Uncertainty Creates Opportunity

by | Mar 31, 2020

The first quarter of 2020 marked the abrupt end to the longest bull market in history triggered by the fallout from the COVID-19 virus epidemic. Concerns about the magnitude of a global economic recession have led to an unprecedented level of uncertainty. The resulting market volatility and broad based selloff have provided a unique opportunity for us to invest in companies whose valuations are at levels not seen since the Financial Crisis in some cases. Sprucegrove has always worked tirelessly and consistently to develop a proprietary Working List of investable ideas akin to a wish list of high quality companies we endeavor to acquire at attractive valuations. We are now capitalizing on these opportunities, some for the first time.

The initiation of eight names in the first quarter of 2020 is indicative of this. Putting this in context, there were a total of four new names for all of 2019. We have also been more active than usual, adding to existing positions as valuations reach bargain levels. Our trading remains incremental, thereby reducing entry point timing risk in such volatile markets. The economic environment will remain challenging this year and now more than ever, we believe the quality criteria we seek in our companies will be critical. This includes: a record of above average and consistent profitability, sustainable competitive advantages and importantly a strong financial position. We expect companies selected based on these criteria to not only survive the downturn but to also take advantage of a subsequent recovery. Throughout our history and as long term value investors, we have always viewed periods of uncertainty as providing opportunities to further improve the quality of the portfolio and our approach is no different this time. We believe the actions we are taking today will contribute positively to performance over the next cycle.

A brief description of each new portfolio holding is provided below.

AIN Holdings is the largest pharmacy operator in Japan with over 1,100 dispensaries. As the largest purchaser of generic drugs in Japan, AIN’s scale enables them to secure more favorable pricing from drug wholesalers. Their scale also enables them to better navigate ongoing changes to government policy pertaining to pharmacy services as they are able to hire and train a larger pool of pharmacists. The company has delivered a consistent record of profitability with ROE averaging 14% over the past decade. Growth prospects remain attractive given the fragmented nature of the market, aging demographics, the expanding role of pharmacists in their health care system and the opportunity to open on-site hospital pharmacies. Management has positioned the business well to take advantage of the opportunities given their strong balance sheet.

Ambev is the world’s third largest brewer with dominant market shares in Brazil (over 65% market share), its largest market accounting for over half of sales, as well as Argentina (over 60% market share), the Dominican Republic (over 70% market share) and Canada (over 40% market share). The company’s impressive portfolio of brands includes local Brazilian beers Skol, Brahma and Antarctica as well as the exclusive rights to global beers (of its parent AB Inbev ) such as Budweiser, Stella Artois and Corona. Scale in distribution and shrewd cost control have led to operating margins of 39% and ROEs of 28% over the last ten years. It has a strong balance sheet with a net cash position. Looking ahead, it is positioned to benefit from growing annual per capita beer consumption and premiumization in most of its markets. We met with the company back in 2017 when visiting with companies in Brazil and a formal report was completed in 2018. This allowed us to to take advantage of the significant drop in valuations recently to initiate a position in the name.

Check Point Software is a leading global cybersecurity solutions provider to corporate enterprises and governments with demanding security needs. Thanks to its strong reputation, access to high quality technical talent, and a large, sticky customer installed base, the company has generated a high and consistent level of profitability. Over the last 10 years, its operating margins have averaged 50% and its ROE has averaged 19%. It has an excellent balance sheet with a net cash position. Looking ahead, growth is expected to come from an increased demand for cybersecurity solutions as customers increasingly utilize cloud-based applications and infrastructure. Check Point Software is a name we have followed informally as valuations remained elevated. Our detailed analysis of the firm was completed in 2019 and we have now capitalized when the opportunity presented itself given the market volatility in the first quarter of this year.

FANUC is a global leader in industrial factory automation equipment. Their success can be traced back to their longstanding dominance (approximately 50% market share) in computer numeric control (CNC) equipment. These CNC systems control the precision, function and overall performance of machine tools and industrial robots in which they also enjoy a leadership position (approximately 20% market share). The company stands out for its high level of profitability, low-cost production, exceptionally strong balance sheet and reputation for building reliable and easy-to-use products. Operating margins have averaged 34% and ROE has averaged nearly 12% despite holding over 40% of their assets in cash. Structural themes such as wage inflation, productivity, and supply chain efficiency are driving the long-term demand in automation. FANUC is a name we have followed since Sprucegrove’s founding in 1993. This is one of the best examples of Sprucegrove’s ability to consistently take advantage of market uncertainty. We were unable to own FANUC despite following it for 22 years, due to its premium valuation, until an opportunity availed itself during the Financial Crisis in 2008. We eliminated the name in 2012 for valuation reasons. The COVID-19 crisis has now presented us with a second opportunity to build a position in this name.

