Top Ranked Manager on Norwegian Small Cap Opportunities

Henrik Heffermehl is one of the most consistently and best ranked SumZero members, having topped our All-Time, Last Twelve Months, Long, GARP, Western Europe, Micro-Cap, and Energy rankings. Heffermehl is the Portfolio Manager of Oslo based Park Lane Family Office, where he specializes in Nordic stocks. His annualized median return across his 22 SumZero ideas is a staggering 25.92%.

SumZero sat down with Henrik to discuss value investing, Nordic stocks, and his most recent idea on PROTCT:NO.

Kevin Harris, SumZero: During your time as a SumZero member, you have topped the All-Time, LTM, Long, GARP, Western Europe, Micro-Cap, and Energy rankings. Could you detail your background in value investing and your investment philosophy?

Henrik Heffermehl, Park Lane Family Office: I have an unorthodox background in that I’m a med-school dropout without a formal business or economics education. Which means I’m essentially self-taught for better or worse. I have been fortunate to work with a lot of great people which has helped. First I worked at Pareto Securities where I was assistant to one of the senior brokers which was a great learning experience, and later, before coming to work for my current employer, I worked for a Nordic focused long/short fund for a few years where I was given a great deal of freedom to work independently as an analyst and junior PM under the guidance of my boss at the time. That experience really helped me build a solid approach to investing. This mostly meant reading anything I could get my hands on from the value investing canon, constantly discussing them with my colleagues and then applying those principles in practice. I still spend 80% of my working hours reading in my office. Blaise Pascal would approve.

Over time my approach became more Fisher/Munger/Buffett than Graham, which I suppose is a common development. Greenblatt and Pabrai have also influenced my approach to investing for the better, as have my current employers.

If I were to describe our approach in more detail, I would say that at Park Lane we like to think we analyze businesses, not pieces of paper and we invest for the long term. We’re very clearly long biased, and will only rarely short stocks or indices, and only through put options as we believe cash shorting has an unfavorable risk profile. We mostly focus on smaller companies with little or no analyst coverage because we believe the opportunity for meaningful outperformance is greatest in this space, and we are generally not afraid to invest in illiquid stocks. That said, we are mindful of the fact more esoteric does not equal better and all else equal, we prefer liquidity and larger capitalization.

We expect to do well over time partly because of analytical competence and because our chosen focus area gives us a better opportunity set than most asset managers, but most importantly, we believe our structure is important: very patient capital that does not care much about volatility is an important asset. Competition is much less intense if you look out 5 years or more instead of 12 months. We also have the flexibility to concentrate heavily in our best ideas and usually only have 10-15 positions.
To be able to think truly long term is incredibly rare in this business, and one of the reasons we haven’t been willing to take on any outside investors so far as we are afraid it might impact that ability negatively, so today my employers, myself and my family are the only investors in Park Lane. (That being said we could see taking in a limited amount of outside capital in the future if we found the right partner and a workable structure). Our long term approach is also reflected in my bonus structure, we want everything to be properly aligned.

Our investments usually fall into one of 3 types:

The first is the Buffett-type: investments in companies with a proven track record of profitability that can reinvest their profits in their primary businesses for increased growth and long term value creation. A subset of this category are investments in companies that generate large free cash flows, but that can no longer be reinvested at a high return in the core business, but at least be distributed to shareholders through dividends or stock buybacks (at attractive prices), and that we believe can increase these cash flows over time. Companies in both these categories must have wide and durable moats and great management in place. We hope and expect that our portfolio will continue to be dominated by companies in this category the majority of the time.
The second is the Graham-type investment: Companies that may not exhibit the quality traits described above, but that trade at unreasonably large discounts to net asset value or normalized earnings power due to what we perceive to be temporary problems. In this category we aim not to pay for future growth potential. So far this has been a smaller part of our portfolio.

The final category is the Greenblatt-category: Special situations like spin-offs, liquidations, rights issues and the like belong here and has also been a small part of our portfolio to date.

We hope and expect that our approach and methodology will evolve beyond this framework over time. An investment framework shouldn’t remain static over the course of decades. Looking at the all-time greats of the business, they have all been able to adapt as times and market conditions changed.

Harris: Nordic stocks seem to be systematically undercovered by American investment professionals. Why is this?

Heffermehl: To the extent that that’s true (hard for me to evaluate, but sounds reasonable), I think limited size and liquidity is the most obvious reason. It takes work to get to know a new region, and for many big players, the Nordic markets aren’t large enough to put a meaningful amount of money to work. That being said, quite a few quality small and mid-cap companies don’t get much analyst coverage and this of course also creates opportunity. For large cap stocks the analyst coverage is much better, but there are still opportunities and compared with North American markets, pricing in the Nordics is probably much less efficient.

Harris: What are the biggest challenges involved with investing in small cap Nordic stocks? What would be your advice for non-Nordic managers interested in investing in the region?

