June 2016 | Half Year Report

Snapshot

The Alluvium Global Strategy (Strategy) posted a net loss of 2.9% over the six months to 30 June 20161,2.

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 (net 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

For those investors interested in short-term numbers, this would be disappointing. It begs the question: How should one compare that return to a simple investment in an index or a long/short fund?

I think wise investors should not only look to returns, but also to the risks inherent within different investment strategies. But what exactly is risk and how is it measured?

Investment risk is an interesting concept. Traditional finance theory and many market participants view risk as volatility. I contend they do this for convenience. As Mr Buffett rhetorically questions: if the share price of a business falls by half, then is the subsequent purchase of those shares a more or less risky investment?

I do not view investment risk as volatility. My view is that risk is subjective and it cannot be accurately measured (not even in hindsight). Investment results are a function of outcomes, and whilst the past has a defined outcome, that outcome was one of an infinite number that could have eventuated. Who knows and understands how an investment portfolio would have behaved under different environments? And who can accurately predict which environmental conditions out of the plethora of possible conditions will eventuate?

“The idea that the future is unpredictable is undermined every day by the ease with which the past is explained.” – Daniel Kahneman

When we view investment risk from this perspective we realise it cannot be quantified. Rather, we would need to understand an investment manager’s philosophy and process, monitor them, and then form a judgment. And this makes the risk assessment difficult, effortful, and time consuming. Even worse, as it is subjective, for those involved in the industry it exposes us to business and career risks. So I understand why most market participants adopt academia’s convenient and quantifiable risk measure of historic volatility.

Getting back to the risks inherent in those two alternative investment examples. Let me ask you two questions:

  • Is a long/short equity fund that has exhibited low volatility in its monthly return more or less risky than an investment strategy with a more widely fluctuating unit price?
  • Is an investment in an index (which may comprise thousands of stocks) more or less risky than a concentrated portfolio of around 25 stocks?

Well, I simply highlight that:

  • I will NOT make an investment that could lead to uncapped losses, like a “short” position; and
  • I will NOT hold a share of a business without first analysing and understanding its fundamentals and value.

Periods of poor investment performance are challenging. In difficult times I like to ask myself the question: “what would Warren and Charlie do?” Based on my readings, I think Mr Buffett would look at how well he has performed relative to his own criteria, his “inner scorecard”.

“When there is no enemy within, the enemies outside cannot hurt you.”” – African Proverb

In developing the Strategy, I simply asked myself: What do I wish to achieve from investing in listed equities? The answer was not to outperform an index, nor was it to beat competitors. Rather, the answer was to provide access to investments in businesses with particular attributes I see as attractive, with the intent of compounding capital while minimizing the chance of permanent loss of capital (when adopting a long term outlook). This is in tune with how I view listed equity investments fitting into my broader investment portfolio. As a consequence, the Strategy became a differentiated offering, not designed to mimic an index or to copy peers.

So when I reflect upon my inner scorecard I become a little less hard on myself.

However, poor performance does prompt some further thought – and it may be useful to highlight what I see as some of the key risks to future portfolio performance? The following concerns come to light:

  • Broad based equity price levels, as reflected by the various indices, are setting new highs. This is not being driven by improving fundamentals of the underlying businesses; rather it is being driven by investors’ willingness to pay a greater amount for future earnings. Effectively, by paying up now, future return prospects are diminishing. And this is concerning. However I do draw some comfort from the “value” versus “growth” premium appearing to persist. It is my view that irrational prices are more prevalent amongst equities trading at high multiples and/or attracting passive inflows. Conversely, I do consider my portfolio of businesses to be more than reasonably priced (refer to Table 4 – Pricing Metrics);
  • Should there be market panic with broad based declines in global equity prices I may not be as protected as I would have been in the past. History has suggested that in times of panic, capital has flown from the AUD to currencies perceived to be less risky, such as the United States dollar (USD), the Japanese yen and the Swiss franc. This has provided a natural hedge for Australians investing globally. With the current level of unprecedented market intervention by central banks, I am unsure whether this relationship will hold going further. However, when I contemplate how to address this concern, I fail to find a better alternative to the status quo, so I have chosen to simply acknowledge and accept it; and
  • The possibility that my analytical techniques (which rely on the use of historic financial information to identify quality businesses available at reasonable prices) may become less effective as the pace of increasing technological innovation continues to increase. In essence, I am concerned of the possible vulnerability of the portfolio’s businesses to innovative and disruptive influences. I do have some objective measures in place that are designed to identify this (such as the Piotroski score5 and deteriorating returns on invested capital) but they cannot be regarded as foolproof. I am also cognizant that any measure I may implement to address this concern may be counterproductive in that it may cause us to omit investing in a business likely to benefit from the markets mean reversion tendencies. However, I have chosen to address this by adding discretionary components to the “subjective” checklist.

So, in relation to the first two concerns – no action, and with regard to the third, we’ll see how this plays out over time.

Now moving on to a few semantics. I had previously operated the Strategy simply in the form of a separately managed account (SMA). However with the view of offering it to a broad base of external investors, in early June I established, funded and invested in the Alluvium Global Fund (Fund). Going forward I will now simply refer to the Strategy as the Fund, and this is my principal offering to investors.

