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Fundamentals versus Fears

by | Jun 30, 2020

Sprucegrove consistently applies a fundamental, bottom-up process which allows us to invest at times when fear and paranoia may be rampant. We illustrate this within two largely jettisoned segments during the first half of 2020: airlines and cruise lines. As of December 31, 2019, our three holdings in these segments along with their respective quality and valuation metrics were:

31-Dec-19 Quality Valuation
Share
Price		 Projected
ROE (%)		 Financial
Leverage (x)		 Normalized
P/E (x)		 P/B (x) % of
Portfolio
Ryanair 87.41 20 2.3 14.0 2.8 0.45
Copa Airlines 107.85 15 2.2 15.3 2.3 0.84
Carnival 36.44 11 1.8 11.8 1.3 1.33
MSCI EAFE Index 11 2.8 15.3 1.7

[Note: The tables included in this report pertain to Sprucegrove’s U.S. International Representative Portfolio and is intended to provide an illustrative example of Sprucegrove’s process, consistently applied across all mandates. Actual weightings of each holding, therefore, may vary between those presented here and the actual weightings in other portfolios.]

Ryanair

Ryanair is the largest low-cost airline in Europe. Its Projected ROE of 20% is supported by the fact that it is the most consistently profitable airline in the world, a result of 30+ years of being disciplined in executing its low-cost business model. This includes having a high aircraft utilization rate, flying into secondary airports (as opposed to congested, higher-fee primary airports), maintaining a no-frills model (no free meals, beverages or access to onboard entertainment) and having only one type of aircraft across its fleet. Ryanair’s strong balance sheet in such a capital-intensive industry is notable. Growth prospects will come from route expansions within Europe, market share gains from industry consolidation and higher ancillary sales.

Copa Airlines

Copa is a full service airline based in Latin America. Its Projected ROE of 15% stems from its attractive and consistent profits due to its optimally-situated hub in Panama City thus allowing it to be the gateway to South America coupled with an efficient, cost-conscious business model. In having the highest level of profitability compared with its Latin American peers, Copa has built a strong balance sheet with net-debt/equity of 18%. Latin America is expected to be the third highest growing region for air travel in the world at 6% per annum over the next 20 years, providing attractive growth potential over the long-term.

Carnival

Carnival is the world’s largest cruise company with a fleet of over 100 ships. Carnival’s Projected ROE of 11% reflects their industry leadership, with 40% market share in an oligopolistic industry where the top three companies wield more than 70% market share. Carnival’s offering spans the full range of market-segments (i.e. from budget to ultra-luxury) and is one of the most profitable operators with a stronger balance sheet than their closest peers. Cruising remains underpenetrated, providing Carnival opportunities to grow their business.

31-Mar-20 Quality Valuation
Share
Price		 Projected
ROE (%)		 Financial
Leverage (x)		 Normalized
P/E (x)		 P/B (x) % of
Portfolio
Ryanair 53.09 20 2.4 8.4 1.7 0.74
Copa Airlines 45.29 15 2.3 6.6 1 0.78
Carnival 9.81 11 1.8 3.1 0.3 0.87
MSCI EAFE Index 11 2.7 12 1.3

Fast forward to March 31, 2020, the global pandemic had forced airlines and cruise lines to cease operations without any sense of when travel may return. Extreme uncertainty surrounded the future of travel and leisure vacation which drove a broad, deep sell-off across these segments. From their December 31, 2019 valuations, Ryanair’s share price declined by 40%, Copa Airlines fell by 58% and Carnival plummeted by 73%. Through it all, our investment team continuously evaluated each company against the investment thesis. While there were certainly areas of concern, our goal was to ensure that these companies still passed our five key quality criteria. From our view, the quality of each remained intact and given very attractive normalized multiples (levels not seen since the Global Financial Crisis), we added to each position in March.

