The Alluvium Global Fund (Fund) posted a net return of 4.6% over the September quarter.1

An offsetting factor to some strong share price returns was the rising Australian dollar (AUD). Had we held most of our cash in AUD rather than foreign currencies our returns would have been 0.5% higher.2

The longer term net returns of the Fund as well as some alternatives are shown below:1,    2,    3,    4

Figure 1: Value of AUD 100,000 (Net Dividends Reinvested)

Source: Interactive Brokers, Alluvium, Apex, Factset

Figure 2: Net Fund Returns Compared to Gross Index Returns (AUD)

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

General Commentary

We are more accepting of AUD appreciation when the Fund’s foreign currency is invested in businesses, rather than cash. This is because we are usually receiving an offsetting benefit of rising equity prices (one of the reasons we choose not to hedge our foreign currency). However, currently we see few opportunities that meet our pricing criteria so the Fund holds a high level of cash and because this is predominantly denominated in foreign currencies, the Fund’s returns were affected by the strength of the AUD to a greater extent than we would have liked.

We do not make macro calls, rather we merely run a sensible bottom-up investment process based on rules. These rules require diversity of currency – both with our equity and our cash holdings. At times the “implicit” macro calls that flow from our investment rules will derive unfavourable short term outcomes. This continued to be the case over the September quarter. So this makes the strong return we generated, despite this headwind, all the more pleasing. Perhaps though – you may see this as fair warning – no doubt at some unforeseeable future time we will discover that the converse also holds true.

Quarterly Performance Review

Figure 3: Top Contributors/Detractors

Source: Interactive Brokers, Alluvium, Factset

It was nice to achieve a good spread of returns over the quarter. Twelve positions returned in excess of 10% and only three posted price declines of more than 10%. Bpost5, the old Belgium post office was up 19.0%. Our Canadian timber producer was up 14.1%. Due to their sizeable positions they contributed most meaningfully to the Fund’s returns. But Lear Corporation (Auto parts) and Crawford (Insurance services) fared even better – up 21.8% and 28.6% respectively. And Sanderson Farms returned 37.2% from the start of the quarter to the time we sold. The total gain of 59.6% was realised over our holding period of just over six months (of course, it kept going after we sold…). It was also pleasing to see one of our US retailers (American Eagle) recovering some lost ground by returning 18.7% over the quarter.

Conversely, the evidence to date suggests we have cost our investors dearly by taking positions in Hawaiian Holdings (the Airline) and Welling Holding (which makes motors for air conditioners and washing machines). Both were down 20% over the quarter). Although InterDigital and Goodyear fared better, they were down 4.6% and 4.9% respectively.

Portfolio Profile

Figure 4: Diversification by Sector

Source: Alluvium, Factset

Figure 5: Diversification by Region

Source: Alluvium, Factset

Table 1: Fund Overview

Top 15 holdings56.7%
Number of holdings26
Weighted Average Market Cap. (USD m)9,281

Source: Alluvium, Factset

Table 2: Quality Metrics (weighted average)

Debt (% of EV)610.6%
Piotroski score77.3
Return on Invested Capital (5y average)25.5%
Latest Return on Invested Capital28.2%

Source: Alluvium, Factset

Table 3: Pricing Metrics (weighted average)

Enterprise level yield (EBIT/EV)612.3%
Earnings yield (NPAT/Mkt Cap)69.6%
Free cashflow yield (FCF/Mkt Cap)610.8%

Source: Alluvium, Factset

Table 4: Top 15 Holdings

Western Forest Products4.9%
Goodyear Tire4.1%
Lear Corporation4.1%
American Eagle3.9%
Wabash National3.4%
Magna International3.3%
Gilead Sciences3.3%

Source: Alluvium, Factset

Trading activity has settled a bit, but because we are lazy – we are still a little too active for our liking. During the quarter we completely sold four positions, bought five new positions, and trimmed a few here and there to ensure we remain within our portfolio diversification rules. We have already mentioned our sale of Sanderson Farms – a big poultry farm that just got too damn expensive. We also sold three small Japanese listed companies. They either failed to meet our financial strength criteria and/or became too expensive and higher quality alternative businesses were available at a cheaper price. All were reasonable but not outstanding investments. From the two that we held for the better part of a year we realised low double digit returns. The other we only held for a couple of months and achieved a marginally positive return.

The most exciting news is our purchase of Gilead Sciences. This is notable because of its size (over USD 100 billion). There’s only been a couple of other occasions where our rules have led us to invest in such large company. Gilead Sciences develops and commercialises medicines, particularly for those living with life-threatening diseases – but also for preventative purposes. We also bought two real estate businesses: Haseko, which builds condominiums in Japan and a Scandinavian real estate developer. And smaller positions we acquired include a Japanese industrial electrical equipment manufacturer, a Canadian pulp and paper producer and an Australian listed electronic/communications equipment manufacturer.

We have suggested previously that there is little reason for us to quote our “Active Share” because it is always so high. But – after our purchase of Gilead Sciences – it is worth pointing out that it is now approaching its historic lows, at 99.4%!

We remain of the view that there is unseen risk in the broader market, and although we are not market timers our preparedness to hold cash in the absence of suitably priced investments makes absolute sense. As we start writing this in late September geopolitical tensions seem extreme – but equity investors appear non-fussed. According to the Bank of International Settlements, both bond and stock market volatility are low, margin loans for equities are at their highest level ever and “equity valuations might be stretched”.8 Robert Shiller was recently interviewed on CNBC where he stated that, based on his CAPE ratio, the US market is at its most expensive since 1929.9 Who knows what outcomes will eventuate – however our concern is not helped by historical experiences. Whether it be the panic of 1907, the crash of 1929 or Black Monday in 1987, October is a particularly noteworthy month for stock market corrections!

So, we still think investors in general are vulnerable to a sharp pullback in equity prices. In fact, to a certain extent we hope this occurs – just preferably not for the businesses we own. If alternative quality businesses suddenly become available at attractive prices, we would dearly love to snatch them up with the substantial cash we hold.

Again we would like to express our gratitude to both existing investors and those interested in understanding us. Rest assured that assets entrusted to Alluvium are managed according to our high standard of ethics, with full transparency, no conflicting interests and with the same level of care and diligence as our own investments – they are, after all, in the same capital pool.

Despite our best efforts at providing succinct commentary, feedback has been our reviews are too lengthy. So we stop it here, and suggest 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

7 October 2017

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. Returns are based on price movements only and expressed in local currency. 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.

8 BIS Quarterly Review, September 2017

9 Shiller, CNBC interview, 20 September 2017

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.