Interview #67 : Gehlen Bräutigam Capital
Looking for highly undervalued small caps in Europe.
For this issue we had the pleasure of interviewing Marc-Lennard Bräutigam and Daniel Gehlen, founders and portfolio managers at Gehlen Bräutigam Capital.
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Hi Marc and Daniel, thanks so much for taking the time to do this interview.
Can you please tell readers about your backgrounds, and how you got involved in investing?
First, thank you very much for reaching out and for this great opportunity for an interview with you. We are great fans of the Capital Employed podcast and tune in regularly. We very much appreciate this sort of exchange with independent managers and their ideas.
We both have an investment banking background, most recently we worked together at Barclays in London and Frankfurt. I guess that is where we learnt to deep-dive into business models and valuing them on different metrics and by different methods as well as how to communicate with C-level management for example.
We also got great insights into the inner workings of capital markets on the equity and debt side, which was a very valuable experience. Our time at Barclays was also where we got to know each other by working together on several projects.
As you can imagine the hours and the pressure to perform were quite intense, so it was an ideal test of our ability to be working together as a team. To be fair, at this stage we had no idea that we would end up as business partners, starting a fund post investment banking.
The two of us had been investing in stocks since our later teens in different shapes and forms. Marc was fortunate enough to intern with an equities fund manager in New York at a time when he was still in high school.
This experience inspired him and basically ever since he wanted to start his own fund and kept investing privately. Daniel also started investing early and built a strong track record, in his limited spare time at the bank.
We both read many books and letters on value investing since our late teens and it clicked. Today, the ideas still make a ton of sense to us.
Why did you start Gehlen Bräutigam Capital? And is it difficult to set-up a fund in Germany/EU?
Fairly early in our career we both independently decided to quit our jobs to focus on a new adventure. By chance we quit at the same time and helped each other out while looking at different opportunities.
We relatively quickly learned about our common passion for value investing and decided to join forces and to focus on the challenge of starting our own equities fund.
We simply thought it would be the greatest thing to do what we are truly passionate about for the rest of our careers and to help people and institutions we like compound their capital over the long term and thereby creating win-win relationships.
To be honest, in the beginning, it was not easy for us. We had limited prior experience in the industry and no insights into how we could launch a fund.
Fortunately, with the help of good friends and partners we quickly climbed up the learning curve and launched the Gehlen Braeutigam Value HI fund 6-9 months after kick-off.
Overall, there is a good ecosystem and regulation in place if you would want to start a fund in Germany/EU. The process is also straight forward, and partners can help you with their in-house capabilities.
We also liked that we were able to outsource a lot to very capable institutions so that we have been able to focus as much as possible on what we want to do, investing. Finding initial investors to start has of course been the most difficult thing to overcome.
Next to that choosing the right structure for your strategy and finding the right partners with a good personal fit are also great challenges.
We were very fortunate to find investors among family and friends, as well as through further recommendations from these, who invested a total of about EUR 5m with us in mid-2018.
Today, our fund has c. EUR 22m in assets under management and we believe EUR 80-100m is a good target range for it.
What type of businesses do you invest in? Are there any specific quantitative or qualitative characteristics you seek?
We focus on European small and micro caps. We analyse opportunities with a long-term mindset and look for highly undervalued companies.
Our internal return expectations for an attractive case are typically higher than 20% per year in the medium-term. At the same time, we put a significant effort on understanding the (longer-term) downside of our investments.
We prefer to look at companies with high returns on capital, net cash, sustainable competitive advantages, and attractive growth opportunities. We also pay close attention if we, as (minority) shareholders, will participate in the value of the company over time (by the capital being well invested or returned to shareholders via dividends or share buybacks).
We feel that that is a very important point, especially when investing in small and micro caps. In many companies, there is a larger shareholder (often the founder, but can also be external) which can be a very good, but also a very bad thing, depending on the specific shareholder and situation.
As the opportunities we are looking for are rare, we must be opportunistic by nature and will very often say “no” to new ideas very quickly.
In general, we tend to prefer companies that trade at low valuations but have the capacity to extend their multiples over time. Next to the above-mentioned preferences, there are no specific quantitative or qualitative characteristics which we require.
It really depends on the individual situation. Regarding sectors, we look at stuff that we can understand as generalists and stay away from very specific fields such as biotech stocks for example.
What does your investment process look like?
At the beginning of our investment process is the idea generation process, where we find opportunities through a variety of sources. When we decide to prioritize an idea, we usually follow an in-depth due diligence process.
This process can take up multiple weeks or sometimes months or years of following the company and often leads to no investment after all.
The process can obviously vary a bit depending on the situation, but we start with the publicly available information on the website. As a second step we speak to management, customers, and industry experts to get an even better understanding of the company and the competitive nature of the industry.
We also conduct site visits, if appropriate, and meet management at their premises. The office of a CEO can tell you a lot about how he or she thinks about allocating capital. Once we have an in-depth understanding, we fine tune our valuation models and have a final discussion on the case.
