Business review to the Investment Committee

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16 September 2014

Reflections After 2 Years

Since inception, the funds performance has been disappointing. However, we consider that our mistakes
are progressively enabling us to learn some valuable lessons.
LESSONS LEARNED
Avoid macro investing: Our good friend and mentor, Luis Arenzana (an experienced Portfolio Manager)
warned us from the very beginning that we should stay away from any macro trades. Despite his wise
piece of advice, we tried to execute a handful of them. The truth is, overall, our macro portfolio has cost
money to our investors and thus we have finally come to terms that we do not have the capabilities or the
knowledge to develop an edge in the macro landscape at this point in time. As such, we decided to avoid
investing on the basis of geopolitical and macroeconomic events that we are unable to foresee and focus
on our bottom-up company specific analysis. For example, early 2014 we turned bullish on the price of
gold. We invested in a basket of gold miners which would greatly benefit if the price where to stay above
$1,300oz. However, the fact that gold is a non-yielding asset, and thus very difficult to value, made the
trade too nerve-wrecking and we couldnt stand its price volatility.
Dont time the market: It is of common wisdom on the street that markets can remain irrational much
longer than you can remain solvent. It is our main task to focus on picking promising businesses rather
than trade on our feeling of where the broad market is heading. We have thought that the equity markets
are overvalued or at least fairly priced for a long time, however being short would have proven to be an illfated strategy. We do believe there are times when we should hedge our portfolio or increment our cash
balance if we dont find appealing investment opportunities, but trying to time the market as a target itself
should be out of our priority scope of action. As an example, in Q1 2013, we had a bullish view on the
Japanese equity market and decided to buy call options on the Topix with 1Y maturity. Even though the
strategy eventually proved to be correct, we lost all the money we had invested due to an incorrect timing.
We believe options may be an interesting asset that in some cases can help to enhance returns, but we
prefer now to buy long-term maturities so that we are not dependant on short-term market swings that are
driven by the crowds gut feelings rather than by fundamentals.
Keep it simple: In our view, the best way to obtain an adequate return for our investors is to focus on a
specific strategy and to stick to it for a long period of time. It is also important that this strategy has a good
fit with your personality, as it is crucial to avoid losing control over your feelings and to keep a cool mind. In
our case, we consider value investing to be the good match. Additionally, this should enable our investors
to better understand our rationale and avoid negative surprises driven by a change in style or losing
strategic focus.
Concentrate on your best ideas: According to the Efficient Market Theory, our college professors taught
us that the way to reduce the systemic risk of an equity portfolio is to diversify by buying a large number of
equities in unrelated sectors. This makes sense as you are not putting all your eggs in one basket.
However, Joel Greenblatt argues that the diversification effect is practically the same for portfolios
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containing 50-500 stocks (held by most mutual funds) and those concentrated in just 8 stocks . On top of
this, the advantage of focusing on our favourite ideas is twofold; On the one hand, we believe this is a
good way to obtain better than average returns and, on the other, we try to reduce risk by performing a
thorough research of the investments we are involved in and by trying to build up a strong understanding
of each company in our portfolio.
Additional findings on stock picking: One of our main fears when searching for undervalued stocks is
falling into a value trap (buying a cheap stock with deteriorating fundamentals). To avoid these situations, if
the initial thesis for making an investment changes, we now prefer to exit the position rather than creating
a new justification to hold it. As David Einhorn puts it Losers are terrible because it takes a success to
offset them just to get back to even.
Moreover, not only we need to understand the underlying economics of a business, but equally important
for us is to correctly perceive the quality of management. Prior to investing in any company, it is essential
to double check managements proven track-record of integrity and honesty when conducting business.
There are times when investment returns can be undermined by negligent executives. As an example, last
year we invested in an Italian engineering company called Saipem. This company was (and still is) the
technological leader in its market niche and was positioned to benefit from the shale gas revolution and the
capex upgrades of oil companies. Unfortunately, management failed to correctly address its true financial
situation and after two subsequent profit warnings the share price plunged. Furthermore, Pescanova was
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For reference, please read You can be a stock market genius by Joel Greenblatt.

