December 2015 | Annual Report

Snapshot

The Alluvium Global Strategy (Strategy) posted a net return of 16.5% over the 2015 calendar year1.

The longer term net returns of the Strategy, in Australian dollars (AUD), as well as some alternatives are shown below:1,2,3,4

Figure 1: Value of AUD100,000 (dividends reinvested)

Source: Interactive Brokers, Alluvium, Factset

Figure 2: Comparison of Net Returns (AUD)

Source: Interactive Brokers, Alluvium, Apex, Factset. Inception: 1 Jan 2015 (Annualised)

General Commentary

This inaugural year included two contrasting periods. What started as very impressive returns over the first half tapered significantly over the last six months, particularly in the fourth quarter. As a professional investor I seek opportunities that offer “asymmetric return” possibilities. But over the last couple of months I developed an appreciation of the concept of “asymmetry of emotions”. As the portfolio represents the majority of my family’s liquid investments – my distress of the capital loss of over 4% in the last quarter was immeasurably more intense than the pleasure I experienced by the 22% gain over the preceding nine months. Despite repeatedly reading about this phenomenon – the pain of losses being more than double the pleasure of gains (drawing on elements of “loss aversion”) one can only really appreciate it as they experience it.

As we progress through 2016, global financial markets have experienced heightened levels of volatility, mostly in a downward direction. During the first couple of months of 2016 the Index is down almost 5% and the Strategy is down around 1.6%1,2,3,4. Neither has been helped by a surprisingly strong AUD, given the weak and turbulent markets. But, in my view the earnings and cash flow streams stemming from the portfolio of businesses provide quite acceptable yields (please refer to Table 4 – Pricing Metrics).

2015 was a good year for an Australian to invest offshore. A simple strategy of holding United States dollars (USD) rather than AUD would have returned 12.5% and bettered most indices in AUD terms. BUT, Harry Hindsight5 suggests one would have been best to avoid “value stocks” – just look to the right column in the table below:

Table 1: “Value” Performance

Year ended 31 December 2015 All
Stocks
Value
Stocks
Value
Outperformance
Alluvium Global Strategy (AUD) 16.5%
MSCI World Net Total Return Index (AUD)6
11.5% 5.4% -6.1%
MSCI USA (USD) 0.7% -3.0% -3.7%
MSCI AC Asia Pacific (USD) -2.0% -3.8% -1.8%
MSCI Europe (EUR) 8.2% 0.6% -7.6%
Australian Global Equity Products (AUD)7 12.4% 11.6% -0.8%

Source: Interactive Brokers, Alluvium, Factset, Morningstar, Inc.

Simply put, 2015 was the year for the “momentum investor”. The “FANGs” – Facebook8, Amazon, Netflix and Google/Alphabet massively outperformed – Netflix and Amazon more than doubled! But small caps performed poorly, Energy and Materials stocks posted dismal returns and Financials and Utilities not a great deal better. The S&P 500 did manage a return of 0.7% over the year, BUT, an equal weighted version of it would have posted a negative return of 2.8%2.

There have been many interesting analyses of market conditions by leading industry practitioners. James W. Paulsen compared valuation levels between a “Popular Portfolio” (the top 100 performers over the last year of the S&P 500) and a “Disappointing Portfolio” (the bottom 100 performers). His conclusions based on median price/earnings multiples, are enlightening9 :

  • the Popular Portfolio is currently in the 85th percentile of its historic range at about 23 times; and
  • the Disappointing Portfolio is currently trading at 13 times (which is lower than 70% of the time during the last 25 years).

Joel Greenblatt, one of the founders of Gotham Asset Management, LLC, noted in September10:

“Buying the top momentum stocks and shorting the bottom momentum stocks (from the Morgan Stanley momentum index) would have achieved positive 18% returns so far this year whereas buying the top value stocks and shorting the bottom value stocks (from the Morgan Stanley value index) would have lost 13%.”
“Money flows into passive investments vs. active investments are running at levels of 8 to 1 or more. Buying only those companies that lose money has earned investors anywhere from 20% to 50% over the last twelve months.”

If you are thinking all value investors stick to the same script, you’re right – we do. Why? Because over the long term, time and time again value investing shines through. But, in order to allow it to do so, we must stick with it. And, to facilitate this I admit to succumbing to “confirmation bias”, seeking views of like-minded investors which serve to reinforce my belief in the merits of the Strategy.

So, let us now explain a little about value investing.

Expectations of the performance of listed businesses are reflected by the trading price of their equity as a multiple of earnings (that are available to equity holders). Businesses with their equity priced at lofty multiples simply reflect the expectations of high growth in earnings. If the business fails to meet those expectations, investors are disappointed and their equity price suffers.

Conversely, businesses priced at low earnings multiples reflect low or no expectations of growth, and if the business fails to meet those low expectations, the sell-off is usually not so dramatic. And, if they exceed or sometimes simply just meet those low expectations, they can be re-rated at a higher multiple (and often from a higher earnings base). These are the businesses that my process is designed to target.

