Banco Santander Chile is the largest bank in Chile and among its most profitable. When compared to its local peers, it stands out for its best-in-class efficiency ratio of 41% and high return on assets. Its large branch network fuels its deposit gathering ability and thereby provides it with a low funding cost advantage. The bank’s state-of-the-art technology and customer database platforms enable it to provide superior customer service, generate higher fee income and lower operating costs. Meanwhile, BSAC’s astute underwriting practices keep credit costs low. Its superior profitability and risk management results in a high return on equity of 19.2%. Unsurprisingly, it sports a high credit rating of A with a positive outlook by S&P.
The Macro Backdrop
A bank is only as good as the macro-economic and regulatory environment in which it operates. Fortunately, Chile has a reputation for being one of the most business-friendly countries in South America – offering a favorable backdrop that benefits the bank. Economic freedom in the country is accompanied by a rule of law that protects and encourages entrepreneurial activity, investment, and growth. The government is prudent with budgets and actively promotes deregulation and trade. As a result, Chile has one of the highest sovereign debt ratings in the region. The country’s regulators are reliable and independent. The International Monetary Fund deems its banking supervision to be "robust." The political environment is largely stable and business friendly while the economic environment fosters growth.
Of course, even a pretty face can have wrinkles. As a leading exporter of commodities such as copper and lithium ion, Chile is exposed to the vicissitudes of the commodity markets. Falling inflation and net interest margins constrain revenues and earnings, while a weak economy can cause more loan defaults. Not to mention, a small country, however strong, can suffer disproportionately from weakness in large neighboring countries such as Brazil or key trading partners such as China. However, the bank has taken proactive steps to mitigate these challenges. It has effectively segmented its customer base and cross sold fee generating products to offset shrinking interest income. It has capped its loan exposure to copper exporters and avoided risky investment banking activities.
After weighing all aspects of the investment proposition - the good, the bad, and the ugly - we found the deck stacked in favor of Banco Santander Chile. For years we had admired the franchise – its investment in IT, pivot to consumer lending, and ability to generate fee income. That said, lofty expectations and hefty valuations kept us away from the stock.
Luck Favors The Prepared
The opportunity to own its shares came unexpectedly but predictably. When the Brazilian market and currency crashed on the back of an economic and political crisis in 2014-15, other Latin American markets corrected through sheer contagion. Chile was no exception. Banco Santander Chile ADR (BSAC US) fell -40% from its high and its risk/reward became compelling enough for us to own. Since we began accumulating the stock beginning in late 2014, BSAC has been a strong performer, validating our patient and contrarian approach to investing.
Founded in 1912, Illinois Tool Works, Inc. (ITW) makes specialty components and equipment for numerous industrial applications, from automotive manufacturing to commercial food production. Through its engineering expertise and defect-free production, ITW has earned the trust of its customers. The company chooses quality over quantity, growing only where it has a compelling competitive advantage. This gives ITW scale within key niches, which increases barriers to entry and drives excellent long term economics. However, as fears of a trade war have intensified, ITW’s share price has declined this year, providing an opportunity to own this competitively advantaged and diversified firm at prices well below its intrinsic value.
Trade Woes Add to Uncertainty
ITW’s shares have declined since late January, after President Trump brought global trade into focus at the World Economic Forum Annual Meeting in Davos, Switzerland. Manufacturing sentiment is declining, automotive production is slowing, and projects are being delayed in sectors such as semiconductors and chemicals. The end markets in which ITW operates will go through inevitable cycles. Trade tensions add another level of uncertainty. However, our view is that the value of a business to its owners is driven by the value that business provides to its customers. On this basis, ITW’s value to its customers will increase because as its customers innovate, ITW is trusted to solve more complex issues.
The Long Term Opportunity
Uncertainty regarding global automotive trade has obscured the fact that ITW is relied upon by many of the leading automotive manufacturers in China, Europe and the U.S. While automotive production is cyclical, a car’s engineered components consistently increase in complexity and importance. As this occurs, ITW grows market share. While Wall Street is focused on the absolute number of cars and light trucks produced annually, ITW’s value proposition – customized engineering free of defects – is stronger than ever. Solving complexity is also the linchpin of ITW’s 6 non-automotive business segments. At ITW’s scale, the economics of small, consistent gains with customers can be surprisingly attractive.
In addition to our confidence in ITW’s value proposition to its clients, we are also confident that excess profits will be used to pursue only high quality reinvestment opportunities, leaving a substantial surplus that will be returned to shareholders through dividends and repurchases. ITW’s disciplined capital allocation is an important, though difficult to quantify, positive for long-term investors. Also, a rational and shareholder-friendly capital allocation policy allows its management team to act decisively when attractive acquisition opportunities arise. We believe ITW is trading ~17% below our assessment of its intrinsic value and recommend owning it for the long-term.
Based in Seattle, Nordstrom (JWN) is one of the country’s premier retailers. It was founded in 1901 by Swedish immigrant John W. Nordstrom, whose descendants continue to manage the company today. JWN combines best-in-class customer service with seamless integration between its 122 Nordstrom full-line and 242 Nordstrom Rack stores and their respective online storefronts. This high quality shopping experience drives growth amongst a sizable and loyal customer base while also eliminating reliance on promotions. A customer service mentality is ingrained in the company’s corporate culture, which further separates Nordstrom from its competition.
