Silver Ring Value Partners Q1 2023 Letter

courtneyk

Dear Partners:

I hope that you are doing well. It continues to be a challenging environment for me to find compelling new investments that combine both business quality and a margin of safety in the form of a large gap between price and intrinsic value. This isn't a top-down statement about the market. It's the result of examining many potential candidates, casting a wide net, and still not being able to find anything attractive enough to add to our portfolio.

In the last letter I wrote to you that I found a small group of promising candidates. While I am still doing research on some of them, none have proved as attractive as I initially hoped. I would be much happier writing to you that I found plenty of new ideas to invest in. I am as eager as any of you to deploy our capital on attractive terms. However, what I am not going to do is to force the action and compromise on either quality or price. Doing so would be a good way to lose our money.

Warren Buffett in his 2022 annual letter to Berkshire Hathaway shareholders wrote that over Berkshire's 60 years, about a dozen investments accounted for almost all of the excess returns. The rest of his investments did not contribute much to Berkshire's returns as a group. That's one investment every 5 years.

Please rest assured that I am not somehow unusually risk-averse and unable to commit capital when the opportunities are there. I have done so plenty of times in my 20+ year investment career. I have also learned to trust my judgement and not to lower my standards when I can't find anything that clears the hurdle. Instead, I use it to motivate myself to look harder, but not to act faster.

The good news is that the math of waiting, which I lay out later in this letter, is quite forgiving of patience. That math is not at all forgiving of large permanent capital losses.

We had one new partner join us in Q1. The partnership is open to long-term investors who want to safely compound their capital at attractive rates, and who use process rather than outcome to measure short-term progress.

I made the following change to the portfolio during Q1 2023:

• Exited the Apple (AAPL) put options position, as I came to the conclusion that I was wrong about the degree to which the stock is overvalued. While I still believe it's optimistically priced, the fundamentals over the last few years made me believe that my initial decision to buy the put options was wrong

The Math of Waiting to Invest

The "Too Long, Didn't Read" version is this: if you wait to invest, your likely range of outcomes is between slightly below-average and very good. If you force yourself to invest and end up making a typical sized mistake, you could lose a good portion of your capital. Let me show you the math.

Currently, the ~1,000 quality companies that I described as my hunting ground in the last letter are trading at an average normalized forward Free Cash Flow (FCF) yield of 4% to 4.5%. I give a range because without doing the work on all individual companies it's hard to know exactly how much to penalize the FCF over the last 5 to 10 years for a lack of a real economic recession. If we assume that this universe grows FCF at about 5%, a typical historical growth rate, this would imply about a ~9% Internal Rate of Return (IRR) from buying this group of companies.

So, let's compare the following scenarios:

As you can see, with these assumptions, at worst we do slightly worse than we could have done by investing right away, but have a very decent chance of doing much better despite waiting a whole 3 years. In practice, I don't think the whole 3 years is likely to be needed, as good ideas historically have come more frequently than that, but I wanted to use that waiting period to illustrate the point.

Let's say however, that we think ourselves to be Mr. Stock Pickens McPickens. McPickens doesn't need to settle for mere group-average returns of 9%. He is one insightful hombre, and he is going to find that winning stock even in a tough market. That's what he is paid to do, darn it!

Maybe. Or maybe McPickens makes a mistake. In his desire to find high returns and look smarter than his peers, he gets too clever for his own good.

Let's say he buys a quality company at the average FCF yield of 4.5% that is available today. McPickens has a very fancy argument, supported by reams of data and lots of field research that makes him believe this is a high-growth business. A compounder, perhaps the next Costco or Amazon!

Except that such companies are exceedingly rare. So, let's say that this time the market got the better of McPickens, and he was actually a bit too optimistic on the starting FCF of the business. Perhaps he didn't fully appreciate the cyclical boost to current profits. Also let's assume that while the business he picked is still quite good, it ended up being mature and couldn't generate much more than low single-digit future growth. That is the growth of a typical mature business, after all.