From April to mid-May, COVID-19 infection and mortality rates continued to climb around the world. Forecasts of airlines and cruise lines to incur tens of billions of dollars in losses, doubt as to adequate levels of future demand returning, and companies having to get government support continued to suppress travel-related stock prices. Strong balance sheets are always a critical component of our quality criteria. In April, Carnival indicated that, without any revenue generated from new bookings, they have enough cash to carry them to at least November, 2020 and likely beyond. Copa and Ryanair also provided insight into their solvency, each able to sustain their businesses (again, without any revenues) for at least 12 and 18 months respectively. While not as low as in March, valuations in April and May still provided attractive relative levels, and we added to positions when the market presented us the opportunity to do so.

30-Jun-20 Quality Valuation
Share
Price		 Projected
ROE (%)		 Financial
Leverage (x)		 Normalized
P/E (x)		 P/B (x) % of
Portfolio
Ryanair 66.34 20 2.4 13.3 2.7 1.02
Copa Airlines 50.56 15 2.2 7.2 1.1 1.01
Carnival 9.86 11 1.9 3.3 0.4 0.89
MSCI EAFE Index 11 2.8 13.9 1.5

By end of June, decelerating growth rates of COVID-19 were realized in many regions with stay-at-home measures being relaxed in a number of countries. While global concern for a second COVID-19 wave remains present, the gradual reopening of economies provided airlines and cruise lines with a better sense of timing around an eventual return to a meaningful level of business.

Over the course of their respective histories, Ryanair, Copa Airlines and Carnival have each faced meaningful idiosyncratic and industry-wide challenges, testing management’s skill in navigating through the storms. Impressively, each company has demonstrated an ability to not only survive these headwinds, but have come through even stronger as a result. While we cannot predict when these companies will return to full capacity and at what pace, we believe each represents distinct competitive advantages, coupled with a strong balance sheet and remain attractively valued.

This information is intended to provide insight into our disciplined investment process, consistently applied across all portfolios. Holdings examples may not apply across all accounts. Data is “as of” the date indicated and should not be relied upon as a complete or current listing of holdings (or top holdings) of the Representative Account. Holdings are subject to change without notice, and may not represent current or future portfolio composition.

The opinions, estimates and views expressed are on behalf of Sprucegrove, constitute Sprucegrove’s best judgement as of the date of this document and are subject to change at any time based on market or other conditions. Sprucegrove does not guarantee the accuracy, adequacy or completeness of any third party data. Any predictions, opinions, and other information contained in this report are subject to change and without notice of any kind and may no longer be true and accurate after the date this report was first completed and disseminated. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. In addition, any forecasts are based upon subjective estimates and assumptions about circumstances and events that may not yet have taken place or may never do so. While the information set out in this document has been prepared in good faith, no representation or warranty is given, and no responsibility is accepted, by Sprucegrove in relation to its accuracy or completeness.

The information provided herein should not be considered a recommendation to purchase or sell any particular security. The securities discussed herein are examples of Sprucegrove’s investment approach but do not represent an entire portfolio or the performance of a fund or strategy and in the aggregate may represent only a small percentage of portfolio holdings. It should not be assumed that any of the securities discussed herein were or will prove to be profitable, or that the investment recommendations or decisions made by Sprucegrove in the future will be profitable.

Any index information provided is for illustrative purposes only and is not intended to imply past or future performance. Please note an investor cannot invest directly in an index. Unless otherwise noted, index returns reflect the reinvestment of income and dividends, if any, but do not reflect fees, brokerage commissions or other expenses of investing.

The MSCI data is comprised of a custom index calculated by MSCI for, and as requested by, Sprucegrove. The MSCI data is for internal use only and may not be redistributed or used in connection with creating or offering and securities, financial products or indices. Neither MSCI nor any other third party involved in or related to compiling, computing or creating the MSCI data (the “MSCI Parties”) makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and the MSCI Parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to such data. Without limiting any of the foregoing, in no event shall any of the MSCI Parties have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. [www.msci.com)

This material is for informational purposes only to provide general information and is not meant to be legal or tax advice for any particular investor, which can only be provided by qualified tax and legal counsel. Please read the constating documents carefully prior to investing. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal, and tax professionals before making any investments.

All data is in U.S. dollars, unless otherwise noted. Past performance is no guarantee of future results.

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