What are the best capital allocators in Eastern Europe, Steve Gorelik?

Steve Gorelik works for Firebird Management – a good investor with a good track record in Eastern European markets. With Steve, I could talk in November 2019.

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In this interview we have discussed the following topics:

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Introduction

[00:00:00] Tilman Versch: Welcome to the second part of our interview with Steve Gorelik. Here we’ve talked about the comparison of investing in the US and in Eastern Europe. We also took a deeper dive in part two on portfolio concentration, so please enjoy the video and if you like it, subscribe to my channel.

Outstanding Eastern European capital allocators

Steve, welcome back to the second part of our interview on value investing in Eastern Europe or general investing in Eastern Europe. What are outstanding capital allocators and CEOs in Eastern Europe?

The companies that may not have known much about capital allocations have really figured it out over the last 10 to 15 years.

[00:00:33] Steve Gorelik: I think there are quite a few, and that’s one of the things that what we’ve seen. The companies that may not have known much about capital allocations have really figured it out over the last 10 to 15 years. One of the companies that come to mind, when you talk about capital allocation, is a company called Georgia Capital, which is listed in London. It is run by a management team that has a very strong track record of building value when they were leading the Bank of Georgia, which is also listed in London separately.

They spun out. They were building value within the bank, but there were certain opportunities that have come up that had nothing to do with banking but made sense to take advantage of them, so they did it using the bank’s balance sheet. For example, they had some real estate projects that they were developing over the years.

They built the country’s leading healthcare company as a result of being involved in health care insurance, and then realizing that “Okay, because there’s a public option, the money is not on the payer side, but on the provider side.” As a result, they invested in hospitals and clinics, and then they bought some pharmacies. They’ve built an integrated health care company that they then separately listed.

This is a team that showed that they generate a lot of value over the years by investing in different projects. How they do it, and they do it on the bank side as well, is that they’re very much focused on returns on invested capital. If you talk to the Bank of Georgia CEO today asking, “How do you guys make new loans?” He says, “Well, we want the loan to have 20% ROI and we price it accordingly.” I haven’t heard that type of talk from a lot of bank CEOs, and I speak to quite a few of them.

If you talk to the Bank of Georgia CEO today asking, “How do you guys make new loans?” He says, “Well, we want the loan to have 20% ROI and we price it accordingly.” I haven’t heard that type of talk from a lot of bank CEOs, and I speak to quite a few of them.

These guys have always been very much focused on capital allocation. Last year, what happened, because all of these other businesses have become a relatively large part of the bank’s balance sheet, it made sense to just split it out into two companies. Georgia Capital was listed as a separately listed company. It was spun out to the shareholders. It is fully listed in London.

The management team, the key management that has been building the bank for over 12 years, decided that they want to go with the new company. Because, while the bank is great, they find the opportunities to allocate capital much more interesting here because they can do not just banking, but they can get exposure to all sectors of the economy.

The way that they are doing it is that they have this approach, “Okay, we have our two publicly listed companies that we invested in, which are the Bank of Georgia and Georgia Healthcare Group.” That is part of our NAV that’s delivering value to us. Then they have a few areas where they can invest a lot of money at very good rates of return with the returns of invested capital of 10% plus. Similar to ideas when Berkshire bought an energy company or when they bought a railroad company, it was a way for them to allocate a lot of capital at very good rates of return.

These guys (Georgia Capital) do not have a railroad company, but they do have an energy company. They have a water utility where the returns on a regulated asset base have double-digit yields. They get very good returns on the money they put to work in making the network better. They are investing a lot of money in renewable energy with purchasing power agreements that guarantee to them double-digit returns in US dollars. They have a lot of ways to allocate capital and that is why they got into those sectors in the first place.

Then, the third thing that they are doing is they are looking to consolidate certain sectors that they participate in by establishing a beachhead by buying an important company in the sector. Then either spending money organically once, again, at high rates of return or if there’s an opportunity to buy other players, they buy them. Georgia Capital has a lower cost of capital than other Georgian companies because they are listed in London. They raised the bond when they listed separately.

Last year, they raised a $200 million bond at a very good interest rate. They have a cost of capital advantage and are very good at capital allocation. They are combining those two things to find opportunities that generate a lot of value for their shareholders including us. The other thing that they do is, if the value available in shares is better than what they can do by deploying capital in the market, then they just buy back our own shares.

