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2023 Q4 Portfolio Perspectives

by | Jan 12, 2024

If there is one principle that the last few tumultuous years has taught us, it’s that no one has a crystal ball, no one can reliably or consistently predict the future. This is a notion that Sprucegrove has embraced since inception and it’s the reason we dedicate our attention first and foremost to assessing the quality of the businesses we invest in and ensuring that we are disciplined on the valuation that we buy and sell these businesses for.

From our experience, a company that we deem to be attractively valued may fall to an even more attractive valuation after our initial purchase.  Similarly, a company that we are trimming may continue to climb to even richer valuations.  This is why, when we initiate a position in a new name, we tend to start with an initial weight of 25 basis points and then generally add at increments of 10 basis points.  When selling, we will also do so in a similar manner, in increments of 10 basis points except when the decision to sell a company is the result of a deterioration in quality, whereby we act more expeditiously. We take the opportunity presented by the market to build or trim our positions in portfolio companies at valuations that we find compelling.  For long-term readers of our quarterlies, this will be a familiar theme. Our incremental, and in most cases, gradual approach is designed to mitigate both entry point and exit point risk because we do not profess to have any tangible ability to time markets. This quarter, we highlight two names in order to underscore that these core tenets of ‘quality first’ and our incremental approach apply equally to both developed market and emerging market companies, as well as to companies that we have invested in both in the near term as well as over the long term.

We have followed Ryanair for 20 years having initiated coverage on the company back in 2004. The quality of the business, as considered through the lens of Sprucegrove’s five pillars of quality has strengthened during that time. In terms of its leadership position, not only is Ryanair one of the lowest cost airlines, but it also has the world’s largest point to point network and is Europe’s largest airline by passenger volume. In the last 10 years, Ryanair has achieved a record of profitability that includes average operating margins of 17% and an average return on equity of 17%. We believe this is an impressive record for any business and exceptional in the airline industry. The company is in a strong financial position with a net cash balance sheet. We continue to anticipate several long-term growth opportunities for Ryanair as the airline continues to expand its network, entrench itself in new regions, particularly Eastern Europe, and increase its ancillary service offerings. We have met regularly with the management team over the years and consider them to be disciplined, cost-conscious and long-term minded.

We got our initial opportunity on Ryanair in 2004 at a valuation of ≈13x NP/E. In the following years, Ryanair demonstrated it could not only maintain, but enhance its profitability in the face of rising oil prices and this was reflected in the company’s valuation. During 2007, we incrementally trimmed our position in Ryanair a number of times over the course of the year at valuations that ranged from ≈17x to 24x NP/E. The very next year, during the heights of the Great Financial Crisis, we were again presented with a number of opportunities to build our position at valuations ranging from ≈8x to 12x NP/E, the lowest valuation for Ryanair we have ever seen historically. We continued to add selectively to Ryanair over the next few years as valuations remained attractive.  By 2013, fuel prices elevated once again, and Ryanair demonstrated its ability to outperform in a high fuel price environment.  Consequently, we began trimming between ≈18x to 30x NP/E and by 2015 we had completely eliminated Ryanair for valuation reasons.

As we continued to reaffirm the company’s quality, Ryanair remained on our working list and we watched it closely for a future re-entry point. The Covid-19 pandemic provided us just that opportunity and in early 2020 we started a new position at ≈11x NP/E, a valuation cheaper than what we originally paid in 2004. Since then, the market volatility in recent years has given us chances to both add and trim incrementally at valuations we found compelling.

When it comes to emerging market companies, we follow the same rigor and discipline as we do with developed market companies. Adani Ports has an enviable leadership position as the largest port operator in India with a portfolio of ports that cover 95% of the country’s hinterland and account for 32% of overall port capacity.  In the last 10 years, Adani has achieved a record of profitability that includes average operating margins of 48% and an average return on equity of 19%.  As an infrastructure operator, Adani has a solid financial position with net debt-to-equity of 82.5% supported by strong cash flow generation. The combination of growing export/import trade in India and congestion and capacity constraints at the country’s other major ports is expected to create long-term growth opportunities for the company. Finally, we have met with Adani’s management both in our offices and in India and have consistently found them experienced operators with a track record of execution and a long-term focus.

While Adani Ports is a considerably newer addition to the portfolio than Ryanair, our incremental approach has been executed in the same manner. We first became owners of Adani Ports on the cusp of the Covid pandemic in the fourth quarter of 2019 at a valuation of ≈16x NP/E. As the pandemic increasingly impacted global trade in 2020, we found opportunities to build our position in Adani Ports at valuations ranging from ≈12x to 13x NP/E.  By 2021, ports and logistics companies were among the major beneficiaries of the easing of Covid restrictions and the resumption of global trade.  We took several opportunities to trim our position in Adani Ports during 2021 and 2022 at valuations ranging from ≈24x to 28x NP/E. At the beginning of 2023, Adani’s valuation plunged following the release of the Hindenburg (short seller) report. We reviewed the report, interacted directly with management and conducted our own due diligence on the situation. We concluded that most of what was in the Hindenburg report was already known in the public domain and we were encouraged by management’s commitment to further deleveraging the balance sheet and simplifying their business including pausing any significant M&A. Our due diligence and the reinforcement of our quality pillars gave us confidence to incrementally add to Adani Ports this year at valuations ranging from ≈14x to 15x NP/E, which we consider attractive for this ilk of business.

To paraphrase Christine Lagarde (president of the European Central Bank), Sprucegrove is not in the business of reading tea leaves and timing remains an elusive and challenging skill for nearly anyone to master. For instance, in 1908, you could have predicted that the Chicago Cubs would win another World Series, but you would have been wrong for 107 years before ultimately being proven correct in 2016. It has always been our philosophy that the best way to compensate for this is to focus on quality first and then to take an incremental approach to valuation dependent on the opportunities presented by the market.

[1] Source: Sprucegrove, MSCI, FactSet

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