Heffermehl: Apart from the limited liquidity in many stocks from an institutional perspective, there aren’t region-specific challenges here the way I see it. The relatively low analyst coverage of small and mid caps is more of an opportunity. Reporting standards are good and politically and economically it is a very stable region where corruption levels are very low and the legal systems work as they should. Historically, the region as a whole has produced very strong stock market returns. It’s a good pond to fish in which I probably shouldn’t advertise…

As for advice, I would start by reaching out directly to local investors and money managers. I think there are quite a few buy-side people here who would welcome the opportunity to interact more with foreign investors. Through SumZero and certain other online investment forums I’ve been fortunate to get in touch with many really impressive people and benefit from that over the last few years both economically and otherwise. Scheduling a trip over here to meet with companies’ management teams is also a good idea. Management access is pretty good in general in the Nordic region (even for small fry like me).

Also, building a relationship with one or more of the top brokerages in the region like DNB, ABG and Pareto etc which employ lots of smart people with deep knowledge of many industries can help new investors get a lay of the land. I’m irritated by investors who love to speak negatively of brokers and sell-side analysts, in my process they’re often very important resources (it’s up to us as investors how we make the most of their knowledge).

Harris: Could you walk us through your recent thesis on Protector?

Heffermehl: Protector Forsikring is a P&C insurance company listed on the Oslo Stock Exchange. It operates in three different lines of business, commercial, public and change of ownership (COI). The stock market is currently focusing on a weak Q2, near term problems in Denmark and softer markets in Norway instead of taking the longer term view, and the stock is way off its recent high. At around 60 NOK, you can buy a long term float growth story at an attractive price. There have been several large insider buys recently, and the board members and CEO combined own well over 10% of the company. I believe Protector will see many years of double digit premium and float growth and that it will stay solidly profitable on underwriting, albeit with a somewhat higher combined ratio than the historical average. Of course, if you believe that 10+ years of profitable underwriting was a fluke and that PROTCT on average will underwrite at a loss going forward, PROTCT is not interesting. But I think that’s unlikely.

I think the most appropriate way to value a fast growing, float generating company like PROTCT is the method outlined on pages 10-12 of this Morningstar document, which essentially «seeks to capture the premium of the insurance business over book value by capitalizing the future cash flows from the insurance float (the excess of premiums paid by policyholders that have not yet been paid out as claims).» https://msi.morningstar.com/Image/BRKvaluation.pdf
As the article also correctly points out, this approach is not without pitfalls. It is very sensitive to what float growth rate, discount rate, CR and investment return assumptions you put in. (But what estimate wouldn’t be). I’ve used the assumptions I believe to be the most appropriate, but others may disagree. In any case I feel this approach comes closer to reflect the future economic reality of PROTCT than a randomly assigned EPS multiple a year or two out. An investment in PROTCT should be held for the long term and the valuation efforts undertaken should reflect that long term horizon. Using a float based valuation approach with conservative assumptions, I get a fair value above NOK 100 for Protector.

PROTCT’s growth will be enabled by it’s economic moat as the low cost provider – and cost is the only moat that matters in a commoditized P&C insurance market. Their cost advantage looks convincing and sustainable and stems from internally developed IT systems vs less efficient legacy systems at competitors, but also- and most importantly- a solid company culture focused on continuous improvement and focus on efficiency gains in all aspects of the operation. Improvement programs are a constant at PROTCT and they are systematically implemented.

I will include great management and a top notch investment team with skin in the game as a kind of competitive advantage also: even if it does not fully qualify as a moat the way value investors usually define moats, it is in essence what creates the moat. CEO Sverre Bjerkeli is what Ian Cassell would call an intelligent fanatic. He has been with PROTCT since 2004 and owns over 3m shares, which constitutes the clear majority of his personal wealth, so incentives are clearly aligned with us as shareholders. He is as close as you get to Thorndike’s archetypal «Outsider» CEO in the Nordics (look at the aggressive buyback just undertaken for a recent example of smart capital allocation). CIO Dag Marius Nereng and his team’s in-house track record is very strong, both on the equity and the fixed income side. Investments are considered core business for PROTCT, which cannot be said for many competitors out there.

Harris: As most active managers cannot outperform the market, why should an insurance company’s investment team? Why should Protector’s?

Heffermehl: Most active managers who outperform the market tend to come from Graham & Doddsville, according to Buffett. I think we could probably modify that to say Buffett & Mungerville now. The investment team at Protector is built on the practices and teachings of those two and a fomalized framework that makes continuous improvement of the process possible. Nothing is certain, but I can’t think of a better way to improve one’s odds of outperformance over the long term.

Harris: Berkshire’s 2009 letter emphasized that “cost-free float is not a result to be expected in the P/C industry as a whole”. Could bull market outperformance have misled insurers into the magnitude of underwriting loss they should carry on their books to pay for float?