It seems sensible for future reporting dates to fall in line with the Fund’s financial year end of 30 June. So I am forewarning that the report in December 2016 will also be a half year report and the next annual report will be in one year’s time. Also, going forward, the quoted performance will be sourced from the net asset values of the main series of Fund units as provided by Apex (the independent Fund Administrator). As the Fund simply represents the implementation of the Strategy in a pooled structure, I feel it is entirely appropriate to combine track records. So, the historic track record (including the returns quoted in this report and prior Strategy reports) reflect the performance of the SMA for the period from inception of the Strategy (1 January 2015) to the Fund’s inception (6 June 2016), and the Fund thereafter. The SMA performance has been reduced to reflect an administration fee of 0.45% and a base management fee of 0.90% (both are inclusive of GST).

Performance Review

Figure 3: Top Contributors/Detractors

Source: Interactive Brokers, Alluvium, Factset

The impact of closing the SMA coupled with funding and investing in the Fund in the midst of the volatile markets during May and June was pronounced. The Fund’s performance, albeit negative, during the period of investing cash inflows (from inception to the end of June) was better than it would have been if it were fully invested. However, this was more than offset by the cash drag on performance experienced in the SMA in May as a combined consequence of funding the SMA redemption and the custodian’s trading restrictions on that account (these fortunately do not apply to the Fund). These affected my ability to trade currencies and withdraw unsettled cash. Had market prices been stable, or had the SMA been of the same structure as the Fund (allowing it to hold a typical portfolio throughout the month), I estimate that its returns would have been around 3% higher in May.

But more interestingly, the main individual stock contributions (far too many notable detractors) are provided below:

The biggest stock detractor was my holding in Debenhams, the British retailer bought in the SMA in February and still held at a 3.5% position in the Fund at the end of June. The stock has declined by around 30%, and this has been further exacerbated by the 10% fall in the British pound relative to the AUD. I’m currently reviewing this and I expect to provide further commentary in future reports.

Valero Energy, Western Digital and Yuasa Trading were positions sold during the wind-up of the SMA and not purchased in the Fund due to fundamentals no longer meeting my acquisition criteria. With the benefit of hindsight, I sold all of these positions near their nadir realising losses of around 18% on Yuasa and 25% on Valero and Western Digital. K & S, still held in the Fund, was recently purchased and fell by around 18% in the last three weeks of June.

On a more pleasing note, there were a couple of nice performers, most notably British Polythene Industries (a packaging company), which was subject to an agreed takeover. I bought this stock in February and sold in June realising a profit of around 48%. Similarly Ipsos, which is a French marketing and advertising business, ended up being another short term holding due to its share price shooting up after the release of its quarterly update in late April. I simply felt the capital could be better deployed elsewhere. Peak Sports Products, which designs, manufactures and sells sporting footwear and apparel, was sold in May after a privatisation scheme was announced and the share price rose significantly. I realised a gain of around 20% over a holding period just shy of two months.

Portfolio Profile

Figure 4: Diversification by Sector

Source: Alluvium, Factset

Figure 5: Diversification by Region

Source: Alluvium, Factset

Table 2: Fund Overview

Cash 12.7%
Top 15 holdings 66.6%
Number of holdings 27
Weighted Average Market Cap. (USD m) 5,412

Source: Alluvium, Factset

Table 3: Quality Metrics (weighted average)

Debt (% of EV)6 17.9%
Piotroski score7 6.9
Return on Invested Capital (5y average) 20.2%
Latest Return on Invested Capital 19.7%

Source: Alluvium, Factset

Table 4: Pricing Metrics (weighted average)

Enterprise level yield (EBIT/EV)6 13.8%
Earnings yield (NPAT/Mkt Cap)6 12.6%
Free cashflow yield (FCF/Mkt Cap)6 8.4%

Source: Alluvium, Factset

Table 5: Top 15 Holdings

Movado 5.5%
Target 5.3%
American Railcar Industries 5.2%
Neopost 5.1%
Monadelphous 4.8%
Transcontinental 4.7%
Avnet 4.7%
Wabash National 4.7%
NagaCorp 4.6%
K+S 3.9%
Michelin 3.9%
Huabao International 3.9%
Flight Centre 3.9%
Debenhams 3.5%
Pendragon 2.9%

Source: Alluvium, Factset

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.

With the sharp sell-off during June, together with the changing positions (which have led to an increase of smaller company holdings), the portfolio has become cheaper. It is offering earnings yields a couple of percentage points higher than it did in December – albeit with slightly higher (but still relatively low) levels of financial leverage.

It was a challenging half year for the Strategy, and indeed for me personally. The process of closing the SMA and seeding the Fund just happened to coincide with two highly volatile months – a market bounce in May (around 6.5%) followed by a “Brexit” sell-off in June. However, I am pleased to report that we arrived at the position as at 30 June with the Fund being fully invested in line with the Strategy, holding interests in 27 diversified global businesses.

Thank you 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), Apex Fund Services Limited (Apex).

3 Comprises: (1) a separately managed account for the period 1 January 2015 to 6 June 2016 sourced from Interactive Brokers and reduced by an assumed administration fee of 0.45% and a base management fee of 0.90% (both inclusive of the net effect of GST), as calculated by Alluvium; and (2) the Alluvium Global Fund from 7 June 2016 sourced from Apex.

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

5 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.

6 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).

7 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 Half Year Report originally prepared in July 2016 to provide relevance to Alluvium Global Fund investors. 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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