So what would McPickens’ visionary bravery do to the capital he invested if he were wrong?

He would lose 50% of his money.

By the way, while McPickens is not a real person, he is inspired by my voracious reading of many investors’ letters and investment theses. And perhaps by some of my own McPickens-like mistakes of the past. In investing, experience needs to build both confidence and humility. The former without the latter is just unwarranted hubris.

O-I Glass (OI)

The company has been consistently exceeding expectations. Most recently, management raised EPS guidance for 2023 to a range of $3 to $3.50, up from previous guidance of $2.50+. What are some possible concerns by the market that account for a price which still values the company at 7x the low end of expected earnings for this year?

Given the above, I expect one of the following scenarios to play out over the next few years:

Garrett Motion (GTXAP)

As a reminder, the convertible preferred stock that we own was a security that came about as a result of the bankruptcy process. Unlike most preferred stocks, which are issued to benefit the seller, and which are usually structurally unattractive securities, this security was structured under duress to benefit the buyers. As a result, it has the best of both worlds – strong downside protection and full upside participation with the equity.

Alas, all good things eventually come to an end. The preferred stock was never meant to be a permanent security, but rather a bridge to better days for the company, when the intent was always to convert it to common equity. With the company on the threshold of hitting the profitability metrics at which the preferred would have converted to equity, the board struck a deal with the major holders of the preferred to proceed with the conversion.

We will receive our accrued dividends, some in cash and some in the form of additional shares, and one share of common equity for each share of the preferred. I view this as a negative development for us, since the downside protection of the preferred would come in handy in case of a severe recession, which is a possibility at this point. Now owners of the convert will not have the extra protection as the economy enters a likely recession. Given the above, I intend to re-think the position sizing once the conversion occurs to make sure it's consistent with the new risk/reward.

Aimia (AIM CN)

Aimia is a holding company managed by value investors which is undergoing an asset conversion. Having sold its minority stake in the Aero Mexico miles loyalty program last year, the plan was to deploy the proceeds into good operating businesses at an attractive price. This would also allow the company to utilize its substantial NOLs.

This year the company announced that it has agreed to buy two businesses. Tuffropes is an Indian family-owned company which manufactures specialty ropes and netting for the marine industry. Bozzetto is a European specialty chemicals business. In both cases, management partnered with the same private equity firm which sourced the ideas and which will receive a percentage of the profits above an 8% growth rate in profits.

Many investors seem to be unhappy with these transactions. Reasons cited include the heightened risk of acquiring foreign companies, having to give up a portion of the economics to the private equity firm, the fact that multiples of profits paid for the acquired businesses weren't particularly low, insufficient disclosure about the historical economics of the acquired companies, general frustration that the stock hasn't done well and that management didn't just return its ample capital to the shareholders.

It's easy to start letting emotions drive the narrative when the stock hasn't been performing as investors had hoped. I would wager that if the stock were trading at 2x its current levels, which is closer to my estimate of its intrinsic value, there would be far fewer complaints. However, I do share some of the concerns and wanted to share my view on the company's transformation and where it leaves the shares as an investment at current prices.

I agree that the historical financial performance disclosure of the acquired businesses is insufficient, and I have shared my concerns with the management. I am also not thrilled to be sharing future business economics with a PE firm. However, in both cases the company was able to avoid an auction, so perhaps the PE firm did add some value. The ultimate measurement of success will be based on the returns the company will earn on its capital employed in these two transactions, not based on how they were found or structured.

My estimate is that the two businesses being acquired together will generate normalized operating income that will slightly exceed the sum of corporate costs, preferred dividends and the interest expense on the non-recourse subsidiary-level debt that the company intends to obtain shortly after the transactions close.

Assuming everything goes according to plan, this should leave the company with the following:

What can go wrong?

