General

Interest rates have been on the rise in recent months, as central banks around the world have been tightening monetary policy in an effort to combat inflation.

I am still using a discount rate of twice the 10-year bond yield which is currently around 4%. However, I am not sure what long-term growth rate to use in my valuations. I am currently using 2.5% which is 50bps lower than general near term expectations.

Hotel Chocolat

During the quarter, I made a new investment in Hotel Chocolat. Hotel Chocolat is a British chocolate company that sells its products mainly through its own stores, though they have around 30%ish sold through online, and third-party retailers (e.g. Amazon, John Lewis, etc). The company has a strong brand image in the UK. Its revenue is just shy of Lindt UK which is a big UK competitor. It is larger in revenue size when comparing to Cadbury UK Limited – amidst this is the UK entity of Cadbury which I’m not sure if there is more than 1 UK trading entity for Cadbury.

I am attracted to Hotel Chocolat for three reasons:

1. Valuation: The company is trading at a normalised UK-segment earnings of around 10x. The company has 0 debt.
2. Management: The management team is owner-operator. Angus Thirlwell and Peter Harris founded the company in late to early 2000s, each own roughly 30% of the business and have been running the business since its founding.
3. Moat: Hotel Chocolat has a strong brand that is well-known among British consumers. This brand does play in part in explaining a wooping price per kg chocolate sold of around £50 at Hotel Chocolat, compared to a national average of around £4. Yet I don’t think this is overpricing as you can find entry level products at Hotel Chocolat that goes for just £4.5 a pack (go for their “Selectors” which is 6 pieces of chocolate, and they do taste great!). Therefore they capture the best of both worlds, appealing to consumers as a high end chocolate but their products are consumed as if they are affordable luxury (like Starbucks).

The reason the share price is trading at 10x earnings is due to market volatile sentiment around Hotel Chocolat’s past international expansion which is much slower than expected, and rising cost concerns – supply chain and cocoa prices. None of this is fundamentally impairing the UK business and I do expect them to fiercely protect their existing position in the UK (£200m sales and historically have achieved at least 10% EBIT margin for a number of years, and importantly this is during the period when they were adding a lot more stores and therefore registered lots of one-off store opening expenses and initially high depreciation costs).

Broad comments on the portfolio

The major tech holdings in the portfolio – Meta, Amazon and Google have had a nice run up YTD. That said, I think they are trading at around 10-30% discount to their current intrinsic value. If taking into account potential growth in intrinsic value due to future growth the discounts will get wider. Therefore I don’t expect to significantly sell down any of them to the extent there are other opportunities (e.g. I sold down Google a fair bit to buy up Hotel Chocolat).

There is general concern regarding commercial office real estate – one of my holdings – Brookfield corp has large exposure to it. That said, as long as cap rate is around 4-5% ish for class A office (which is justifiable if the market assumes a discount rate of 6-8% and a long term growth rate of 2-3%), then the current debt cost of 5-6% shouldn’t cause any impairment to the equity (assuming 50% LTV of course). That is because, if rent grows at 2-3%, the effect of 50% LTV means you will realise a 4-6% cagr from selling the property down the line. Adding to this 3-5% in yearly equity payout after debt cost means total equity irr is still a pretty nice 7-11% cagr throughout holding period.

So the maths work, but as they go through this period there will be small blow up here and there due to mis-recognising which office is Class A and which is Class B and C in Class-A disguise.

Overall I expect to continue owning Brookfield Corp stock.