During the market conditions experienced over 2015, the trading multiples placed on businesses perceived to have highly growing earnings streams reached extreme levels. It is my view that many of these multiples will be proven unjustifiable by future business results and investors will lose capital. By applying strict long term earnings criteria, investors in the Strategy are not so exposed to this risk.

Whilst clearly no long only equity investor is immune from short term market movements, this principle of “not paying up for expected growth” is one of the elements designed to afford downside protection to investor’s capital – and my aim is to best protect capital over the longer term.

Performance Review

Figure 3: Top Contributors/Detractors

Source: Interactive Brokers, Alluvium, Factset

Let’s start with the obvious – the main contributor to returns was currency. I mentioned at the outset that a long USD short AUD position would have returned 12.5%. While far from professing my forecasting ability, the AUD did seem to me to be on the bounds of Buffett’s “zone of reasonableness” at the start of the year. By year end though, it is not so clear-cut – and the AUD’s subsequent strength has confirmed this. In my view, those reasonably easy gains are not repeatable going forward.

The broad reasons the Strategy managed to achieve better returns than the Index, the Value Index, and many of its value investing peers appear to be:

  • Energy sector returns. This sector accounts for around 6% of the Index. Global energy stocks in USD terms fell around 23.5% (14% in AUD terms), hence detracting more than 1% from the Index return. However, one of our positions in the energy sector (Valero Energy) performed very well and net-net the energy sector actually contributed 1.2% to the Strategy’s performance;
  • Finance and Utilities sectors. The Strategy does not invest in highly geared companies, or equities which are not capable of being analysed under our preferred methods. This includes stocks in the Financials and Utilities sectors. These performed poorly, down 3.5% and 6.5% respectively in USD terms (up 9% and 5% in AUD terms). So not holding them provided a small relative return boost; and
  • Japan. This country represents about 9% of the Index and was the best performing region, returning around 10% in local currency terms and over 23% in AUD terms. The Strategy’s weighting toward Japanese companies (an outcome of my bottom-up investment process) was around 12.5% over the year, and its Japanese holdings have, in the main, performed well.

The return contribution from currency across the Strategy’s array of investments was around 10%. That leaves around 9% from equities in their local currency terms. In relation to that 9%:

  • Larger stocks (greater than USD 2 billion) were detrimental to performance by around 3%;
  • Japan listings contributed over half of the returns and Hong Kong listings also contributed meaningfully (due to China Lilang), whereas our US listed stocks detracted by around 2%;
  • At a sector level (as defined by Factset) detractors were:
    • Producer Manufacturing, due solely to our position in Dana Holding; and
    • Technology Services (due to IBM and NeuStar); and
  • At a sector level (as defined by Factset) contributors were:
    • Consumer Non-Durables (due solely to China Lilang);
    • Communications (Inteliquent and Cable & Wireless Communications);
    • Commercial Services (as a result of ITE and Transcontinental);
    • Consumer Durables (with Cooper Tire & Rubber, TS Tech and Token performing very well); and
    • Transportation (Alaska Air and Hamburger Hafen und Logistik).

More interesting for me is the detail around individual stock contributions. We can see there were a few clear winners and the magnitude of the wins was far greater than the magnitude of the losses.

The top contributors to the Strategy’s returns were:

  • Fujitsu General, a manufacturer and seller of electronic and electrical equipment, which was purchased at inception and continues to be held. At year end it closed 40% higher than the purchase price;
  • China Lilang, a manufacturer and wholesaler of menswear and accessories that operates in China. This was purchased at inception of Strategy in late December 2014 and sold in May (because its ranking decreased) providing a net return of 57%;
  • Terra Nitrogen, a manufacturer of nitrogen fertilizer products. Purchased at inception it was sold in March (with a 40% profit) because of the change in rules that prohibited investing in partnerships and trusts;
  • Alaska Air, which was bought in May and sold in September for a 22% gain (because its ranking had fallen significantly); and
  • Kohl’s, a department store operator which was bought at inception and sold in March (with a 25% gain) because it failed to meet some base screening requirements.

The main detractors were:

  • Dana Holding, a manufacturer of driveline systems for trucks and passenger vehicles. This position was purchased in May. It finished the year 37% lower and is still held;
  • American Public Education, an education provider mainly for the military. This position was bought in June and is still held. The price declined to finish the year 25% lower than purchase price; and
  • Albermarle, a chemical developer which was bought at inception and sold with a 20% loss in late January (after new results indicated declining business fundamentals and higher likelihood of financial distress).