In thinking about the worst case scenario for my intrinsic value estimate, I made the following assumptions:

The result is my Worst Case value estimate in the low CAD 3s, not far from where the current stock price is trading. I am not oblivious to the risk that things might not go the way that management expects. However, given my analysis that there is limited long-term downside to my worst case value and that the stock is trading at less than half of my base case value, I am maintaining our medium-sized position.

I encourage you to consider the results summarized below in conjunction with both the investment thesis tracker as well as the discussion of the individual companies in this letter. Any investment approach that is judged over less than a full economic and market cycle is liable to appear better than and worse than it really deserves at different points. Ultimately, it is the quality of the investment process and the discipline with which it is implemented that determines the long-term outcome. Therefore, I strongly encourage you to focus on process over outcome in the short term.

* Performance fee is presented based on the 20% rate, which reflected the majority of the assets during these time periods

** Option-Adjusted Net Exposure adjusts for the use of options by replacing their weight with the delta-adjusted notional value for each option. While imperfect, it takes into account both the use of put option hedges and the presence of call options

Disclaimers: Please see the "Disclaimers" section at the end of this letter

As I have committed to do in the Owner's Manual, I will use these letters to provide answers to questions that I receive when I believe the answers to be of interest to all of the partners. This quarter I received one question that I wanted to answer for everyone's benefit. Please keep the questions coming; I will do my best to address them fully.

I really enjoy the articles that you publish, but doesn't writing them take time away from you doing research on stocks?

This came to me from a business acquaintance who is not involved with the partnership, but I thought it relevant to address it here nonetheless. First, my writing doesn't come at the expense of research as I prioritize investing over other activities. So why do I write?

There are three reasons:

The first two are self-explanatory, so let me dive in to the third reason, marketing. I used to think of marketing as a dirty word. Something to be ashamed of. It took me a while, but I finally understood why I felt that way, and also why it's the wrong mindset.

For much of the investment management industry marketing is quite a dirty part of the business. Why? Let's examine how the industry typically does marketing. The thing I want you to pay attention to is how in these cases it's done with an almost adversarial mentality of the customer as someone to profit from rather than to help.

Industry Marketing Strategy #1: The field of a hundred funds blooming.

This one works as follows: a mutual fund complex launches 100 funds. Five have standout 1 to 3 year results, so the marketing apparatus sells the heck out of those to unsuspecting customers. When the inevitable reversion to the mean (mean being equal to market returns less fees) occurs, they find another five funds to market in the same fashion.

The hope is to always keep bringing in new customers, and to try to minimize the churn among the disappointed ones by keeping them within the mutual fund complex and selling them the new "fund of the year." Hopefully you can see how this ends: customers make a return that's equal to roughly market minus fees, and the mutual fund complex skims its 0.5% to 1% off the top for no value added. Where are the customer's yachts, indeed.

Industry Marketing Strategy #2: Shooting star

A hot-shot hedge fund manager launches a modest-sized fund. He sits relatively quietly until he hits a stretch of 2-3 years of great returns. Perhaps he even invests in a way to take large risks to achieve the possibility of big gains that he can market. Perhaps not and he is simply waiting for positive randomness, it doesn't matter.

Having hit the lucky streak, he goes on a marketing rampage. Of course, he supplements the amazing recent results with a narrative. Nothing sells like a story about the "special sauce" that he uses to produce these amazing results. The performance-chasing customers pile in, just in time for the reversion to the mean. The result is that on an asset-weighted basis his customers have a result ranging from terrible to mediocre, whereas the manager makes a killing for himself. Ouch.

Industry Marketing Strategy #3: Don't think for yourself

This is done by marketing ninjas skilled in the black arts of behavioral persuasion. It usually involves some combination of the following:

Social Proof – "Did you know that [big name XYZ] invested with us?"

Scarcity – "This is only available for the next 2 months, closing the fund soon, we are so successful."