The value in the shares since the company was listed last May, in May 2018, has been good. Within a little over a year, they bought back 11% of the shares that were outstanding at the time. It shows you that they are putting their money where their mouth is. Management gets paid primarily in shares. It is a situation where we feel very excited about how these guys allocate capital and the future going forward.

Position sizing & portfolio concentration

[00:05:55] Tilman: It gets real that you have a high conviction about the stock, and you’re very convinced about your companies. Could you give us some insight: How do you approach position sizing, and portfolio concentration in general if you have such good ideas?

One of the things that we find about investing in emerging markets, in Eastern Europe, is that no matter how good the idea is or how comfortable you are with the management, there is a chance that something might happen that you just don’t expect.

[00:06:12] Steve: Sure. One of the things that we find about investing in emerging markets, in Eastern Europe, is that no matter how good the idea is or how comfortable you are with the management, there is a chance that something might happen that you just don’t expect. Either a macroeconomic story that influences that particular sector of your portfolio or something else that you just don’t expect.

Because of that, we run a much more diversified portfolio than we would want to. Our top 40 positions represent about 80% of the portfolio. Then we have a long tail of smaller positions that, we are either building up to be a bigger position or companies that have a compelling risk-reward but can be zero. It can go up 10 times, so we’ll make it a relatively small part of the portfolio.

In general, we try not to have any position over 10%. A company like Georgia Capital that we feel pretty good about and have high conviction, it is about 4% of our portfolio. This is a good size because we have to keep in mind liquidity. 40% of our fund is our own money, but a lot of the things that we invest in are illiquid relatively speaking. We will buy companies that trade $100,000 a day and we’ll build our position over six months.

We do not want to be caught in a situation where investor says, “Okay, we want our money back,” and that influences the value of their remaining investors in the portfolio. Georgia Capital is somewhere in between, it does about a million dollars per day, which we would consider medium liquidity.

We would try to manage the portfolio in a way, “Okay, this much can be medium liquidity, this much has to be highly liquid, this much has to be in things that are completely illiquid, but very interesting on their own.”

The steps in getting conviction to invest

[00:08:09] Tilman: Can you tell us more about the steps you do in your process to get the conviction to invest?

[00:08:15] Steve: We start with top-down analysis. The first thing that we do is, we want to identify the macroeconomic opportunities. Both the countries, from a point of view of rule of law and from a point of view of the economic trends that we find to be supportive and positive for a country as a whole. Then we look for particular sectors within the country. That is the start, because we may find a company that we like in a country that has issues, but we are not going to touch it because we find that in emerging markets macro and the country will sweep away everything, no matter how good the underlying economics of a company is.

We find that in emerging markets macro and the country will sweep away everything, no matter how good the underlying economics of a company are.

Then, once we identify the sectors, what we do is start looking for companies, we focus on first and foremost is capital generation. We try to find companies that generate excess cash flows because of the good business models they have developed over the years. The second part that is very important to this part of the analysis is, how they allocate capital. Make sure that they allocate capital in a way that we would allocate capital if we would run that business.

As a result of that, and then that really narrows down our investment field into companies that could end up being in our portfolio. Within that, once we find the company that we want to own, we have a conversation about the liquidity, the risk profile, which country it’s in, and try to establish what should be the weighting in the portfolio as a result of that.

Comparing the investing process in the US and Eastern Europe

[00:09:57] Tilman: Interesting. If you compare the processes of investing in the US and in Eastern Europe. What is different?

[00:10:08] Steve: In the US, we find that this macro portion, I would say, I think less relevant is the wrong way to say it, but it is not as important. You do not have to worry about the things that we talked about in the first part of the interview as far as understanding how the asset was created, and understanding the players. Well, it is a little simpler in a developed country like the United States.

We spend a lot less time on that in the United States than we do in Eastern Europe, where, as I mentioned, we need to be comfortable with how things are, and how they allocate capital because it’s very easy to get into a valley trap. In Eastern Europe, you can buy companies at net cash, but you’re never going to get that cash. It is just not as common in the United States. That is probably the biggest distinction.

From our point of view the things that we focus on, and that’s part of the reason why we started the US fund seven years ago, are how cash flow gets generated and how the cash gets spent. I know a lot of value investors do that.

