With the exception of Michelin5 , all positive contributors were sold during the quarter. It is not our intention to hold stocks for only a short period. However in all of these instances there was a meaningful rise in the share price and/or new financial information was released which resulted in us deeming the business too expensive or too risky.
The returns we realised ranged from around 13% for Neopost (over the three months we held it) to over 30% for Urban Outfitters (which we held for a mere six weeks). However, before the mutual back slapping and all-round high-fives, let’s also reflect that with the benefit of hindsight, as we write this at end of October, Neopost continued its stellar rise by another 17% and Tocalo by a further 6% (although the others had all fallen by between 5% and 10%).
By the quarter’s end we had moved on from our Avnet position (realising a 4% loss). We monitor risk on a weighted average basis across the portfolio, and Avnet was a holding that was increasing risk to a level beyond our criteria, whilst not providing any appreciable benefit. We continue to hold Japan Airlines and American Public Education.
We also highlight a notable absentee. We are not trying to hide anything – like stock selection and portfolio construction we have rules in place as to the ten stocks that comprise the graph. And Debenhams, which cost the strategy 1.6% during the June half year, cost us a further 0.15% during the September quarter.
The capital destruction from our Debenhams position was the catalyst for some introspection. Whilst we were aware the business is suffering from declining retail fundamentals, our objective process is “supposed” to identify when the poor fundamentals are more than adequately reflected in equity prices. And in this instance it failed. With hindsight’s benefit, we know that had our process adequately accounted for “hidden” leverage we would have avoided this costly mistake. As at September 2016, Debenhams had debt of only around GBP340m, but it also had significant long term lease liabilities of GBP4.6 billion which are not reflected on its balance sheet. The fixed rental charges associated with these leases magnify the earnings effects of declining revenues.
With our risk focussed approach, we created new rules to become more discerning around investing in capital intensive business operations where the equipment is leased, rather than owned. As a result, we are less likely than otherwise to hold positions in retail companies and airlines.