December 2016 | Half Year Report

Snapshot

The Alluvium Global Fund (Fund) posted a net return of 17.6% over the six months ended December 20161.

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)

This result looks great in isolation. And, fortuitously for us, as it represents the first few months of the Fund’s “official” operation it also sets us up well in the performance “league” tables.

However, it would be remiss of us not to mention that our mood was decidedly somber in June and early July (refer to our June report). The six month performance for the strategy had been pretty flat for the year to April, then it didn’t benefit from a market rally in May. To top it off, the absolute returns were decimated in the broad market sell-off during Brexit in June. So, in early July we were staring down the barrel at returns of -3.1% for the prior six months3. Of course, that does not mean it cannot get worse in the future.

In stark contrast, a “Brexit Bounce” in July (6.5%), and a “Trump Bump” in November and December (9.4% and 4.2%) saw the Fund post that solid net return of 17.6% over the second half2.

General Commentary

We were certainly not alone in enjoying that rally. Value investing was back in vogue in 2016. As measured by the various indices, value stocks significantly outperformed over the calendar year, in stark contrast with 2015 as illustrated below:

Table 1: “Value” Performance

1 Year
to December 2015
1 Year
to December 2016
2 Years
to December 2016
All
Stocks
Value
Stocks
Value
Outperf
All
Stocks
Value
Stocks
Value
Outperf
All
Stocks
Value
Stocks
Value
Outperf
Alluvium Global Fund (AUD)2 18.1% 13.0% 15.5%
MSCI World Index (AUD)5 11.5%
5.4% -6.1% 8.0% 13.1% 5.1% 9.7% 9.2% -0.5%
MSCI USA Index (USD) 0.7% -3.0% -3.7% 10.9% 17.7% 6.8% 5.7% 6.8% 1.1%
MSCI AC Asia Pacific (USD) -2.0% -3.8% -1.8% 4.9% 7.2% 2.3% 1.4% 1.6% 0.2%
MSCI Europe (EUR) 8.2% 0.6% -7.6% 2.6% 7.4% 4.8% 5.4% 4.0% 1.4%
Australian Global Equity Products (AUD)6 12.4% 11.6% -0.8% 7.5% 10.3% 2.8% 9.9% 10.9% 1.0%

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

So who says markets don’t mean revert!

Counter-intuitively, the Fund performed strongly over the 2016 calendar year despite:

  • the extremely high levels of cash we held in May (up to 60%) and in November and December (in the order of 20% to 25%) when the markets posted very strong returns (the Index returned more than 4.5% in each of those months); and
  • our low or non-existent investment in Energy and Materials companies which returned over 28% and 23% respectively.

One of the concerns we highlighted in our June report was high equity prices (as revealed by various equity price indices). This concern remains. Further, the solid performance of “value” stocks as shown in Table 1 has meant that we are finding it increasingly difficult to source opportunities at what we consider to be attractive prices. Consequently, as we write this in late January, the Fund is holding a high level of cash (around 30%), and we are actively looking to deploy it as opportunities arise that meet our investment criteria and portfolio diversification rules.

Although the tables and charts illustrate what we consider to be pretty reasonable performance, we would like to take an opportunity to reiterate our view that investors are ill-advised to judge the merits of an investment strategy or a manager by short term numbers. And, we consider two years is still short term.

As the time horizon of an investment track record lengthens, the relative influence of skill versus luck increases. At this early stage we still ask that we be judged on process, not performance – we are far from the point where performance can be considered a reliable indicator. (For those interested in better understanding skill versus luck, we refer you to the excellent work of Michael Mauboussin)7.

“Because investing involves so much luck in the short term, it would stand to reason that short term success or failure is not a reliable test of skill. But all of us effortlessly find causes for the effects we see, and making money appears to be clear evidence that the investment manager knew what he was doing. Investing is a field where this fallacy is very costly.” – Michael Mauboussin

From our personal perspectives, we have a high level of confidence in the process; that is obvious, we are heavily invested in it. But when we consider an external investor’s view, we can understand that past performance is the most readily calculable and available metric and therefore the most commonly (almost exclusively) used.