Group Affinity – "Trust us, we are part of the same group."

Reciprocity – "We like you, now like us back."

Switch The Question – "Don't answer whether you think we will do well with your investments, answer a different question, such as do you like us, are we well dressed and look the part, etc?"

The point of all of this is for you to stop using the rational part of your brain and to switch to the "reptilian" brain which uses short-cuts that favor the persuader to get the prospects to make quick decisions.

What do all of these methods have in common? The customer is the "mark" that exists primarily to provide wealth to the investment manager. They can't be too smart or thorough in their decision making process, as these tactics work best on those chasing trailing performance and the easily persuadable who make impulsive decisions. Sadly, there seems to be no shortage of customers who fit these characteristics and fall for these tactics.

Almost a quarter century ago I took the Investments class at the Sloan School of Management at MIT with Ken French, of the Eugene Fama and Ken French academic fame. In it, Professor French asked us how long did we think it would take for a typical mutual fund to generate a record of beating the market that we can have 90% confidence in being skill as opposed to luck. The guesses ranged from 3 to 7 years. He then derived the answer on the board – it was about 12 years.

The industry focuses on 3-year, and maybe occasionally on 5-year results. So do the famous Morningstar "stars." These lengths of time have almost no statistical significance. That's why studies have shown that Morningstar "stars" have little to no predictive power in selecting fund managers who will outperform the market in the future.

Why does the industry act this way? Two simple reasons: it's very profitable and they don't have many impressive 12+ year performance records. So, the next time someone talks to you about their 1, 3 or 5-year results as a primary reason to invest, replace the words they are using with the phrase "we think that you are gullible and are an easy mark to make some money off of." Then act accordingly.

Let's come back to what I am trying to accomplish with respect to marketing by writing:

What I described does not scale. It would not work at a large investment firm – that's why I left that world. It's not the path to the highest personal net worth – that's not my goal. Instead, I am fortunate to be able to practice my craft with a group of likeminded partners that I enjoy interacting with and who make my job easier.

We are a small tribe of people who think about investing rationally through the lens of measuring process over the long-term rather than results over the short-term. I hope to slowly grow our tribe over time, but never at the risk of allowing the wrong people inside. It's just not worth it.

I track a number of metrics for the portfolio to help me better understand it and manage risk. I track these both at a given point in time, and as a time series to analyze how the portfolio has changed over time to make sure that it is invested in the way that I intend for it to be. Below I share a number of these metrics, what each means, and what it can tell us about the portfolio. As time passes, you should be able to refer to these charts and graphs to help you gain deeper insight into how I am applying my process.

Price % Base Case Value

This metric tracks the portfolio's weighted average ratio between market price and my Base Case intrinsic value estimate of each security. This ratio is presented both including cash and equivalents, which are valued at a Price to Value of 100%, and excluding those. All else being equal, the lower these numbers are, the better. Excluding cash and equivalents, a level above 100% would be a red flag, indicating that the portfolio is trading above my estimate of intrinsic value. Levels between 90% and 100% I would characterize as a yellow flag, suggesting that the portfolio is very close to my estimate of value. Levels between 75% and 90% are lukewarm, while levels below 75% are attractive.

Quality Quintiles

As outlined in the Owner's Manual, I evaluate the quality of the Business, the Management and the Balance Sheet as part of my assessment of each company. I grade each on a 5-point scale with 1 meaning Excellent, 2 Above Average, 3 Average, 4 Below Average and 5 Terrible. The chart that follows presents the weighted average for each of the three metrics for the securities in the portfolio.

Portfolio at Risk (PaR)

I estimate the Portfolio at Risk (PaR) of each position by multiplying the weight of each position in the portfolio by the percent downside from the current price to the Worst Case estimate of intrinsic value. This helps me manage the risk of permanent capital loss and size positions appropriately, so that no single security can cause such a material permanent capital loss that the rest of the portfolio, at reasonable rates of return, would not be able to overcome. I typically size positions at purchase to have PaR levels of 5% or lower, and a PaR value of 10% or more at any time would be a red flag. The chart below depicts the PaR values for the securities in the portfolio as of the end of the quarter. Positions are presented including options when applicable.

