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Saturday, July 20, 2024

Performance review 6M 2024 – Comment: “How do you know if your horse is dead ?”


In the first 6 months of 2024, the Value & Opportunity portfolio gained  +1,4% (including dividends, no taxes) against a gain of +2,2% for the Benchmark (Eurostoxx50 (25%), EuroStoxx small 200 (25%), DAX (30%), MDAX (20%), all TR indices).

Links to previous Performance reviews can be found on the Performance Page of the blog. Some other funds that I follow have performed as follows in the first 6M 2024:

Partners Fund TGV: +6,9%
Profitlich/Schmidlin: +5,4%
Squad European Convictions: 7,9%
Frankfurter Aktienfonds für Stiftungen: -0,9%
Squad Aguja Special Situation: +8,0%

Paladin One: +3,0%
Gehlen & Bräutigam: +4,3%

Performance review:

Some Performance reviews are more fun to write, some less so. This one is clearly in the second category.

Within my subjective small cap peer group, the portfolio performed significantly below average. Overall it clearly mirrors the divergence especially between Large caps and small caps. Within my mixed benchmark the performance for 6M was as follows:

Eurostoxx 50: +10,4%
DAX: +8,9%
Eurostoxx small: -2,7%
MDAX: -7,3%

The difference in performance in my opinion especially for the German index is quite stunning. Other than the US, we do not have Apple, Nvidia or Microsoft.

The main factor that contributed to the bad performance was clearly my overweight towards German and French small caps. 48% of the Portfolio are allocated to those two countries. Within that country selection, I also managed to own 2 very unpopular sectors, Construction & Materials and Renewable Energy. Being early for a Contrarian investment often feels quite painful. On top of that, a (in my eyes) quality company like Sixt suffered to very specific (and most likely temporary) problems with EV price declines.

On a monthly basis, the only consolation price is that in Q2, every month the portfolio was slightly better than the benchmark, however June was clearly really bad, actually the worst month since September 2022.

I will talk more about learnings and consequnces in the comment.

Transactions Q2:

Q2 was a decently busy month. I sold Solar AS, DEME and Biontech. New positions were Hermle, EVS and STEF. I used the temporary weakness in the Eurokai shareprice after the AGM to increase the position by 1%.

Average Holding period is now 4,1 years, cash is at 7,2%.

The portfolio, as always, can be seen in full on the portfolio page.

Comment: “How do you know if your horse is dead ?”

One way to look at the current underperformance of small caps in general and my own portfolio in particular would be to say that “markets are simply irrational”. There are some signs that this might indeed the case with stories like Gamestop, Shitcoins, Tesla and all the newly minted Tech Experts touting AI stocks like Nvidia & Co as the sure way to become mega rich.

On the other hand, one really should ask oneself: Maybe this time is different and the (European) Small Cap horse is indeed dead and you should get off as the old Indian Proverb recommends ?

To answer this question, one needs to look at this question at 2 diffetent levels:

Level 1: Are European Smallcaps resembling a dead horse ?
Level 2: Is maybe my specific selection of stocks the problem and I am riding some indiviual dead horses here ?

Let’s go through with them one by one:

Level 1: Are Small caps resembling a dead horse ?

The supporting argument for that thesis would be that the big guys, especially the Big Tech companies will continue to monopolize everything that has to do with technology and continue to “tax” everyone else with higher and higher costs for that technology. So profits for the big guys will increase for the foreseeable future and with that also stock prices at the expense of everyone. This is essentially Jensen Hwang’s case that the market for AI is unlimited as it will enter all sectors and, of course, all those players will need to pay massively for it.

It is indeed no secret, that some of the big companies like Google or Microsoft look like sure winners, especially if their “Generative AI” models turn out to be the game changer that everyone assumes. In such a scenario, everyone one else would just fight over breadcrumbs and one would be indeed better off by just bying into the big guys.

What goes against this scenario in my opinion are three arguments:

a) Maybe the Generative AI models are not as good as everyone assumes right now. Wikipedia has a great post showing that the earliest AI Cycle with a hype and subsequent “AI Winter” happened already in 1966. There is clearly a probability of those models plateauing at a level that might not justify the investments that are currently made. MAybe it’s different this time, maybe it’s not.