The Digital Party
The rise of internet shopping has increased price transparency and elevated the convenience factor for today’s shoppers. Millennials, now the largest demographic segment in the US, are adept in all things digital, focused on value, and more willing to spend on experiences rather than things. This has placed pressure on the traditional retail ecosystem, which has been late to the digital party. Retail stocks declined as much as -25% between 2015 and 2017. As a mall-based retailer, JWN was certainly not immune to industry headwinds; however, while Amazon and other online-only retailers have disrupted the industry, JWN finds itself on much better footing relative to its peers.
Strategic Focus and Expansion
The customer experience is in JWN’s DNA. What was once characterized by exceptional service, has evolved to address the “what”, “where”, “when”, and “how” of the consumer buying process. JWN carries more exclusive brands such as Top Shop, Madewell, and other on-trend labels. This has led to more full-price selling, a quality that is reflective of only the best retailers. Prudent store growth over the years has the company mainly positioned in the highest quality malls and top US markets, eliminating the need for aggressive store closures. More recently, measured expansion into Canada and NYC has been successful thus far and only enhances the company’s brand and growth profile in the long-term.
One could argue JWN has always been ahead of the curve when it comes to the integration of the internet and the physical store. Nordstrom.com was launched in 1998, well before many competitors offered dedicated websites. Additionally, over the last handful of years, the company has accelerated its omnichannel investments. Besides a robust digital commerce platform, JWN also offers service enhancements such as buy-online-pickup in-store, reserve-online try-in-store, and curbside pickup to name a few. From a profitability standpoint and unlike many of its peers, JWN is agnostic as to whether it sells through its full-line digital or physical store channels – no small feat given the variable nature of shipping costs. Currently, JWN is experimenting with smaller format guide shops in LA, its largest market, in an effort to further localization and enhance its customer experience value proposition.
A Long-Term Perspective
Emerging benefits from these initiatives, coupled with and a now-shelved management buyout, have resulted in strong stock performance. We believe there is further upside from here, especially given our positive view of management and its ability to successfully execute on its strategy going forward.
Stericycle, Inc. offers regulated waste management services and document destruction. Waste management services consist of medical waste including needles and blood products, expired pharmaceuticals and hazardous chemicals and toxic solutions. The shredding of confidential paperwork was added to the business in 2015 through the acquisition of Shred-It, International. Additionally, Stericycle manages regulated recall and return programs for both food and consumer product recalls, as well as communication services for calls and after hours appointment scheduling. Although the majority of its more than one million customers are in the healthcare industry, the company also provides services to the retail, manufacturing and financial services industries.
High Barriers For Growth
We believe barriers to growth are not fully appreciated by investors. First, regulated waste has governmental-imposed handling or disposal guidelines since it is deemed hazardous to a population’s health or environment. Not to mention, medical waste can potentially cause an infectious disease. Regulated document destruction targets papers that could be detrimental in the wrong hands. Against this rigid regulatory backdrop, fees and fines for improper handling of these items can be significant. Therefore, companies seek to work with organizations, such as Stericycle, to meet the required laws. In addition, large customers desire a vendor with a national footprint and diversified product offerings. This enables such customers to leverage their scale and purchasing power through fewer vendors.
Although it has strengthened its business through scale over the past 28 years, the company is now faced with a multi-year organizational transformation. With Stericycle’s rapid growth, driven by nearly 500 acquisitions through the years, de-centralized processes are increasing costs and inefficiencies. To address this ever escalating cost infrastructure, the company is implementing an Enterprise Resource Planning (ERP) system. Although ERP system implementations can initially be costly and disruptive, once completed, operating efficiencies and margin upside can be meaningful. Second, commercial excellence is now an area of high focus. After many years of price hikes to its long-term customer base, Stericycle’s value proposition diverged significantly from competitors. To promote greater customer retention, they have initiated greater transparency in their contracts and adjusted pricing. Although revenue disruption and margin pressures have occurred primarily within the smaller healthcare customers, management continues to estimate overall revenue retention rates of approximately 90%. Going forward, the company’s standardization and expansion of its service options should also improve customer retention. Finally, the company is right-sizing its current portfolio of services through a comprehensive strategic review of its offerings.
The company maintains a strong market share position in a highly-regulated environment. It produces strong recurring revenue, and operates with solid free cash flow. After a long history of growth, the company has recently stumbled. We believe management is aggressively addressing its challenges in a manner that will drive revenue, earnings and free cash flow improvements. In our view, patient investors will ultimately be rewarded. As of September 30, 2018, the company traded at $58.68, a significant discount to our $109.13 private market valuation.
Investing in small cap and mid cap stocks is more risky and more volatile than investing in large cap stocks. The intrinsic value of the stocks in which the Funds invest may never be recognized by the broader market.
On this page, we candidly discuss three individual companies to illustrate our investment process. These companies are current holdings of certain Funds, one of which was a top performer for the quarter, one was a new addition to a Fund, and the other was, in our view, undervalued by the market. The information and our opinions were current as of June 30, 2018, but are subject to change. The information shown does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security. These securities do not represent all securities purchased, sold, or recommended to investors during the period. Investors that were not invested in a Fund that held each stock for the entire holding period shown will not have experienced the performance shown. Past performance does not guarantee future results. The performance of any single portfolio holding is no indication of the performance of other portfolio holdings of any Fund or of any particular Fund itself. Portfolio holdings are subject to change. Click here for the top holdings of the Funds.