Housing Development Finance Corp Ltd (HDFC) is the largest housing finance company in India. Its primary business is providing mortgages to consumers where it has a strong and multi-decade underwriting track record in an underpenetrated loan category. Other key strengths are its wide distribution network and its reputation for excellent customer service. Further to its core business, HDFC also has several other financial subsidiaries that include HDFC Bank and various insurance operations. The company’s record is impressive with ROEs averaging 21% over the past decade. The balance sheet is well-capitalized, has a diversified funding mix, and high asset quality. The long-standing management team is conservative and shareholder friendly. We first met with HDFC Ltd in 2004. By 2005, we had written a basic report and added it to our Working List. Since that time, shares have typically traded at a premium, but we have been patient. While we have waited, we have continued to research the company and its subsidiaries. In addition to a detailed update in 2018, we wrote a basic report on HDFC Bank, its largest subsidiary, in the same year and we met with HDFC Life in 2019. The recent market sell-off in addition to ongoing challenges in India’s financial sector have pulled down HDFC’s share price. We were thus able to buy HDFC’s shares at attractive valuations.

Johnson Matthey is a global materials science leader focused on using platinum group metals for auto and truck catalyst systems to reduce vehicle emissions, more efficient chemicals processing and as active pharmaceutical ingredients in new and generic drugs. The company’s competitive strength lies in its technology and process leadership around precious metals, catalysts and fine chemicals. Growth opportunities stem from the long-term demand for cleaner air and tighter emission standards, more efficient chemicals manufacturing, new medicines and the development of new battery materials for electric vehicles. The company has a record of high profitability with ROE averaging 17% over the last decade and benefits from a strong financial position. Johnson Matthey has been on our Working List since 2002. We owned it from 2003-2012 and was eliminated at that time for valuation reasons.

Maruti Suzuki is the dominant auto manufacturer in India with a market share of approximately 50%. Maruti stands out for their scale, dominance in mini to small-sized vehicles, trusted brand, a high degree of localization and the most expansive distribution network in the country. Maruti has generated a high and consistent level of profitability with operating margins of 10% and ROEs of 18% over the last decade. The company has a pristine balance sheet with virtually no debt and management has successfully pushed back foreign OEMs who have sought to enter their smaller car market segment. Looking forward, growth is expected to come as incomes rise in India and vehicle penetration rates grow. Maruti is a company that we have followed and met with over the past 15 years. A formal due diligence was completed on Maruti Suzuki in 2017. The conclusion was an excellent company but expensive at the time. The COVID-19 panademic concerns in India allowed us to initiate a position at reasonable multiples.

Zee Entertainment is India’s largest content creator and TV broadcaster. It stands out amongst peers as a pan-Indian operator with 41 channels broadcasting movies, television series and music across 10 Indian languages. Its sustained leadership ratings across several regions makes it an attractive partner to advertisers and allows it to better monetize content by adapting it across languages. Growth prospects remain attractive given the low penetration of cable-TV and internet within India, allowing the company to grow its traditional broadcasting business while making investments in its digital streaming platform. The company has a long record of profitability with ROE averaging 19% over last decade coupled with a strong balance sheet.

As summarized in the Transaction Summary section of this report, each of these companies are leaders in their respective fields, and we believe they are great additions to the Fund. We did eliminate certain holdings that were not as compelling as these aforementioned entities, either due to higher relative valuations or less robust economic moats in this evolving environment, resulting in upgrading the portfolio from a quality perspective.

Company Sector Country Mkt.
P/B Div.
D Bn
(%) (x) (x) (x) (%)
AIN Holdings Consumer Staples Japan 2.1 14.0 1.8 13.9 2.0 0.9
Ambev Consumer Staples Brazil 36.2 24.0 1.7 12.5 3.0 5.7
Check Point Software Information Technology Israel 14.6 22.0 1.6 16.4 3.6 0.0
FANUC Industrials Japan 27.7 13.0 1.1 15.1 2.0 2.6
HDFC Financials India 37.5 18.0 6.0 12.5 2.3 1.3
Johnson Matthey Materials United Kingdom 4.3 15.0 2.3 12.6 1.9 4.8
Maruti Suzuki Consumer Discretionary India 17.2 18.0 1.4 16.6 3.0 1.9
Zee Entertainment Communication Services India 1.6 18.0 1.5 11.2 2.0 2.8
MSCI EAFE 11.0 2.7 12.0 1.3 4.1
All figures are representative of prevailing prices and exchange rates during buying period.


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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