b) Even if the models do not plateau, how do we know that the big guys will be indeed the winners ? I am not a super expert, but the fact alone that Microsoft didn’t invent ChatGPT, Apple only managed to produce Siri and Amazon only Alexa shows that they are clearly not the innovative leaders here. The assumption is that with their current power, they will just harness and exploit whateer is created elsewhere. At the moment, everyone correlates purchases and ownership of AI chips with future world dominance, but I think this epsiode will be over at some point

c) Size matters. Over longer periods in time, investment returns for a certain period depend on two variables: The growth in profits and the difference bewteen the entry and exit multiple. Growth in profits historically was higher for small caps. If the AI revolution doesn’t happen quickly, proft growth will be harder and harder to achive for the Mega Caps. Microsoft according to TIKR is trading at a trailing P/E of 40 and a 55x Free Cashflow multiple. In order to justify the current valuation, the need to grow pofits for at least 10% p.a. for the foreseeable future. In the last 7 years, they were able to increase EBIT margins from 30% to 45%. In order to achieve the same effect going forward, they would need to increase the EBT margin by a further (relative) 50% to ~67,5% on top of further revenue growth. Maybe they achieve this, maybe not.

I could go on but the point I want to make is that for the Mega Caps, the likelyhood for a continued, long term outperformance declines with the increase in size, the increase in profitability and the increase in valuation multiples.

On the other side, many small caps now have very low valuations, are still growing decently and most likely wil not be replaced by AI anytime soon. It just doesn’t interest anyone at the moment. As history shows, these situations are often very good starting points for a very decent performance over a longer period in time.

Time machine: A look back to 2014

A little bit more than 10 years ago, I wrote a comment that was at the extreme opposite of today’s situation. Small Caps had been outperforming large caps for years after the GFC:

Back then I told the story about one of my “formative experiences” in my job from the late 90ties where Large caps were supposed to dominate forever, too:

Interestinlgy, the valuation gap between Small caps and large caps looked exactly the opposite to what we see today in 2014:

So looking back we can see that as the famous proverb says, history doesn’t repeat itself but it rhymes. 2014 was clearly the time to buy Microsoft & Co (of course not GE or Boeing), but back then it was not very popular.

In my opinion, the probability of the large Tech Mega Caps significantly outperpforming for another 3,5 or even 10 years is relatively small, on the other hand, the probability that a cheap, quality portfolio of Small caps might outperform over the same time horizon is relatively high. As investing over the long term is mostly a game of probabilities, the conclusion should be quite clear.

Maybe one comment on what is currently happening politically in Europe: As much as I dislike the rise of populism and extremism in politics, in my experience, these political topics have a limited shelf life in the markets. Unless a country really goes down the line of outright dictatorships and/or abandoning a Democratic set up, in my experience most companies are able to adapt to these kind of chnages fairly quickly. I also think that many pundits underestimate the underlying cohesion of the Eurozone. If Brexit wold have been a great success, this might be different, but with the UK struggling at least as much as the Eurozone, I personally think (and hope) that the Eurozone as such is not in danger.

However, for many market participants, that kind of “knowledge” is totally irrelevant, as their time horizon is the next quarter or the end of the year, but for anyone with a slightly longer time horizon I would recommend: Don’t give up the hope.

Level 2: Is maybe my specific selection of stocks the problem and I am riding some indiviual dead horses here ?

Even if the set-up for small caps in general is good for the mid- to long term, that doesn’t mean that on an individual stock level, there might be still some dead horses that will not benefit much from an overall trend reversal.

I don’t want to go through each stock now but I just want to focus on a few aspects that are importiant in my opinion:

  1. Especially for “contrarian” stocks one needs to make sure that the contrarian thesis develops as planned. In my portfolio I have a couple of construction related businesses where I bet on some reversal in the next 12-18 monhts due to hiopefully lower interest rates and the underlying demand for housing. If, for whatever reason, this does not materialize, one needs to really reassess the situation.
  2. In some cases, where I hold the stock for a long time, management has changed. For instance at Admiral and Bouvet, the initial founders have left and now normal Managment has taken over. One really needs to make sure that the “original spirit” still exists which made these companies succesful and that interests are still aligned.
  3. Overall, over a couple of years, the economics for any business can change profoundly. Therefore it clearly makes sense to systematically check on KPIs if long term holdings still make sense or if better alternatives are available.

So overall, revieiwing and challenging existing positions, especially the older ones should be at least as important as finding new ideas.

Another topic that I am just considering is the following: In the past I have “outsourced” some of my investment activity to Funds in the form of my two fund investments TGV Partners and AOC because both funds cover areas where I don’t feel so comfortable. I am currently considering to create a kind of “virtual” fund / basket where I outsource some areas where I am not very knowledgable myself but where I know some very good investors that I could just follow without any real deep DD. Japanese stocks would be one example, Deep Value another. I am currently thinking of adding a 5% Basket with the 10 best ideas that I can find that are outside my circle of competence to see if this adds any benefit.

Bonus track

This song from INXS captures my current mood quite well:

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