Heffermehl: This is always a risk. But if you look at the Nordic insurers, the average cost of float for the important P&C players has historically been negative though, and I expect that going forward as well, although with higher CR’s than in the past. The competitive climate is not as fierce as in the US for example and the focus of the main players here is sustained technical profitability and not float growth. I think PROTCT’s CR will stay way below 100 for many, many years.

Harris: How did you approach the notoriously complex analysis of an insurance company’s underwriting policies? Are there blind spots in the GEICO / BRK inspired orthodoxy of thought when it comes to analyzing underwriting and float?

Heffermehl: Beyond what the company itself describes in reports and presentations (which inspires confidence), there is very little I can do to gain insight into the details of underwriting policies of Protector (or any other insurance company for that matter), this is not information that is shared for obvious competitive reasons. In the end, you have to trust the judgment of the management team in place, so it ultimately boils down to: A good track record overall (trouble has mostly been concentrated in change of ownership which now constitutes very little of PROTCTs GWP) and a demonstrated willingness to walk away even from big business when prospective returns have been inadequate. Those two things have been the most important for me in the evaluation of PROTCT as an underwriter.

Harris: Could a market correction massively impact firms that may have paid too rich of an underwriting loss for bull market float? How would Protector fare in this case?
Heffermehl: That sounds very likely, yes. PROTCT is well capitalized and has a solid looking investment portfolio with an equity weighting of only 17%. Their bond portfolio is very high quality on average. Even a financial crisis scenario should be ok for PROTCT. Additionally, PROTCT entered into a solvency based reinsurance solution with Hannover Re starting on July 1st 2017 which helps insulate the company from negative solvency changes, which is renewed annually. This is meant to protect the company from sudden and unforeseen negative changes in the solvency ratio such as a stock market crash. For readers interested in looking at this more closely, it is detailed on slide 27 of the 2017 CMD presentation.

Harris: What do you perceive to be the biggest risk to your thesis? What could go the most wrong?

Heffermehl: A failed growth effort in the UK (either because of a soft market which requires very high underwriting discipline for a long time, or because the underwriting itself turns out to be poor and large losses materialize over time). Also loss of key personnel, especially Sverre Bjerkeli (either because he chooses to quit or because he dies during one of his marathon runs or extreme cross country skiing races…maybe PROTCT should be happy they’re not insuring him personally). It is a fact however that PROTCT spends a lot of time and resources on developing leaders in-house, and when asked about succession issues they are very firm in saying they have people who can take over for Sverre Bjerkeli immediately. That being said, he is a very charismatic leader and losing him could impact company culture negatively, which in turn could undermine the competitive advantage that PROTCT relies on.

Harris: Where else do you see value in the market today? Which names or sectors in particular?

Heffermehl: I think oil services are increasingly interesting. Standard Drilling (written up on SumZero previously) is a very cheap, debt free way of playing a recovery in oil services. It is also a very likely take-out candidate for the bigger OSV players like Gulfmark/Tidewater e.g. Offshore supply ships is a very depressed industry that will benefit as offshore capex begins to grow again and rig activity picks up. In addition, we own call options in Schlumberger that we expect will be very profitable once the market sees oil industry capex levels rise from current depressed levels. We expect this to start in Q4 of this year.

I also like the Nordic IT consultants in general, and in particular Webstep
(WSTEP NO), which I wrote up on SumZero some time ago. It trades at an absurd valuation both in absolute terms and relative to its industry despite being low-cyclical, debt free, paying sizable dividends, having above average margins and a long growth runway underpinned by increasing need for IT consulting services. Cloud services are in extremely high demand today, and machine learning and IoT is the next growth pillar for the company. Today, you can buy Webstep for around 10x EPS (peers trade at 15x) and a 9% FCF yield (that FCF is likely to grow by >6% annually for at least the next 5 years). A conservative DCF value for WSTEP is 40 NOK, and the stock trades at 25.

Harris: Your mean total return across your SumZero ideas is 66.25%, (Median 26.22%). What is your investment checklist?

Heffermehl: I have a couple of different ones, and they are constantly changing…which they should I suppose. At the moment I have 10 questions that I think are the most important to check off for a core holding:
Is this an understandable business within my circle of competence and with a low risk of technological disruption?
Is the valuation reasonable, enabling multiple expansion to act as a possible second engine of returns (in addition to significant earnings growth)?
Does the company have a history of compounding per share value at a high rate both on an absolute and a relative basis?
Does it have the ability to reinvest earnings for a long time at high rates of return, i.e. a long growth runway?
Does it have at least one durable, significant competitive advantage?
Does it have experienced management with significant skin in the game who treat shareholders as partners?
Does it focus on continuous improvement of operations and efficiency gains – i.e. a strong company culture?
Does it have a fairly limited market cap / size at the outset?
Does it have a solid financial position and thus low risk of future dilution of shareholders?
Is political, legal and regulatory risk low?