Precision Castparts uppköpt


In my previous letter I wrote about how much I liked our new investment, Precision Castparts (PCP). It seems that I was not the only one enamoured by the company and the price because ten days later Berkshire Hathaway (the holding company run by Warren Buffett) offered to buy the whole company for a price approximately 10% above what we paid. It is Berkshire’s largest investment ever. 

It might seem like good news I must say that I am not entirely happy. A 10% return over a couple of weeks is of course not bad, but I think that the returns would have been much higher if we would have owned PCP for another couple of years. Luckily, we can find some comfort in the fact that we will continue to own PCP through our investment in Berkshire. 

Rolls Royce


Rolls Royce (RR) makes engines to the aerospace, marine and industrial markets. (The namesake car manufacturer is a separate company owned by BMW.) RR has two divisions: one selling jet engines and services to civil and defence aerospace customers and another selling engines and power solutions to marine and industrial customers. The aerospace business is the most important, representing c. 75% of profits. 

Selling jet engines is an interesting business, in some ways similar to selling razors. When you buy a Gillette razor they are very cheap. It is when you need razor blades that it starts to cost you.  The benefit for Gillette is that once you have decided to use their razor they will sell you all the blades since no one else is allowed to. RR does the same but with jet engines. They sell the engines cheap, so cheap that they actually loose money doing it. But then they add a service contract to the deal that lasts for 10-15 years. The services and spare parts revenues on an engine are more than four times bigger than the price of the engine. Profits in the aftermarket are high and makes up the initial loss many times over. 

RR recently appointed Warren East as CEO. This is great because the previous CEO was not very good and Warren seems to be. During his 12-year tenure as CEO of ARM (a competitor to Intel) he increased the earnings per share with 15% per year. That said ARM did benefit from the tremendous growth of the smartphone market where they became a leading supplier, so there was a component of luck. But as Ingemar Stenmark used to say: “the more I train, the more lucky I seem to get”. Besides being a good operator Warren was a great capital allocator during his years at ARM, and that is equally important. 

What did we pay for this gem then? Not much. We paid around 10 times operating profit for a company that will, based on the current order book, double its profit the next five years. RR deserves (and has historically had) a higher multiple. As an additional upside, it is not unlikely that the new management might increase the margins of the business a couple of percentage points. General Electric, RR's largest competitor, has double the margins and there are several simple things that RR could do to catch up with them. 

I see limited risk of us losing any money in this investment. It is a conservatively financed company with a clear growth path. If the worst would happen and an external event would lead to large order cancellations RR will still grow revenue. Even a highly unlikely 50% cancellation rate should give us a return that is higher what we can expect in the general stock market.

RR is a great example of the market's short-sightedness and Pandium's edge in being able to invest long-term. We know that the company will sell around 4,000 engines the next ten years and that most of those engines will give RR a long valuable service contract. Although this is publicly available information, the market has reacted to a couple of short-term profit warnings as if the RR model is broken. So despite the fact that RR's future has never looked brighter the stock has gone from GBP 12.70 to GBP 7.00. Just by being one of few investors that care more about the earnings five years from now than this year’s we are able to buy this high quality company at a bargain price. 

Investerar i Precision Castparts


Since the start of the Fund I have looked at a couple of hundred companies, most of which have been either too bad or too expensive. If a company is good but too expensive I put it on a watchlist and wait for the price to go down. That paid off during the second quarter when the market became more volatile and we were able to make a couple of investments. Thank you Mr Tsipras!  

Precision Castparts Corp

One of the investments is a high quality business with a great management that we bought at a discount. US-based Precision Castparts (PCP) is a diversified manufacturer of metal components and products. The company is one of only a few that can manufacture certain highly complex components (used in aircraft jet engines and power turbines) that maintain their functionality under extreme temperatures and conditions.

The main reason PCP is such a good business is that once a customer has decided to use PCP’s products they are very unlikely to switch to another producer given the high costs of doing so.[1] So, once PCP has become part of a new airplane model they have a long runway of revenue ahead of them. For example, PCP has had a relationship with their largest customers GE since 1967.