Going back to my experience as an Operational Strategy Consultant, we take an approach as if we were running the company. How would we make a decision?  What we would do with the cash? That part of the approach is the same in Eastern Europe and in US markets. That part is the same, but obviously, how we size positions is different and the macro part is different.

Special risks in Eastern Europe

[00:11:42] Tilman: Interesting. What are special risks in Eastern Europe?

[00:11:52] Steve: With Eastern Europe, I think each country is different. When you talk about risk in Estonia, it’s not the same as the risk in Russia. There are things that you have to keep in mind, especially how an asset has been created. I will give a specific example from a few years ago. There was a situation with a company called Bashneft in Russia, which was part of a listed company in London called Sistema.

This is a situation where Sistema received this asset shortly after the 2008 crisis, and the way that they got this asset was not 100% clear. There are different rumors going around, which I am not going to be repeating, but they got the asset at a very good price. They were running it very well. They were running it for dividends. At some point, it looked like they would have to sell the company, at also a very good price for the buyer, to another company in Russia called Rosneft.

We just never got involved in that station in the first place, because even though Bashneft looked really cheap and Sistema looked really cheap, we were not certain about how the asset was created. We decided that this goes into the “too hard pile”, and we’re not going to touch it. In the end, the transaction happened and not everybody was happy with the price. The Sistema shareholders, in my understanding, were definitely not happy with the price.

On occasion, you have to worry about these things, but we address them by, as I said a couple of times at this point, trying to understand how the asset was created and how it was made. Is this special about Eastern Europe? I don’t think so. I think it’s the case for all emerging markets, and even sometimes in Western markets is that you will have special situations.

One of the things that is probably misunderstood about investing in Eastern Europe that these types of special situations are an exception, as opposed to the rule. That’s the headlines that you’re going to get. You’re not going to get a headline about a company doing the right thing day in and day out. That’s what 99%, maybe 98% of the companies that we’re in the market, they just do things right thing day in and day out.

They allocate capital and they make money, and then they take that money and then they allocate it again to what they consider to be value-added projects. Sometimes we agree and sometimes we do not agree, but this is no different than anywhere else.

Meanwhile, you have macroeconomics, and you have political risks in places like Kazakhstan or Russia, where if you had a particular person in power for a long, then there’s a question about the transition.

How would the transition happen? There are definitely risks. There is something to think about, that’s why we feel comfortable investing in Eastern Europe. We do not invest in places in Asia. We do not invest in places in Latin America, because there are things that you have to worry about there that we just don’t know. “We don’t want to be the patsy at the table,” as Buffett would say. We are not the patsy at the table in Eastern Europe, but we would be somewhere else.

Future Returns in Eastern Europe

[00:15:14] Tilman: You are a value investor and have a portfolio full of stocks where you think they’re undervalued. What would you be your best guess on future returns from that portfolio? Is it different from 10 years ago or do you think there are good times ahead for you?

[00:15:33] Steve: From 10 years ago, definitely is the same, if not better. From 25 years ago, it is hard to say. I was not there. In terms of how we think when we add a position to a portfolio, what we are looking for is a return of, at least, 15% without assuming any change in multiple. When you are buying things at 6 or 7 PE, well, that’s what you get. That is the starting point for us.

If we are buying into something that is less liquid, or in a more complicated situation, then we will look for a return of 20% or 25%. Then if things are working wonderfully and other people realize the value, then the multiple goes up, then the return goes up as well.

Some of the best investments that we have done over the years, are the companies where you come into a situation that is considered to be complicated. We had a view on it, “Okay, things are improving, the corporate governance is improving,” and you have a company going from 5 PE to PE of 9 while growing earnings at 15% per year. Then you get a wonderful return. We had a number of companies like that.

We are not counting on multiple expansions. On occasion when that happens, we welcome it. We will trim the positions accordingly. That said, if we are talking about multiple today, we have a market multiple of around six, and the historical range is 4 to 12. That gives you an idea of where we are.

I would argue that the top end of the P/E range today should be higher than it was in 2007, because you have better quality companies, and plus the market overall is higher. The top end is probably higher than 12, but it doesn’t really matter because we’re at six. From the point of view of the opportunity, we think it is quite compelling today.