We maintain our view that investors are best to choose fund managers based on the manager’s process being “in tune” with their way of thinking and having a like-minded philosophy. By doing so, provided the investor trusts the manager to continue to run that same process as communicated and to operate in a fair and transparent manner, then they will most likely have the fortitude to stick with manager during testing performance periods.

“Ultimately, of course, you want people with good process and good outcomes, but I’d rather have somebody working for me who had a good process and a bad outcome in a given year that somebody with a bad process and good outcome.” – Dan Loeb

Performance Review

Figure 3: Top Contributors/Detractors

Source: Interactive Brokers, Alluvium, Factset

Wabash contributed most meaningfully to the Fund’s returns. The share price increase of over 20% was one factor, but also volatility was our friend here. We were able to take advantage of a sharp price decline in early November and we more than doubled our position prior to a significant rebound over the last two months of the year (refer to our article What we do when another of our holding plummets on release of earnings). Further, we note that due to subsequent ongoing price strength its position size caused breaches of our diversification rules, so post year end we trimmed our position a little (however it still remains around 5% of the Fund).

The next two top contributors ended up being short term holdings. This is disappointing in some respects, as our preference is to hold for the long term. There was a sharp rise in the share price of Urban Outfitters after the release of its quarterly result in October, to the point whereby the rules allowed a “discretionary sell”. As we were concerned the price encapsulated lofty expectations that the business may fail to deliver, we ended up only holding it for around six weeks before realising a gain of more than 30%. Interestingly, the price has now (as at late January) reverted to an interesting level below our original purchase price, so it may well re-enter the portfolio. Monadelphous was sold in two tranches, the first to address portfolio diversification (as it became too prominent in the portfolio) and then after it reported results which, upon our analysis and rules, required divestiture.

It seems the market viewed American Public Education as one business set to reap benefits from Trump’s policies. The share price was decimated after it reported third quarter results in early November, but then rebounded to above its prior level within two days and went on to finish the year up another 16%. With our updated analysis and rules indicating a “hold” we rode out the volatility to the Fund’s benefit.

We continue to hold Transcontinental (a Canadian media, publishing and packaging company) and American Railcar Industries, a designer, manufacturer and fleet manager of railcars.

Our position in retailers hit us hard.

We purchased Vera Bradley in two tranches (early October and early November) and in both cases we are substantially underwater. This is a business which has experienced declining fundamentals over the last three to four years. However, it is cheap, it has no debt and its lease obligations are, in our view – so far manageable (although we are waiting for the next annual report which is expected in late March to provide further disclosure in relation to the lease obligations). We hope that with the benefit of a longer period of hindsight we will look back at this from a happier light and simply acknowledge that we can rarely pick the most ideal point of entry.

Debenhams was a disappointment. This business has featured in our June and September reports, and here we are again. We sold our remaining position in mid-October. In local currency terms, we lost around 25% of the capital we invested (and with the marked decline in the British pound, we fared quite a bit worse in AUD terms). What went wrong? As we hypothesized in the September quarterly review we think we failed to adequately consider “hidden” leverage associated with its long term lease liabilities.

A highly leveraged business that experiences a marked decline in fundamentals is a dangerous proposition, and this was reinforced to us via this experience. As we mentioned in our September report, we have now created new rules to become more discerning around investing in capital intensive business operations with hidden financial leverage (off balance sheet liabilities where assets are  leased, rather than owned). As a result, we are less likely than otherwise to hold positions in retail companies and airlines.

GameStop released results which according to our analysis revealed deteriorating financial strength, and therefore it was a position with an increased level of risk. In circumstances like these, our experience suggests we are best to minimise risk, sell the position and accept a short term loss. At least we have an ancillary benefit of offsetting some short term capital gains.