another case of dishonest management. Despite we thought the investment case looked attractive, after
meeting with management in their headquarters we decided not to increase our initial position.
Unfortunately, we did not exit the position disregarding the red flags and the company ended up filing for
bankruptcy after its CEO admitted a huge accounting fraud.
Choosing a good management team is much more important in Europe than in the US. The expansion of
activist investors in the latter makes it easier to change management teams of underperforming companies
through Proxy fights. In Europe, regulations protecting shareholders are far behind and managers are not
easily dismissed when they fail to accomplish their targets. This usually leads to the destruction of
shareholder value.
REDEFINED INVESTMENT STRATEGY
Considering all of the above, we have come up with a redefined investment strategy guided by certain
principles, under which we expect to deliver consistent risk adjusted returns for our investors. The fund will
invest primarily in developed economies, through a concentrated portfolio of our best ideas after an indepth research of each business. Our strategy focuses on:
1. Quantitative approach
When valuing businesses we focus on studying the evolution of FCF (free cash flow) generation and
SOTP (sum of the parts) analysis. This helps us to estimate the underlying value of a company and
compare it to its current share price. We believe that purchasing stocks at a significant discount to its
intrinsic value is key to obtain appealing returns whilst having a sufficient margin of safety to limit the
downside risk. In other words, our goal is to find investing opportunities with asymmetric risk / reward
profiles.
Firstly, we believe FCF (defined as cash from operations capex) is the main source for shareholder value
given it constitutes the actual cash available for dividend payments, buybacks, debt repayments, M&A or
to strengthen the BS position of a company. Consequently, we spend most of our time analysing cash flow
statements and their future evolution. We like to find companies with controlled working capital
requirements, low capex levels and high operational leverage that are capable of generating a recurrent
stream of cash flows going forward. In order to determine if a company is on a quantitative basis
attractively priced we use multiples based on cash flow metrics and avoid P&L valuation techniques as
they can be easily manipulated given their accounting nature.
Secondly, we also look for companies that trade at a discount to its SOTP. In some occasions, the share
price of a consolidated group does not reflect the underlying value of the sum of its different divisions and
assets, creating an interesting investment opportunity. These situations may arise due to a wide variety of
reasons, such as distress in a specific division, inefficient information disclosure, underfollowed by the sell
side community etc. We normally analyse the levels at which peers are trading to determine the value of
each individual division or asset. In other cases management is able to unlock value for shareholders by
simply changing the legal structure (Holdings, REIT, MLP, Yield co) which results in a revaluation of the
companys assets. Activist investors usually act as a catalyst to reduce the gap as they force management
to take immediate actions.
Lastly, we only invest in stocks with healthy financial positions and sustainable debt levels (adjusted by
pension plans, leases and other commitments). We try to never forget that leverage, gearing and interest
cover ratios are necessary to assess whether a business may face financial distress. However we consider
that these ratios should be analysed in the context of the companys cash generation ability as different
business models admit different leverage levels. This, we believe, should enable us to find opportunities
where others turn their backs on.
2. Qualitative approach
We like to purchase businesses with competitive advantages that can sustain their pricing power (their
ability to maintain or increase margins), companies with cyclical tailwinds or recurrent business models not
subject to technological disruptions. On the other hand, we generally avoid investing in tech stocks given
the high degree of uncertainty surrounding these sectors. In addition, we also stay away from sectors with
structural issues or deteriorating fundamentals as it is in these cases where instead of purchasing bargains
you may end up falling into the so called value traps.
Moreover, managements integrity and quality is a must for us. We appreciate executives with a proven
track-record of making shareholder friendly decisions. Efficient capital allocation and disciplined financial
controls play a significant role in the long term performance of a stock and thus we keep track of those
who make a rational use of excess cash (avoiding irrational M&A activity, pretentious expansion plans etc)
and return it to investors when opportunities are scarce (preferably via buybacks, being these more
accretive than dividends). Finally, we support those management teams that take full responsibility for their
mistakes and are flexible enough to turnaround any wrong doing. We listen to conference calls, attend