Recently PCP has increased their revenue per aircraft, in some cases with up to 2-3 times. That combined with the fact that Airbus and Boeing together have an order book of ca. 12,000 aircrafts, representing ca. 9 years’ production makes me quite certain that PCP has good prospects going forward.

PCP is run by the great Mark Donegan. He is obsessed with improving efficiency, lowering costs and serving customers, which is reflected by the results. Since he took over as CEO in 2002 operating margin has grown from 14% to 28% while sales have grown from USD 2.5 billion to USD 10 billion. Not only is Mark great in generating cash, he is also very good at spending that cash wisely. (Cash flow that is wasted on stupid investments is not worth much.) For the period 2003-2014 Mark has increased the value per share three times for every dollar he has retained, which is impressive.[2]

PCP is a great company being priced as an average one. At a price-to-cashflow multiple of around 16 it might not look cheap, but it is. First of all, PCP deserves a higher multiple than the market since it is a higher quality business. Second, we have very good visibility into the future revenues and they will continue to grow. Third, I think margins will improve going forward.[3] Fourth, PCP will buy back around USD 2 billion worth of shares during the next 18 months. Combined, those factors make me believe that PCP can grow earnings per share in the mid teens for the next couple of years. As an extra bonus, smart acquisitions might additional value, although I have not included in my case.  

[1] The process of being incorporated into an airplane or jet engine is long, requires deep technical expertise and is surrounded by red tape in the form of regulatory requirements. The main concern of the manufacturer is to ensure that the machine works and they will not replace an established supplier unless they absolutely have no choice. 

[2] For every dollar of profit a company make the management has the choice to either return it to the shareholders (in the form of dividend) or to re-invest it into the business. The choice should depend on what opportunities the management has to re-invest it profitably. If expected returns are not high enough the profit should be returned to the shareholders. Many CEOs do not follow this simple rule which leads to that a dollar of profit becomes worth less than a dollar a couple of years later. 

[3] Just improving the performance of some recent acquisitions would be enough.

WL Ross Holdings


WL Ross Holdings (WLRH) is a Special Purpose Acquisition Company (SPAC). A SPAC is a publicly traded company that raises money in order to pursue the acquisition of a company (that has not yet been identified). The funds are kept in a bank account until an acquisition target has been found.

In general I do not find SPACs interesting. The reason is that expenses and fees often run high and the acquisitions are not seldom value destroying. But WLRH differs from most SPACs in two important ways. First, it is managed by Wilbur Ross, probably the most successful bankruptcy and distressed asset investor there is. During his long career he has proven to be both competent and honest. Second, once WLRH has found a company to acquire the shareholders will get the option to either participate in the transaction or to be redeemed at $10.00 per share. Since the Fund paid less then $10.00 it means that if we decide to not participate we will get interest on our money. So if Wilbur finds a good investment we get to participate in the potential upside and if he does not or we do not like the target we can get our money back with interest. So, it is heads we win, tails we do not loose.

Oil turmoil


As you know I am not a top-down investor but the decline in oil price during 2014 deserves a comment. The price per barrel of oil went from $110.8 to $58.2, a 47% decline. Few experts saw it coming and now no one can explain why it happened. (Although that has not stopped them from guessing.) The reason I bring this up is to reaffirm my case for avoiding all companies whose success or survival is dependent on macro-economic factors, like e.g. oil price or iron ore price. It is not difficult figuring out that if your revenues get cut in half while your costs are the same, you will get into trouble. I sleep better at night knowing that the Fund’s value will not depend on the supply and demand complexities of some commodity.

Investerar i Vivendi


Vivendi (VIV) is a French media conglomerate. Its main assets are Universal Music Group (UMG) and Canal+ Group. UMG is the world’s largest music label and Canal+ is a French television and movie studio and distributor. Vivendi also owns stakes in e.g. Numericable, Telefonica, Telecom Italia, Activision Blizzard and some other smaller companies.