Portfolio Profile

Figure 4: Diversification by Sector

Source: Alluvium, Factset

Figure 5: Diversification by Region

Source: Alluvium, Factset

Table 2: Fund Overview

Cash 22.8%
Top 15 holdings 62.7%
Number of holdings 24
Weighted Average Market Cap. (USD m) 15,039

Source: Alluvium, Factset

Table 3: Quality Metrics (weighted average)

Debt (% of EV)8 12.9%
Piotroski score9 7.0
Return on Invested Capital (5y average) 27.4%
Latest Return on Invested Capital 26.5%

Source: Alluvium, Factset

Table 4: Pricing Metrics (weighted average)

Enterprise level yield (EBIT/EV)8 13.2%
Earnings yield (NPAT/Mkt Cap)8 9.8%
Free cashflow yield (FCF/Mkt Cap)8 8.1%

Source: Alluvium, Factset

Table 5: Top 15 Holdings

Wabash National 6.2%
American Public Education 5.7%
Buckle 5.0%
Transcontinental 5.0%
LyondellBasell Industries 4.7%
Cooper Tire & Rubber 4.6%
American Railcar Industries 4.3%
Regis Resources 4.1%
Vera Bradley 3.9%
T-Gaia Corporation 3.9%
Japan Airlines 3.6%
Delta Airlines 3.2%
Fuji Heavy Industries 3.1%
Wal-Mart 2.7%
Michelin 2.7%

Source: Alluvium, Factset

It has been an active half year. As we have already mentioned, the Fund’s trading activity has been greater than we would like, and also than we would expect it to be going forward. Most of the major positions sold have already been discussed in the Performance Review. Some other divestments of note include:

  • Target, the US retailer, which we sold (at only a slight gain) to facilitate the purchase of an alternative US retailer (Urban Outfitters). Our thoughts in regard to this trading of US retailers are elaborated in our article We are not “Quant”; we apply common sense;
  • Movado, which designs, manufactures and distributes watches. We sold this business in two tranches as it failed to meet our quality criteria. We realised a healthy gain in excess of 35% over the holding period;
  • Pendragon, which operates franchised motor car dealerships in the UK. We only held this for a short term and realised only a small capital gain. We sold in late August after our analysis of newly released financials revealed a deterioration in the company’s financial strength.

Many new positions were introduced. We’ve gone long airlines (Japan Airlines and Delta Airlines) – not because Mr Buffett has, but because our rules suggest at prevailing prices they are sensible investments. As we mentioned in the Performance Review, we bought American Public Education, and have so far ridden through the volatility (refer to our article What we do when another of our holding plummets on release of earnings), and disappointingly to date, we also bought Vera Bradley. As part of our US retailer trading machinations, we ended the half year owning Wal-Mart and Buckle. And to complement our Michelin position, we have accumulated a decent holding in Cooper Tire & Rubber. A chemical and plastics business, a gold miner, a telecommunications company, and the manufacturer of Subaru motor vehicles rounds out the remaining larger purchases over the half year.

The Fund continues to be completely different from an “index portfolio”. Based on our best estimates, of the Fund’s 24 positions only seven are in the Index (with a combined weight of less than 0.7%). 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!

On to some business matters – it is exciting times for us at Alluvium. With our increased level of personal investment and some solid returns over the last half year, the Fund size has rapidly grown. As we write this, we are finalizing the arrangements for external investors to join alongside us – with the appointment of an external administrator and auditor. We hope to meet with you soon to discuss.

Thank you for your interest,

Stuart Pearce
Principal

Alexis Delloye
Principal

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 In the case of “All Stocks”, the relevant indices are the MSCI World Net Total Return Index (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.

6 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 Fund returns are quoted net of management fees.

7 The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing, 2012, Michael Mauboussin.

8 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).

9 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.

By | 2017-06-22T11:16:41+00:00 January 2017|Reports|0 Comments

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