Portfolio Profile

Figure 4: Diversification by Sector

Source: Alluvium, Factset

Figure 5: Diversification by Region

Source: Alluvium, Factset

Table 2: Fund Overview

Cash 10.4%
Top 15 holdings 72.4%
Number of holdings 20
Weighted Average Market Cap. (USD m) 12,508

Source: Alluvium, Factset

Table 3: Quality Metrics (weighted average)

Debt (% of EV)11 12.7%
Piotroski score12 6.0
Return on Invested Capital (5y average) 21.3%
Latest Return on Invested Capital 23.8%

Source: Alluvium, Factset

Table 4: Pricing Metrics (weighted average)

Enterprise level yield (EBIT/EV)11 11.2%
Earnings yield (NPAT/Mkt Cap)11 9.5%
Free cashflow yield (FCF/Mkt Cap)11 8.1%

Source: Alluvium, Factset

Table 5: Top 15 Holdings

Fujitsu General 7.4%
Cooper Tire & Rubber Company 5.7%
Valero Energy 5.2%
John Wood 5.0%
Quest Diagnostics 4.9%
Westlake Chemical Corporation 4.8%
LyondellBasell Industries 4.8%
Best Buy 4.6%
Transcontinental 4.4%
China Shineway Pharmaceutical 4.4%
Trinity Mirror 4.4%
Yuasa Trading 4.3%
IBM 4.3%
Western Digital 4.1%
NeuStar 4.1%

Source: Alluvium, Factset

Conclusion

The Strategy’s rules include strict diversification, quality and price criteria. I think the portfolio is well diversified and reasonably priced as illustrated by the figures and tables.

I have been operating this Strategy solely for my own benefit and I will continue to do so. However, should other like-minded investors wish to join me I would be honored to accept that opportunity. Those investors can be assured that the assets they have entrusted to Alluvium will be managed according to Alluvium’s high standard of ethics, with full transparency, no conflicting interests and with the same level of care and diligence as my own investments.

Thanks for your interest,

Stuart Pearce
Principal

1 Interactive Brokers, LLC (Interactive Brokers).

2 Interactive Brokers, Alluvium Asset Management Pty Ltd (Alluvium), Factset Research Systems, Inc. (Factset).

3 Sourced from Interactive Brokers and reduced by an assumed administration fee of 0.45% and a base management fee of 0.90% (both are inclusive of GST), as calculated by Alluvium.

4 MSCI World Net Total Return Index (AUD, unhedged), (Index or MSCI World).

5 Harry’s contribution to investment management is immeasurable.

6 In the case of “All Stocks”, the relevant indices are the MSCI World (AUD) and its regional constituents, and in the case of “Value Stocks”, the relevant indices are the MSCI World Value Net Total Return Index (AUD), (Value Index) and its regional constituents.

7 For “Australian Global Equity Products”, “All Stocks” refers to the average return of all global equity funds and “Value Stocks” refers to the average of the long only global equity funds that are identified as “Value” (Morningstar, Inc.). These are gross returns whereas the Strategy returns are quoted net of management fees.

8 Company names have been abbreviated throughout this document in the interest of readability. Should readers wish for more detailed information, please feel free to contact Alluvium.

9 Economic and Market Perspective, 11 January 2016, Wells Capital Management, Inc.

10 Current Market Volatility: A Return to an Appreciation of Risk, September 2015, Gotham Asset Management, LLC.

11 EV refers to Enterprise Value. Alluvium defines EV as the market value of a company’s equity plus the book value of its gross debt. EBIT refers to earnings before interest and tax. NPAT is net operating profit after tax. FCF means cash flow from operations less capital expenditure. Return on invested capital refers to EBIT as a percentage of the average capital invested in the business operations (as defined by Alluvium).

12 Piotroski score is a discrete score between 0 and 9 which reflects nine criteria used to determine the strength of a firm’s financial position.

This report is a simplified, condensed and modified version of the Annual Report originally prepared in February 2016. It has been updated for relevance to Alluvium Global Fund investors, including past performance taking into account management fees.

Alluvium Asset Management Pty Ltd, ABN 69 143 914 390, Australian Financial Services License number 476067 (“Alluvium”), is the issuer of units in the Alluvium Global Fund and is solely responsible for the preparation of this document. The Alluvium Global Fund is an unregistered managed investment trust available to Wholesale Clients as defined under Section 761G of the Corporations Act 2001 (Cth). An Information Memorandum for the Alluvium Global Fund is available and can be obtained from our website. A person should obtain a copy of the Information Memorandum and should consider the Information Memorandum carefully before deciding whether to acquire, or to continue to hold, or making any other decision in respect of, the units in the Alluvium Global Fund. This document was prepared by Alluvium and does not contain any investment recommendation or investment advice. This document has been prepared without taking account of any person’s objectives, financial situation or needs. Therefore, before acting on any information contained within this document a person should consider the appropriateness of the information, having regard to their objectives, financial situation and needs. Neither Alluvium, nor its related entities, directors or officers guarantees the performance of, or the repayment of capital or income invested in, the Alluvium Global Fund.

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