Gary Friedman was an early outspoken critic that the “Covid-bump” to earnings would be fleeting and thus he never stopped re-investing in the company’s long-term vision to “climb the luxury mountain,” by opening flagship locations in England, the US, and launching an entire new product line. This is classic Builder behavior – to invest right through a down-turn, growing operating expenses and capital spending much faster than the benchmark “guiders” focused on hitting their quarterly guidance. Friedman did this during the 2008 housing crisis, and he has once again shown his long-term vision during, and coming out of, Covid. Shares have responded positively in recent months.

On the contrary, the market seems unfazed that Bolloré recently tendered for over 20% of its net shares outstanding. While it was only able to buyback 8% in the tender, it has an active buyback taking place throughout the capital structure, and it trades near an all-time wide discount of over 70% to its net asset value (NAV). This is while nearly all of the assets are getting sold and converted to cash or liquid securities. Vincent and Cyrille Bolloré have used the past few years to both theirs and our advantage.

Bolloré is perhaps a great poster child for the owner operator class over the past decade. Since we purchased the stock in late 2016, it has only modestly outperformed the global benchmark. But over that time, it more than doubled its operating businesses’ profit, has acquired control of Vivendi, spun out Universal Music Group (UMG), sold both its logistics businesses, tendered for over 20% of its net shares outstanding, and has begun the process of simplifying the share count by squeezing out Socfin. The fact that it has only modestly outperformed global benchmarks since then, means the investment remains even more attractive today than when we bought it.

We feel the same way about our first Coinvestment, CTT.

A Tree in the Forest

“Life is never more fun than when you’re the underdog competing against the giants.” -Ross Perot

We’ve always been content to be foraging for treasures in the forest, it’s one of the reasons we’re called GreenWood Investors — “a wood or forest in leaf (regarded as the typical scene of medieval outlaw life).”

When talking with one of our largest partners this past month, this topic came up. When speaking of our efforts at our first coinvestment (CTT), he mentioned it was a bit like a tree falling in the forest – was anyone there to witness it? Using the metaphor, he said that we’ve been able to succeed in most everything we set out to do, but the returns have been still under our hurdle rate.

So how are we to evaluate this constructive activist performance, if not by the share price? We’re very comfortable sticking to the stock price for our benchmark. And we believe the best way to judge our efforts on all of our coinvestments will be to measure by both equity benchmarks as well as the industry benchmark.

Exhibit 2: Logistics Industry Operating Income & Share Price Growth

While CTT is the second fastest growing parcel/post company by earnings, with UPS being the toughest to displace, the stock has lagged the fundamentals, and it remains deeply undervalued.

As another partner also encouraged during the quarter, “don’t get mad, buy more.” We are pleased the CTT board joined us in supporting a third share repurchase program. Given our strong belief in the deliverability of management’s ambitious 2025 target, to roughly double operating income, we see the current buyback program as extremely accretive to both current and future shareholder returns.

As first half 2023 results have demonstrated, using trailing twelve months, the company has already come close to achieving the low end of its guidance range for 2025. And the team maintains a high sense of urgency in continuing to grow better, faster, and greener than the rest of the industry. That’s right- industry-leading growth and quality of service, paired with a net zero carbon footprint by 2030. As Jeff Bezos has said of his own service, “you’d be irresponsible” for the planet and pocket book for Iberian households to not use CTT’s services for their every day purchase needs. Increasingly, more are doing so.

The 13% post-tax FCF yield remains incredibly supportive, and as e-commerce is re-accelerating in Iberia, we are excited that we were able to use the opportunity to add this position to our separate account portfolios during the quarter. Now each of our composites have all three coinvestments generating returns for the portfolio. And now with the third repurchase program active, like RH and Bolloré, we continue to own a bit more of the business every day.

The sense of urgency remains very high at CTT.

Sense of Urgency

“The urgency of doing. Knowing is not enough; we must apply. Being willing is not enough; we must do.” -Leonardo DaVinci

In May, we were humbled when Leonardo shareholders elected all four of our candidates to the board of directors. We are excited for the journey ahead with a terrific group of managers and fellow directors.

A very positive surprise occurred when meeting my new colleagues for the first time — each spoke with an incredible sense of urgency to help improve the company. In every transformation, much less one taking place in the Mediterranean, this is perhaps the most important element needed in order to reach for positive discontinuity. And while Leonardo has been set up well for success in this brave new world for aerospace & defense companies, some discontinuity is needed in order to rectify its languishing stock.

As we highlighted in our engagement presentation we used during the campaign for our board seats, Leonardo has been the worst-performing A&D stock in Europe, and was the only company to trade at a discount to its own historical valuation. We believe there are multiple factors behind this valuation overhang, and are focused on ensuring they are resolved over the coming years.

Exhibit 3: European A&D Historical vs April 2023 Earnings Multiples

Source: The Right Experience at the Right Time

We couldn’t be more excited about the opportunities Leonardo has to accelerate growth, with its largely best-in-class and modern product portfolio, ready for “off the shelf,” solutions that its customers need now more than ever in the past. Even today, shares are trading at a greater than 8% post tax FCF yield, based on a conservative consensus. The yield is even more attractive if we look forward to the next year or two.

As we told investors we engaged with during the proxy campaign, the next few years will determine the next few decades for Leonardo. We are very humbled to be able to play a part in this transformational moment in its history.