The language barrier

[00:17:28] Tilman: On a practical basis, how big is the language barrier if you want to invest in Eastern Europe?

[00:17:35] Steve: I think it becomes less of a barrier. Our investment team is five people. The founders had nothing to do with Eastern Europe until they started this business 25 years ago. One of them was an American guy, who was a Russian translator in his earlier life. The other one was an M&A lawyer that had nothing to do with Eastern Europe. They saw an opportunity.

Other people on the investment team are from Eastern Europe. I am originally from Belarus. We have another guy who is originally from Russia, and another guy from Lithuania. That said, we invest in places like Romania, and Bulgaria, where we do not have any native speakers, but we feel very comfortable investing. Over the years, it (the language) became less important. IFRS filings have become standard a few years ago. I think at this point, it had been four or five.

Where my competitive advantage 15 years ago was knowing how to read the Russian Accounting Standard of filing, that competitive advantage doesn’t exist anymore for me.

Where my competitive advantage 15 years ago was knowing how to read the Russian Accounting Standard of filing, that competitive advantage doesn’t exist anymore for me. That said, it’s much easier for anybody else to come in and look at the IFRS statement that looks the same as the German statement or a Belgian statement and is in English. You will be able to get most of the information that we get without knowing the local language.

Then there’s Google Translate, which is getting better every day. I would say it is not a requirement. I think you have to have an open mind. You have to get into the mentality. Having been from Eastern Europe, I think helps from a point of view like understanding the mentality and some of the quirks, but not the language barrier.

How to invest in Eastern Europe

[00:19:18] Tilman: Another practical question, how can you invest in Eastern Europe? Can you go on your Interactive Broker’s account and buy stocks from there, or?

[00:19:30] Steve: We’re set up locally in all of the countries that we invest in. I do believe, for example, Interactive Brokers a couple of years ago made a connection with the Baltic countries. You can buy any Baltic security on interactive brokers. A lot of the companies in our region are listed in London. The way that you buy any company in London, you would buy that one.

[00:19:55] Tilman: Why are they in London?

[00:19:57] Steve: London is a hub for European trading. Historically, it has been a hub for a lot of countries from emerging markets not just from Eastern Europe. It is where the investors are. Companies over the years have come there, raised money there, and continued to operate there. Moscow Stock Exchange in Russia has become a much bigger player over the years. You can see the volume of trading moving from companies that are traded listed both in Russia and in London, the volume of trading is slowly moving to Russia.

In terms of how easy it is to set up to trade in Russia, I believe it is pretty easy. I am not sure if it is linked with interactive brokers, to your question, but it’s not very hard to set up. They really pride themselves on the quality of the offering that they have. It is another thing that is becoming easier and the region is more welcoming to outside investors. That said, I do not think there are that many.

If you take a look at what’s happening until capital flows, there’s been some passive flows into the region, but the active flows have been negative to zero ever since 2008, which leaves active managers like us, gives us a lot of opportunities.

If you take a look at what’s happening until capital flows, there’s been some passive flows into the region, but the active flows have been negative to zero ever since 2008, which leaves active managers like us, giving us a lot of opportunities. It explains why we can buy great companies at great prices. You want to know: Why are you buying this at this price? We feel very comfortable with what we are getting at the prices that we’re getting because there are not that many people looking.

We go to different industry conferences. If in 2007 you went to a conference in Russia, and there were 200 people in the room and 120 of them, 150 of them would be foreigners. Today, you go to a conference in Russia, there might still be 200 people in the room, but there are going to be 10 foreigners and we’re or two of them depending on how many people go. It tells you about how the markets have changed and who looks at these markets today.

A typical day for Steve

Steve Gorelik on Eastern European Capital Allocators

[00:22:02] Tilman: You’re located in New York?

[00:22:03] Steve: Yes.

[00:22:04] Tilman: How does the typical day look like if you’re researching Eastern Europe?

[00:22:09] Steve: First, we travel quite a bit. We have five people on the investment team. I travel once a month for a week. Whenever I go, I usually hit two or three countries. My colleagues do essentially the same thing. At any given point, we have somebody somewhere in Eastern Europe, not all the time, but quite often. We altogether would do; I think we counted last year we did like 500 different company meetings. It includes some conferences. There’s some double-counting in there, but we meet with a lot of companies.