investor presentations and schedule one on one meetings helping us to get a feeling of positive or warning
signs regarding management.
Finally, we would also highlight the influence the BoD (Board of Directors) has on the performance of the
companies they supervise. The BoD is, in principle, the main instrument to safeguard shareholders
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interests . We believe they should be composed by experts in the sector that can review managements
operational decisions, and on the other hand, by directors with a strong financial background to supervise
the companys capital allocation effectiveness and other financial matters (debt structure, refinancing
negotiations, returning money to shareholders etc.). In this sense, we find Boards in the US are generally
better structured than in Europe, given in the latter these are heavily politicised and directorships are
conceded attending to personal interests or preferences rather than by strict professional merits. In
consequence, as part of our due diligence process we like to read the biographies of all board members
that can be found in Proxy Statements (US) and Corporate Governance Reports (Europe).
3. Sources for ideas
Considering the huge investment universe we deal with, and the opportunity cost implicit in each search,
assessment and investment decision, it is important to short-list this wide range of possibilities. We usually
find excellent opportunities in companies that having experienced financial turmoil, adopt a stricter
financial discipline (Restructurings) or those that are refocusing their business model after a period of
strategic paralysis (Turnarounds). In both cases, the share price tends to plunge during the initial periods
of distress, offering an attractive entry price to take full advantage of the subsequent fruition of the
restructuring or turnaround. We try to get involved in situations where we can see a tangible turning point
in FCF generation and avoid business plans that look too aggressive or difficult to accomplish.
Spinoffs are another niche where we find attractive risk / reward ideas. It has been proven that spun-off
companies tend to outperform the market due to their specific dynamics. As it is commonly known, the new
spinoff shares are distributed to shareholders, who, for the most part, were investing in the parent
companys business. Therefore, these shareholders typically sell the spinoffs shares disregarding their
price or fundamental value. Additionally, institutional investors also join in the selling given the spinoffs
normally have small market caps that have no fit in their huge portfolios. This selling overhang creates
shares to trade at bargain multiples at significant discounts to their peer group.
As we have previously mentioned, balance sheet analysis may lead us to find stocks trading at significant
discounts to their SOTP underlying value. However these companies can be forgotten by the market for a
long time, thus affecting the investments performance. For this reason, we only get involved in those
situations with catalysts ahead that could trigger the companys rerating in a reasonable time span. These
catalysts could come in the form of litigations, M&A activity, management changes, regulatory
modifications or new strategic plans, just to mention a few examples.
Ideally we would like to find excellent businesses, with outstanding management teams trading at
attractive valuation multiples. Obviously, these situations are scarce as the market tends to assign
premium valuations to these high quality companies. The only moments where you have the chance to
purchase these kinds of stocks at acceptable prices, normally arise after an overall market correction or
specific short term issues. This is why in market corrections it is important to have clear targets and
enough firepower (cash).
4. Cope with market excesses (in both directions)
We track overall market multiples of those indices we invest in to understand the returns to expect when
putting money to work at different moments in time. It seems to coincide that when global indices look
overvalued, interesting investment cases start to become scarce. Furthermore, in these situations the
equities we hold end up reaching fair valuations. As a result, we would gradually increase our cash
balance and wait for high conviction ideas to appear again. During these periods, it is therefore essential
for us to stay self-minded and extremely patient. We believe that being able at given moments, to cope
with high levels of cash in our portfolio is determinant to accomplish our goal of earning good absolute
returns. To hedge this cash position we would increase our net exposure through stock indices, not
affected by specific risk, to take advantage of tactical pockets of opportunity that appear after sharp
volatility hikes due to short-term shocks. Seemingly, we would reduce the funds net exposure in low
volatility and high multiple environments where adequate risk-adjusted returns turn out to be difficult to
achieve.

Except in certain EU countries where this task may be reserved to the Supervisory Board (Germany, Switzerland, the Netherlands etc.)

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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 document.
Persons reading this document should seek professional financial advice regarding the appropriateness of
investing in any securities or assets discussed in this document. The authors 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. The investment fund Peninsula Capital, FIL may have a position in the
securities or assets discussed in this article. Peninsula Capital FIL may re-evaluate its holdings in such
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