VIV has not been performing well for the last 10 years. It has owned a lot of valuable assets but nothing has been done to realize the value. But that is changing. In 2012 Vincent Bolloré took a 5% position in the company and joined the Supervisory board. Vincent is a French investor with a history of restructuring poorly performing businesses. Since his entry VIV has changed their strategy to focus on its media assets and subsequently sold off non-core assets worth c. $35 billion.

A sum-of-the-parts valuation of VIV would indicate that it is worth closer to €30 per share compared to a price of below €20 when the Fund bought it.  There is also some additional upside in the case. For example, once streaming becomes a larger share of music sales, UMG’s profits should increase substantially. (Streaming generates both higher revenues and higher profit margins to the music labels compared to physical sales and digital downloads. Compared to digital sales streaming could give an EBITDA contribution that is 2-3x larger.) Should this happen the value of VIV would increase another 10-15%. A potential spin-off of UMG could also further highlight the value of the different parts. In terms of downside, I think it is limited. VIV has strong positions in stable industries, a solid balance sheet and properly incentivized decision makers.

Berkshire Hathaway


BRK was the first investment I did for the Fund. So far it has been the most successful, gaining 44% this year (including currency effects).

BRK is a holding company run by the 84-year old Warren Buffett. BRK is a diverse collection of listed and non-listed businesses in various industries such as insurance and reinsurance, freight rail transportation, finance, manufacturing, services and retailing. Most of these businesses have superior managements, strong competitive advantages and operate in stable industries.

Warren probably needs no introduction. He is rightfully regarded as one of the best investors of all time. If you had invested $10,000 with Warren in 1957 when he started his partnership the value of your shares would be worth about $630 million today. (For the period ending December 31, 2014. Assuming that you would move the money from the Buffett Partnership to Berkshire when he closed the partnership.) Putting the same amount of money into an US index had given you about $2.7 million. A pretty decent track record to say the least.

The investment thesis was simple. BRK was, and still is, slightly undervalued compared to its intrinsic value and I think it is likely that the value will compound faster than the general market in the future. When we purchased BRK it had $129,000 in cash and investments per share and the operating business produced $9,100 in pre-tax earnings per share. Applying a 10x multiple on the earnings I estimated the value per share to be $220,000, or c. 20% above to the share price at the time. Since then the value of BRK has increased but not as much as the share price, leading to a smaller discount today. For an average company the current discount would not be enough, but BRK is not average. The margin of safety in BRK lies in its ability to continue compounding its value at an above average rate over time.

Given Warren’s importance and age an important question is: what will happen when he is no longer around? I am not too concerned about it, and here is why:

  1. The current valuation does not include a Buffett premium so his death should not lower the value of the company.
  2. There is a succession plan. Warren’s job will be split into three: chairman, chief executive and chief investment officer and he has told the board of directors who he recommends. Given his track record of judging people I am confident that the managers replacing him will do a superb job. The two investment managers, Ted Weschler and Todd Combs, that Buffett has hired have already proven to be great. Their portfolios have even outperformed Warren’s.
  3. The culture and people. Warren has spent the last 50 years collecting great businesses and great people. BRK is filled with high quality people that share the BRK values. This enables Warren to give the managers of the subsidiaries almost complete autonomy, since he can trust that they will do what is best. (An indicator of BRK’s decentralization is that there are only 25 employees in the BRK head office. That is not much for a company employing 330,000 people.) The benefit of a strong culture is that once it is in place, it maintains itself by only attracting and keeping people that fit it. When Warren is gone, the culture and people will remain.
  4. The competitive advantages of the companies that BRK already owns are generally strong. Most of them will continue to compound their value with or without Warren. There is a saying that “the best business is one that even an idiot can run, because sooner or later, one will”. BRK has a lot of such businesses.

That said, Berkshire will lose Warren’s network and reputation. Berkshire will probably not to be able to do the kind of favorable deals it did during the financial crisis, when it served as a stamp of quality and safety to various companies. (During the crisis, BRK lent money to and invested in companies such as Goldman Sachs, Mars, General Electric and Bank of America. BRK was asked to invest to provide liquidity but equally important to show the market that the companies were safe and strong. ) But then again, that is not required for this investment to work out well.