The Alluvium Global Fund (Fund) posted a net return of 6.1% over the September quarter1.

The return was tempered by the Australian dollar (“AUD”) rising against the currencies in which the Fund’s investments are quoted.

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, Apex, Factset

Figure 2: Comparison of Net Returns (AUD)

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

General Commentary

In the June report we highlighted the following two concerns:

  • the general high level of equity prices as illustrated by broad based indices; and
  • the possibility that the “in-built” historic hedge, which has been the result of the inverse relationship between equity prices (in local currency terms) and the level of the AUD, may break down.

Well, in relation to the high equity prices – this has only gotten worse. We admit to being a little surprised by the market’s broad based buoyancy. But, in relation to the latter, that relationship appears to have held up – we are also surprised by the strength of the AUD over the quarter. The result of course was that the Fund did not benefit so much from those rising equity prices. And – to a certain extent – we were caught out by our large holding in USD cash. This alone detracted around 0.4% from the Fund’s returns over the quarter.

Performance Review

Figure 3: Top Contributors/Detractors

Source: Interactive Brokers, Alluvium, Factset

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.

Portfolio Profile

Figure 4: Diversification by Sector

Source: Alluvium, Factset

Figure 5: Diversification by Region

Source: Alluvium, Factset

Table 2: Fund Overview

Top 15 holdings62.7%
Number of holdings27
Weighted Average Market Cap. (USD m)18,677

Source: Alluvium, Factset

Table 3: Quality Metrics (weighted average)

Debt (% of EV)615.6%
Piotroski score76.6
Return on Invested Capital (5y average)20.5%
Latest Return on Invested Capital20.5%

Source: Alluvium, Factset

Table 4: Pricing Metrics (weighted average)

Enterprise level yield (EBIT/EV)614.0%
Earnings yield (NPAT/Mkt Cap)611.7%
Free cashflow yield (FCF/Mkt Cap)69.7%

Source: Alluvium, Factset

Table 5: Top 15 Holdings

Wabash National5.2%
Eastman Chemical5.1%
American Railcar Industries4.9%
American Public Education4.8%
Huabao International4.8%
Yuasa Trading2.8%
Delta Airlines2.7%
Lear Corporation2.7%

Source: Alluvium, Factset

There was a reasonable level of repositioning within the Fund over the quarter. We purchased four new businesses, two of which (GameStop and Ennis) in meaningful size. GameStop is a retailer of electronic games, you may know of its subsidiary, EB Games – if not your kids do! Ennis is a printing business. The other two smaller businesses are a semi-conductor manufacturer and a broadcasting company.

In addition to the divestments we explained in the Portfolio Review section, we sold a further six stocks, including Target, Nagacorp, Pendragon and three smaller companies. All were divested as a result of implementing our rules. We managed to eke out small gains (low to mid single digit) for all of these except Nagacorp (where we made a profit over 10%) and a small Japanese company where we suffered a loss of around 6%.

The Fund’s composition continues to be completely different from an index portfolio. Based on our best estimates, of the Fund’s 27 positions only seven are in the Index (with a combined weight of only 0.65%). Therefore, our “active share” is over 99.3%. Although this may vary from time to time, we do not expect the Fund to ever meaningfully represent an index portfolio. You pay for active management – you deserve to get it!

A quick update on portfolio holdings – although we remain comfortable with the current price levels of the Fund’s holdings, our cash level has increased. This is the result of the rules requiring us to divest certain positions (as we discussed) and the lack of available alternatives that would still result in the Fund meeting our diversification, quality and valuation rules.

This quarterly update is intended to be succinct. If you are interested in learning more, please simply send us an email. We’re always happy to meet and elaborate.

Best as always,

Stuart Pearce

Alexis Delloye

1 Apex Fund Services Limited (Apex).

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

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

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.

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.