Arisaig Partners, an investment management firm, published its second quarter 2021 investor letter – a copy of which can be downloaded here. Arisaig’s Funds recovered substantially in the second quarter after a muted start to the year, with its Asia and Global Funds gaining 3.4% and 5.3% respectively. You can view the fund’s top 5 holdings to have an idea about their top bets for 2021.
In the Q2 2021 investor letter of Arisaig Partners, the fund mentioned Arco Platform Limited (NASDAQ: ARCE), and discussed its stance on the firm. Arco Platform Limited is a Brazil-based educational software company, that currently has a $1.61 billion market capitalization. ARCE delivered a -21.02% return since the beginning of the year, while its 12-month returns are down by -37.70%. The stock closed at $29.10 per share on August 03, 2021.
Here is what Arisaig Partners has to say about Arco Platform Limited in its Q2 2021 investor letter:
“Our Global and Next Gen Funds have increased their exposure to Arco Platform, a Brazilian education business listed originally in 2019. Arco’s core business is that of digital ‘learning systems’, a comprehensive content solution for schools which provides teachers and students with learning materials and digital tools for lesson planning, teaching and assessment. The company replaces a traditional system of printed textbooks and analogue communication between teachers, students and parents, with a subscription-based integrated digital solution, able to update in real time in line with
changes to the syllabus, optimisation of content (based on data feedback loops), and which can be customised to individual pupils.We believe there is a powerful incentive for schools to switch from current systems to this more effective, typically less expensive solution. Once Arco’s tools are integrated into a school’s operations, however, the disruption that would be caused by discarding them is a similarly powerful deterrent against switching to competitor products. Arco’s customers are private schools, which account for roughly a fifth of students, with average tuition costs of roughly USD185 (monthly) making this a more habitual purchase than might be the case in the US or UK. Content costs are typically passed onto parents, and Arco’s digital solutions both save parents money compared to traditional learning systems, and achieve better than average learning outcomes, based on the ranking of Arco schools in standardised national exams.
Indeed, raising education standards is at the heart of the company’s mission, making Arco a good illustration of the ‘Purposeful Growth’ culture that we seek in our investee companies. Its roots are in the management of a series of high-achieving schools in the State of Ceará in the Northeast of Brazil.
Its founder developed the company’s learning systems as a way of sharing the successes of his family’s teaching methods with a wider network of educators. Arco’s digital-first model (albeit focused predominantly on improving and facilitating in-person teaching) allows for a highly scalable system
which does not diminish in quality as it expands. On the contrary, expansion allows for the reinforcement of ‘data moats’, in other words the real-time adaptation and update of content and platforms in response to user experience.Key to the principles of the Next Generation Fund is that for a company to be able to reliably generate and grow its positive impact over time, it must deliver it in a financially sustainable way, which rewards the investors who provide it with capital. Philanthropic dollars at some stage dry up; so for impact to endure, the business in question needs to generate sufficient cash to sustain its own growth. Our goals in this strategy, therefore, of optimising for both impact and financial returns over the long-term, go hand-in-hand when we select the right business models.
In the education space, for example, those companies which show themselves to successfully enhance learning outcomes are most likely to keep on attracting business over the long-term. Schools choose Arco because its system helps improve its own service, thereby attracting parents and students. As a digitally native model, Arco’s marginal cost for adding each new customer is essentially limited to the sales force which recruited them, and the customer service representatives who keep them happy. Though ROCE of 17% is currently depressed by a recent major acquisition, we expect incremental ROIC to trend towards 100% in periods of organically-driven expansion.
The main risk we perceive is a relatively limited addressable market. It is no sure thing that private education will continue to increase its share of the Brazilian education system (though chronic underinvestment in the public sector seems like a dependable driver for now). We believe consolidation of the market is a more reliable source of long-term growth, and that Arco’s chance of increasing its national market share from its current level of 17% are high. Multiple sources have independently vouched for the superior quality of its offering, and it offers a clear academic benefit and cost saving relative to traditional textbook-based systems. Acquisitions, however, bring added execution risk, particularly given the strength of Arco’s culture and purpose, which does not always allow for easy adaptation by newly acquired subsidiaries.
A silver lining to this dependence on acquisitions is the creation of growth optionality and potential expansion of the company’s TAM. For example, recent takeovers Dom Bosco and Me Salva! have brought it into the realm of state schools (positive for the company’s impact case) and direct-tostudent test prep, respectively. Consistent cash generation from the core business will allow Arco to direct sufficient resources to capture these new sources of growth.
The share price has been weak over the past year, as the market is concerned with a slowdown in subscriber growth, with some schools reportedly reluctant to sign new contracts given the uncertainty related to the pandemic. We do not think these are structural issues that affect the real value of the
business (indeed, the pandemic has actually re-enforced the utility of digital learning tools), and even after a recent bounce-back (which occurred after we had completed most of our top-up buying) we believe the valuation of the shares still looks very reasonable.”
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Based on our calculations, Arco Platform Limited (NASDAQ: ARCE) was not able to clinch a spot in our list of the 30 Most Popular Stocks Among Hedge Funds. ARCE was in 8 hedge fund portfolios at the end of the first quarter of 2021, compared to 15 funds in the fourth quarter of 2020. Arco Platform Limited (NASDAQ: ARCE) delivered a 12.51% return in the past 3 months.
Hedge funds’ reputation as shrewd investors has been tarnished in the last decade as their hedged returns couldn’t keep up with the unhedged returns of the market indices. Our research has shown that hedge funds’ small-cap stock picks managed to beat the market by double digits annually between 1999 and 2016, but the margin of outperformance has been declining in recent years. Nevertheless, we were still able to identify in advance a select group of hedge fund holdings that outperformed the S&P 500 ETFs by 115 percentage points since March 2017 (see the details here). We were also able to identify in advance a select group of hedge fund holdings that underperformed the market by 10 percentage points annually between 2006 and 2017. Interestingly the margin of underperformance of these stocks has been increasing in recent years. Investors who are long the market and short these stocks would have returned more than 27% annually between 2015 and 2017. We have been tracking and sharing the list of these stocks since February 2017 in our quarterly newsletter.
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Disclosure: None. This article is originally published at Insider Monkey.
