Revisiting Verdad Capital Yamaya Thesis

Today we take a look at one of the investment thesis dating back to Q2 2017 that we covered in the Hidden Value Stocks quarterly. HVS is our way of assessing less analyzed and often under-the-radar stocks that draw the attention of skilled investors.

In Q2 2017 Nick Schmitz and Dan Rasmussen from Verdad Capital Management presented the thesis for Yamaya (TYO: 9994) in conversation for HVS. Besides the thesis, they explained the firm's investment process, their focus on small-cap Japanese companies, and private equity. In the end, we did a recap of the investment and how it managed to perform between 2017 and 2024.

Implementing The Private Market Investment Approach Into The Public Markets

While working at Bain Capital Rasmussen examined 2,500 cases of private equity deals with the most success over the course of three decades. His analysis showed that private equity is mostly a small-cap strategy with the vast majority of deals being below the enterprise value of $1.1 billion. The second, crucial characteristic was seven times cash flow.

An interesting conclusion was that when PE firms paid more than seven times earnings before interest and taxes, the chances of success dropped.

From the data between 1965 and 2013, leveraged small-cap investing in the private market would deliver 25.1% annual gains.

Rasmussen decided to utilize these findings in Verdad Capital with a twist. He made an attempt to replicate the process but on the public equity market, what made the original model was made even better.

Verdad's average buy price was less than 6x EBITDA, while debt was at 3x to 4x EBITDA. Another upside is the increased scrutiny of short sellers and financial analysts resulted in public markets being more transparent than private markets.

The final piece of the puzzle is that private market investing is much pricier with the burden of complex transactions pushing up the costs. Public deals also allow a higher level of liquidity being able to exit from the position anytime without a lengthy transaction process.

The Potential Of Leveraged Small Caps

The company's take is that an average private equity manager bets the S&P 500 between 1980 and 2010 by 5% to 6% annually. The cause for this is that most of the deals are small companies that are much more leveraged, and by 2010 significantly cheaper than public equity markets.

They believe that they can replicate those results by buying small, cheap, and highly leveraged companies in the PE markets.

Too much capital has entered the PE market which pushed out the investors from buying cheap. The company’s opinion is that it is wiser to buy in public markets at 5x to 10x EBITDA when compared to the modern PE environment at 11x to 12x EBITDA.

Japan Market And Its Upsides

At the time of the analysis, Japan was very cheap on both a relative and absolute base. In 2017 the difference in valuation between Japan and US stocks is at the largest scale since the dot-com bubble.

Leveraged equities in Japan come with unique characteristics. Japan's economy has practiced no interest rate policy for three decades. That coupled with almost non-existent chances of bankruptcy creates a completely different market for leveraged companies than in the US and Europe.

When Verdad found a market that was combined with almost no chance of bankruptcy they could employ their strategy with low volatility and almost no drawdowns. Japan's capital allocation is not too keen on shareholders, thus leveraged companies mitigate a lot of connected issues. As a result, most value investors are aligned toward cash-heavy balance sheets.

The company wanted to test its approach and it proved that leverage has been the crucial element for predicting future returns. The other approach that investors tried to use was activism, but it achieved only limited success.

In 2017 the valuation difference between Japan and US equity was 7x EBITDA in Japan, while the US experienced 12x.

Managing The Portfolio

Verdad Capital prefers constructing a diversified portfolio that includes 35 to 40 Japanese companies. However, they are very thorough in their research. They screen every name and in case they fit several of their demands the company makes a note about it.

Besides looking at the past performance Verdad is trying to anticipate the future. Since they are looking at underperformers one of the most important goals is to assess if the pessimism about the asset is real, or if it can surprise in the future.

Once the name gets into the portfolio it is carefully monitored. When it stops to fit the bill the asset is sold, and the portfolio is rebalanced. In the rebalancing process, the company aims to be tax-efficient by taking short-term capital losses, alongside long-term capital gains.

There were instances where names delivered a 2x return in the course of a year. At that point, the company starts to trim down and exit from the position.

Yamaya Investment Thesis

Yamaya Corp is a company mainly engaged in the liquor and restaurant businesses. Yamaya's operations grew with acquisitions and aggressive store branching out. While it may seem like a straight-up growth investment, some of the stores are not delivering nearly enough, and they will need restructuring of the network. At the time of the thesis EBITDA was at 3.5x and free cash flow yields around 15% making it a dirt cheap opportunity.

With a 3 billion yen of levered free cash flow, Yamaya has enough space to both bring down the debt and invest in the operations. From the company they see an issue in the constant network growth, and the potential for profitability coming from it. However, once the management fulfills its vision, there will be room for rationalization.

Yamaya is at first focused on conquering new markets, and later moving into margin improvements. So, basically, they expand and test the market with new stores, and later close those that are not profitable enough.

When looking at 101 Japanese restaurant businesses across the scale, they are on average traded at 9.6x EBITDA. According to the company that is vastly overpaid, and the 3.5x EBITDA of Yamaya leaves enough space for the upside if the company manages to shake off the pessimism around it.

The fund loves limited public float, and in the case of Yamaya, it is at 33%. They also love volatility in a diversified portfolio, and while most of the Yamaya share base is locked down, trading volumes are low. That is one of the reasons for the discount, and once the stock is more opened up, it will attract a new string of investors looking to buy at a bargain price.

Yamayo has some clear characteristics that the fund would like to keep away from, including serial expansions and M&A forced growth. This is especially off-putting when it is done at the expense of the margins.

However, from the fund come reassuring voices that most of this “bad behavior” will stop and reconsider focusing on growing margins. In case this happens, the stock can grow two or three times in the period of a couple of years. Also, in this scenario, Yamayo has more than enough room to pay healthy dividends and lower overall debt.

Revisiting The Thesis Seven Years Later

Forward-thinking at Verdad was highly intuitive, and when we look at the price of 1,620 yen per stock at the time of the pitch, the price just continued to grow. It did have a couple of drawdowns over the years, but it did not fall below the buying price ever since.

In the period of one to two years after the buy, the stock reached its peak, doubling in value, which proves that the fund had a very good nose when timing the investment. Since the beginning of 2023, the stock price hasn’t gone below 2,500 yen, and it is currently standing at 2,835 yen.

When assessing the company fundamentals they are all pointing in the upward direction. From the table below you can see the development of the crucial elements that make a specific company a good long-term buy.