In this entire process, we look to kill ideas early if we find information which contradicts our initial view of the quality of a company or other red flags, as well as when doubt creeps up that the situation, i.e., the valuation/return expectations, might not be as exceptional as we initially thought and look for.
After all, the universe of small companies in Europe alone offers a very, very wide range of interesting companies and potential opportunities. Focusing on the most promising situations at any given time is key for us.
Can you talk about two specific companies in your portfolio you're bullish on? What was the thesis for investing?
Yes sure, very happy to share two ideas.
💡Sto SE & Co. KgaA (STO)
Our current largest position in the fund is Sto SE & Co. KgaA (Sto; ISIN: DE0007274136) with a weighting in our portfolio of c. 9.5%.
We first invested in 2019 at prices around EUR 90 per share but believe that today’s valuation is again at similarly low levels.
Sto is one of the leading manufacturers and distributors of wall insulation systems, headquartered in Stühlingen (Southern Germany).
The company focuses on value-add services and has demonstrated historical ROCEs in the high-teens. We think of it as a very solid and resilient business with an excellent long-term track record. The value of an investment in Sto 20 years ago would have increased roughly 20-fold.
Despite what one might think at first, the environment for external wall insulation systems (EWIS) has not been supportive in the last years. Between 2012 and 2020, market volumes in Germany have decreased by 20%. Against this backdrop, Sto has managed to increase its revenues by 25% during the same timeframe.
Today, we are convinced that Sto faces a much better situation. The governments in Germany and the EU have very ambitious targets for the reduction of energy consumption and greenhouse gas emissions of buildings. Large subsidy programs and new building laws are in place and offer great tailwinds for growth in the medium-term.
Sto’s market capitalisation stands at ~EUR 1.1bn, but the free float is much smaller as ~60% is owned by the founding family (Stotmeister). The former also tried to take the company private a long time ago, which failed. Since then, the family has delivered well for shareholders.
Sto has a fortress like balance sheet with net cash of >EUR 200m, which the company seeks to spend on organic growth, dividends, and M&A. Although the balance sheet might not be optimal (as it is indeed very conservative for a company as resilient and cash-flow generative as Sto), we like and are very comfortable with the company’s prudent and patient approach to valuations at potential targets.
Based on our own estimates, Sto trades at 2023e EV/EBIT of <7x or a double-digit FCF yield. These metrics are based on trough margins (7% vs. our expectation of a sustainable margin >9%) given that the company could only pass on the increase in input prices with a certain lag due to the project nature of the business.
Note that the FCF yield assumes a normalized investment level, while slightly higher investments are planned for the next two years to support mid-term growth ambitions. Over a long timeframe, Sto has consistently shown a high cash flow conversion.
In addition to expanding the margin from the current levels, we believe that the company can achieve high-single-digit top-line growth figures after 2023. Currently, we observe a lot of fear and uncertainty in the market with regards to construction-related names in Europe, although we believe Sto could strongly benefit from the afore-mentioned structural drivers.
(Value-accretive) M&A is another trigger and if this was not to happen, we see a decent chance for a special dividend if cash continues to pile up. In 2015, Sto has already paid a special dividend of EUR 25.14 per share. Overall, we very much like the risk/reward here a lot.
💡KSB SE & Co. KGaA (KSB)
The second idea we are happy to share is our second biggest position in the fund with a weighting of around 8.5% of the portfolio.
KSB SE & Co. KGaA (KSB; ISIN: DE0006292030) is a global industrial company from Frankenthal (Germany) which develops, produces, and sells pumps and valves.
Through its own global service network, customers are looked after with spare parts and services.
KSB has a great industrial heritage and was founded in 1871. It is currently one of the top 3 pump manufacturers worldwide in terms of sales. More than 15,000 employees work for around 450,000 customers in various end markets.
However, in the past ten years (before 2020), KSB has not delivered any significant growth or increased earnings. In addition, a tax scandal in 2017 damaged the reputation.
Shortly after, there was a management shake-up, and the new board was put in place with a new strategy for profitable growth and for cleaning up the company. Since then there good progress has been made and KSB is currently showing strong operational momentum, characterized by a high level of incoming orders and a strong order book.
The company’s historical ROCEs do not look attractive, but margins have improved in recent years, and we are convinced that they will strongly improve further over the next few years.
As with many mechanical engineering companies, the business model is somewhat comparable to a razor-blade-model. Like a razor, industrial pumps are important products for the end-user. During one of the expert calls, a former President at a competitor explained: “Pumps are like the heart in your body – a small component cost-wise but very mission-critical”.
However, the main margin opportunity is naturally in the service and especially the spare parts side of the business. Let’s say for example you operate a large copper mine to which KSB supplies it’s higher-end heavy-duty slurry pumps.
If this pump were to break down for an extended period, it would be very costly for you as the operator, and you would miss out on a lot of potential revenue. Therefore, you want to maintain your pumps well at any time. KSB knows that and can demand high margins in its aftermarket business. This side of the business is also the main focus area for growth and demonstrated further good progress in Q1 2023.
Overall, the company is well on track towards its goal to surpass an 8% EBIT margin in 2025 (6.0% in 2021 and 6.7% in 2022).