Since the new board and executives have been appointed, Leonardo’s stock has flipped from being the worst performing aerospace & defense company to now best in class. While we are still in the early days, and virtually none of the fundamental performance has anything to do with the new team, we are encouraged that investors have given the new team the benefit of the doubt. We believe their trust will be rewarded.

The sense of urgency is very high at Leonardo.

Staying Hungry, Not Foolish

“The wolf on the hill is not as hungry as the wolf climbing the hill.” -Arnold Schwarzenegger

As both we and most global managers are just starting to overcome the pronounced distortions between non-US stocks and a US index dominated by a few leaders, our sense or urgency and hunger to continue generating satisfactory performance remain very high. This is despite a market still dominated, three years post-Covid, by fads and niche valuation bubbles.

While we admitted earlier in this letter that late cycle valuation bubbles are not ones where we should necessarily be outperforming, we continue to undertake the work with enthusiasm to overcome the past couple years of mediocre relative performance. The performance thus far this year is reassuring.

Despite an overall index that has been driven by fads and fashions of the day, there are a lot of attractive bargains outside of the tech world. Driven by the AI frenzy, this most recent month just hit a new tech valuation record versus the rest of the world.

Exhibit 4: Tech Stocks vs Rest of World

Source: GreenWood Analysis using data from CapitalIQ, MSCI

This is not an environment that index investors should be enthusiastic about. Accordingly, while we have been winding down the individual short portfolio, we have been recently leaning into index hedges. If insiders of the S&P 500 are any gauge of the expectations of those on the inside, most CEOs and board members of the US market index are suggesting that more mediocre days lie ahead. This sell down of insider holdings is exacerbating a culture of agency over ownership that has been dominating management teams and corporate governance recently – as the robots continue to take over the investment world.

Exhibit 5: Insider Ownership of the S&P 500

Source: GreenWood Analysis using data from CapitalIQ

Except for one position, our entire portfolio is aligned with Builders, or companies where managers or board members own a significant portion of the company. Many of them have been putting their money where their mouth is, and have been repurchasing shares and assertively investing through any weak patch. While this class has yet to generate any satisfactory performance as a whole, we think this offers a tremendous buying opportunity.

As our white paper, currently undergoing a peer review period, highlights, the valuation discount that the asset class has relative to global benchmarks is particularly appealing. Typically, the asset class has carried a valuation premium to the index benchmark, yet today in the US, investors can get the entire asset class at a valuation discount to the index.

That is certainly the case with our portfolio, which even including development projects like NexGen Energy (our largest position outside of the Coinvestments) or our biotech investments, is currently trading at a 16% operating FCF yield. With a few exceptions, this operating free cash flow is poised to continue growing, which is our primary focus. As markets can stay irrational longer than some can stay solvent, we always underwrite our investments without hoping for any valuation re-rating. While the de-rating has particularly been painful over the past few years, a 16% operating cash yield provides our owner-operator portfolio with substantial incremental capital with which to take advantage of their own undervaluation, while also investing in their businesses.

Just yesterday, we learned TripAdvisor joined the repurchase club in the most recent quarter, repurchasing 3.3% of its shares during the quarter. Another portfolio position, International Petroleum Corp, has repurchased 4.6% of its shares in the first half of this year, and we continued to lean into this position while its own repurchase program is constrained by Canadian regulations — the company is buying as much as it possibly can within these legal limitations.

While share repurchase is not the most important investment a company can make, far from it, at particularly attractive valuation levels, it is often the easiest way for companies to improve their per-share earnings and free-cash-flow. Furthermore, forcing other capital investments at the company to surpass this minimum return available from repurchases as a hurdle rate brings discipline to the capital allocation of the company. We have been encouraging more of our portfolio companies to adopt this approach.

As the entire portfolio, except one position, consists of owner managed businesses, we believe we are highly aligned with these Builders. Additionally, as more of our portfolio has shifted to constructive active investments for us, our visibility into more than half the portfolio is unique among other investment managers. This, of course, cannot help us tick by tick, nor day by day, but we are confident in our portfolio’s ability to continue growing in the coming quarters.

We are protected by low valuations, which in the current market environment is particularly important. Our portfolios have cash on hand and index hedges to continue to take advantage of the opportunity set in front of us. On that front, we expect we’ll likely have another new position in the coming weeks. As always, we look forward to providing investors with that research report as soon as we get there.

The opportunity set remains compelling.

And our sense of urgency remains very high.

We thank you for your partnership, and look forward to further growing your capital alongside ours.

Committed to deliver,

Steven Wood

Disclaimer:

This article has been distributed for informational purposes only. Neither the information nor any opinions expressed constitute a recommendation to buy or sell the securities or assets mentioned, or to invest in any investment product or strategy related to such securities or assets. It is not intended to provide personal investment advice, and it does not take into account the specific investment objectives, financial situation or particular needs of any person or entity that may receive this article. Persons reading this article should seek professional financial advice regarding the appropriateness of investing in any securities or assets discussed in this article. The author’s opinions are subject to change without notice. Forecasts, estimates, and certain information contained herein are based upon proprietary research, and the information used in such process was obtained from publicly available sources. Information contained herein has been obtained from sources believed to be reliable, but such reliability is not guaranteed. Investment accounts managed by GreenWood Investors LLC and its affiliates may have a position in the securities or assets discussed in this article. GreenWood Investors LLC may re-evaluate its holdings in such positions and sell or cover certain positions without notice. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of GreenWood Investors LLC.

Past performance is no guarantee of future results.