That’s part of the investment process and a very important one. Then, the first part of the day, we usually start at around 8:00, 9:00. Some of our markets are still open, but the markets close by 12:00. We find this to be an advantage. Most of our working day in New York is spent analyzing the situation without any noise that’s coming from market movements, which gives us the opportunity to step back.

We have a long-term investment period. Our average holding period is seven years. We don’t react to daily movements but being in the office when most of your counterparties already went home, gives you time to step back and say, “Okay, here’s what happened today, let’s think about it.” It gives us a much cleaner way to think about the positions.

Meanwhile, from a point of view of trading, we have great relationships with a lot of the brokers in the region. They know that we’re a long-term investor, the type of investors that the companies like. We feel comfortable putting in an order, when we say, “Okay, we want to buy a company and we want to sell a company.” We’ll put it in with a broker that we know, and then we tell them how we want it to be traded. When I wake up at 6:00 in the morning, I see what happened and I’m usually pretty happy with it.

Buy or hold or also active trading?

[00:23:58] Tilman: Your strategy is more a buy and holds strategy, or do you use actively trading to add returns?

[00:24:05] Steve: It’s more buy and hold. As I said, our average holding period is seven years, we still have some positions in the portfolio since 1994. If things are working well, if the company is building capital year in and year out, then we do not need to do anything. We’ll buy a company; we’ll buy 2% or 3% of a company and it will do the work for us. That is really that is what we’re looking for. That’s the holy grail of investing for us, where we’ll just buy and then we’ll never sell meanwhile the company generates wealth.

How Eastern Europe changed in the last 25 years

[00:24:37] Tilman: Do you want to add something at the end of the interview we haven’t discussed?

[00:24:42] Steve: No. I think the most important thing is that part of the reasons why we do these interviews is to tell people the story of Eastern Europe, the changes that happen there, and the corporate governance changes that happen there. 25 years is, on one hand, not a lot of time, but on another hand, it’s a lot of time for you to learn things. If you are starting, if you’re trying to understand how capitalism worked after 70 years of being in the Soviet system and the Communist system, well, you make a lot of mistakes at first.

Over the years, you’ll learn, “Okay, this is a mistake, this is the right thing to do, this is the wrong thing to do, so let’s do more of the right thing.” These are the changes that we’ve seen progressively happening over the 25 years that we’ve been doing it and I’m really looking forward to seeing what it will look like 25 years from now.

The stigma that’s around, because most of the people I would talk to, and I say, “Invest in Eastern Europe,” the first three or four questions are about, “Well, how do you feel comfortable about the assets that you own? Do you really know that you own there? How do you deal with this risk? How do you deal with this macro risk?”

I’m like, “Okay, you definitely need to keep this in mind, but you guys are missing the point. You guys are missing the point of what happened that this is the company that is a world-class company, it just happens to be in Moscow, it happens to be in Bucharest, but this is a world-class company operating within rule of law that is applied consistently. You just need to know the rules.”

They learn all the rules, they benefit from them. Oftentimes, they benefit, and they can run the company better than a Western company that’s coming into the market. Some of the best investments that we have are banks that are run by locally owned banks that compete against Western-owned banks in a place like Romania or Lithuania. They make decisions locally, as opposed to in Austria or Sweden or wherever it is, and there’s a competitive advantage that comes as a result of that.

An outsider would say, “Well, I want to own the subsidiary of a Swedish bank. No, I want to own the local bank, as long as I can trust the management.”

An outsider would say, “Well, I want to own the subsidiary of a Swedish bank. No, I want to own the local bank, as long as I can trust the management.” That is a change that has happened that we’ve seen with our own eyes, that is not reflected in the multiples at all. From that point of view, I think I would be happy to see the multiple go up.

I think it will influence my opportunity, as I said, but I want people to understand the quality of the companies that are there. I encourage people to go and meet with the companies on the ground and I can almost guarantee that you’re going to be positively surprised by what you see.

[00:27:20] Tilman: Thank you very much.

[00:27:21] Steve: Thank you for now. Thank you for having me.

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Tilman is a very enthusiastic, long-term investor. Over the last years he has taught himself important investing concepts autodidactically. He tries to combine a positive climate and environmental impact with his investments.
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