Normalized Price-to-Earnings (P/E) Ratio

I supplement my intrinsic value estimates, which are based on Discounted Cash Flow (DCF) analysis, with a number of other metrics that I use to make sure that my value estimates make sense. One of the more useful ones is the Normalized P/E ratio. The denominator is my estimate of earnings over the next 12 months, adjusted for any one-time/unsustainable factors, and if necessary adjusted for the cyclical nature of the business to reflect a mid-cycle economic environment. The numerator is adjusted for any excess assets (e.g. excess cash) not used to generate my estimate of normalized earnings. One way to interpret this number is that its inverse represents the rate of return we would receive on our purchase price if earnings remained permanently flat. So a normalized P/E of 10x would be consistent with an expectation of a 10% return. While the future is uncertain, it is typically my goal to invest in businesses whose value is increasing over time. If I am correct in my analysis, our return should exceed the inverse of the normalized P/E ratio over a long period of time. The graph below represents the weighted average normalized P/E for the equities in the portfolio.

Unlike my last letter, the poem below is entirely by yours truly, with no help from any AI-bots. You may hold me completely responsible for what follows:

Rolling Treasury bills isn't fun,

But I would rather our money not be gone.

If we try to be overly clever,

Our capital might be lost forever.

Most mistakes impatience reveal, And an over-abundance of zeal.

We convince ourselves to do acts, When our investment case lacks enough facts.

When a great investment is found, We get a feeling that's rather profound.

We don't need to debate whether it's good, Since it's clearly misunderstood.

I am happy to answer any questions that you have. Your feedback is important to me; please let me know how I can improve future letters. I greatly appreciate your trust and support, and I continue to work diligently to invest our capital.

Sincerely,

Gary Mishuris, CFA, Managing Partner, Chief Investment Officer

Silver Ring Value Partners Limited Partnership

The information contained herein is confidential and is intended solely for the person to whom it has been delivered. It is not to be reproduced, used, distributed or disclosed, in whole or in part, to third parties without the prior written consent of Silver Ring Value Partners Limited Partnership ("SRVP"). The information contained herein is provided solely for informational and discussion purposes only and is not, and may not be relied on in any manner as legal, tax or investment advice or as an offer to sell or a solicitation of an offer to buy an interest in any fund or vehicle managed or advised by SRVP or its affiliates. The information contained herein is not investment advice or a recommendation to buy or sell any specific security.

The views expressed herein are the opinions and projections of SRVP as of March 31st, 2023, and are subject to change based on market and other conditions. SRVP does not represent that any opinion or projection will be realized. The information presented herein, including, but not limited to, SRVP's investment views, returns or performance, investment strategies, market opportunity, portfolio construction, expectations and positions may involve SRVP's views, estimates, assumptions, facts and information from other sources that are believed to be accurate and reliable as of the date this information is presented—any of which may change without notice. SRVP has no obligation (express or implied) to update any or all of the information contained herein or to advise you of any changes; nor does SRVP make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. The information presented is for illustrative purposes only and does not constitute an exhaustive explanation of the investment process, investment strategies or risk management.

The analyses and conclusions of SRVP contained in this information include certain statements, assumptions, estimates and projections that reflect various assumptions by SRVP and anticipated results that are inherently subject to significant economic, competitive, and other uncertainties and contingencies and have been included solely for illustrative purposes.

As with any investment strategy, there is potential for profit as well as the possibility of loss. SRVP does not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk and investment recommendations will not always be profitable. Past performance is no guarantee of future results. Investment returns and principal values of an investment will fluctuate so that an investor's investment may be worth more or less than its original value.

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