In March, KSB has published 2030 goals of a 10% EBIT margin on the back of a >40% aftermarket revenue goal, which appears realistic when looking at peers as well as an order intake target north of EUR 4bn (2023 guidance: EUR 2.75 – 3.0bn).
We sourced the idea from our local network of specialised investors and first invested in the preferred shares in January 2023. At the time of the first purchase, the free float was small at approximately EUR 350m and the shares are even more illiquid than typical for a company with this free float.
The shares are listed in the entry segment of the Frankfurt Stock Exchange (General Standard) with no relevant index listing yet (once listed in the MDAX index).
Given the attractive underlying business model, the favourable market dynamics and the significant growth and margin opportunity, we saw basically no downside at prices around EUR 380 per preferred share (2023/24e P/E of ~5.5-6.5x – own estimates – and a strong balance sheet with high cash position).
How do you avoid value traps, are there any specific red flags you look for?
Although we appreciate situations which have catalysts (but only if they are not known/discussed by everyone already), we don’t focus too much on short-term triggers.
In our view, “value traps” mainly come from two sources.
1. A misjudgment of the actual value of the company on our side, or…
2. A misallocation of capital so that the value of the company erodes over time or doesn’t arrive in our pockets as minority shareholders. We would be happy buying a company at a sustainable 15% FCF yield without seeing any grounds for an immediate rerating if we believe that management is doing the right things.
On 1. we have outlined above what we do when we analyse a company and try to determine a range of the fair value. In addition, we only look to invest when we believe that the margin of safety to that value is high (i.e., 40%+). This provides some room for wrong assumptions on our side.
Especially in the last one to two years, it’s important to consider that some companies might have over-earned due to the specific circumstances (some have under-earned as well of course) and to take that into account in the valuation.
As this can often be hard to estimate (as it has turned out for a lot of companies, also in our portfolio), we try to be especially conservative in these situations.
On the second point, we look for managers or key decision makers who are aligned with us (preferably through ownership in the company). We also believe that actions speak louder than words.
Therefore, we investigate their historical track record and decision-making, especially with regards to (significant) capital allocation decisions and on how they delivered on their promises.
As an example, we do not like when managers pay overly high multiples for acquisitions, especially when compared to other alternatives at the time (e.g., returning money to shareholders).
We are also very careful when management has repeatedly promised a betterment and provided aggressive forecasts but when those have never realized.
Another point that can be particularly important (appears more frequently) when investing in micro caps are issues with regards to the treatment of minority shareholders.
This can range from something as simple as a much too generously compensated management team (especially for the size of a small company), to generous third-party contracts with larger shareholders which divert value away from minority shareholders or even acquisitions of their businesses at too high prices.
We generally don’t shy away from very illiquid situations. But lower liquidity comes with the burden that we can’t change our mind (or that it’s more costly) easily on those points or if adverse developments occur. All else equal, we do require much more attractive risk/reward profiles for our most illiquid investments.
We would also be very mindful with regards to the weighting in the portfolio as well as the overall exposure to such situations and would usually require good reasons to believe that they can outgrow their small size over a relatively limited time frame.
What are your biggest concerns about investing in Europe at the moment?
We believe Europe is a great place to invest in stocks and especially smaller listed companies. There are many (innovative) small companies which only a relatively limited number of investors look at.
We sometimes hear the preconception that successful companies are mainly born in the US or at least outside of Europe. But we have seen very many success stories and a broader look at the market also confirms that there are no less than in other regions.
Europe has many companies which are still majority-owned by founders (or founding families). As mentioned, this can provide its own risks but in general we prefer the alignment of interest and long-term thinking of many of these owners.
There are certainly other culture-specific issues such as a lower willingness to invest into very uncertain outcomes (which can lead to lower success rates in certain verticals such as software) or, broadly speaking, a less strong focus on shareholder value as in the US which investors should be aware of.
We believe that the concerns around investing in Europe have been publicized very prominently in the last year. They are the same as in other regions – an inflationary environment, rising rates, a looming recession – as well as the additional concerns around the impact of the war in the Ukraine and increased energy prices.
At least by now, the risk of a disaster from much, much higher energy prices is much lower but it is of course an important factor when considering an investment, also in the longer-term. On the other hand, there might be new global winners emerging from the current environment such as leaders in the energy transition.
From what we see, valuations often tend to be (significantly) lower than in the US when we look at businesses of comparable quality, especially nowadays.
We are also currently experiencing a time of relatively low liquidity in small- and especially micro-cap stocks which also depresses valuations.
Overall, we feel quite comfortable and encouraged to look for opportunities in this environment.
Where do you see Gehlen Bräutigam Capital in 10 years’ time?
We love what we do and are very passionate, so we would like to see Gehlen Bräutigam doing what it is currently doing (investing in small and micro caps).
Our focus is and will be on maximizing the performance (rather than the assets) and in this way trying to add value to our co-investors.
At the same time, we are looking to grow with partners and new investors who share our investment philosophy.
For more information on Gehlen Bräutigam Capital please visit gbcvalue.com
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