The Fund posted a net return of 2.7%1 over the March quarter. This positive result, when most markets (and our positions) fell decidedly in local currency terms2 , illustrates why we embrace currency ‘exposure’.
Our dear friend ‘volatility’ is back… but only to more conventional levels. Although we do not watch our stocks tick every minute, we can say for sure Mr Market is more agitated than he has been over the last couple of years. We welcome his mood swings and in a couple of instances we took advantage of them by deploying more capital in what we believe are attractive businesses. But we still hold a large cash position which is a consequence of the lack of opportunities that meet our criteria.
The longer term net returns of the Fund as well as some alternatives are shown below3 :
Figure 1: Value of AUD 100,000 (Net Dividends Reinvested)
Source: Administrator, Alluvium, Factset, Interactive Brokers. Past performance is not a reliable indicator of future performance.
Figure 2: Net Fund Returns Compared to Gross Index Returns (AUD)
Source: Administrator, Alluvium, Factset, Interactive Brokers. Returns more than 1 year are annualised. Past performance is not a reliable indicator of future performance. Date of inception: 1 January 2015.
Our objective is to generate attractive returns over the long term – irrespective of benchmarks. The process has always been the same: invest in quality businesses whilst minimising the risk of permanent loss of capital by only purchasing those businesses when they are available at attractive prices. Our experience has been that these businesses tend to be more readily available amongst smaller issues, but sometimes we do find that some larger businesses ‘make the cut’. We are impartial – and we currently find ourselves in a rather unique situation. Four of our 23 positions are actually represented in the MSCI World Index – although their combined weight is less than 0.5%4 – which pales in comparison to the Fund’s position of 15.9%. This serves as a reminder to readers that, despite our portfolio having been overwhelmingly represented by smaller companies in the past, we are not a ‘small-cap’ manager. Incidentally, because our process draws upon elements of quantitative analysis and rules based systems – but is long-only equities with an absolute return focus – we do not fit any box. We are not ‘quant’, ‘smart beta’, ‘alternative’, or even traditional ‘global equities’. Sorry Mr Asset Allocator!
Performance & Activity Review
Figure 3: Top Contributors/Detractors
Source: Alluvium, Factset, Interactive Brokers
One might think a more volatile environment would result in a larger spread between the top contributors and detractors to portfolio returns. Counter intuitively, the March quarter has the narrowest spread since inception.
We continued to build our position in Canfor Pulp5 (the Canadian pulp and paper products supplier) which returned 21.8%6 . We also bought a little more Lear Corp (the US automotive manufacturer which was up 4.8%) and we sold a small amount of Haneda Zenith (the Japanese engineering and construction provider which was up 2.0%). The contributions from Codan (an Australian electronic solutions provider which returned 17.5%) and the smaller contributions from the other positions (which returned around 5% on average) were achieved our preferred way – without trading.
The most successful investments often feel uncomfortable at the time of purchase. Connect Group (the British media distributor) is currently a small position (2.3% of the Fund). It has fallen 17.4% since we first bought it in mid-February. And yes indeed we felt uncomfortable. So what did we do? We bought more – so now we can feel more uncomfortable. It ended the quarter down 13.2% from our average purchase price. Bottom line: We are not market timers and our willingness to go against the herd (subject to our rules) – which often looks foolish in the short term – has not faded.
We sold both Crawford (the US insurance service provider which was down 0.9%) and Marvelous (a Japanese online gaming business which was down 7.3%) as they failed our financial strength rules. When the rule says sell, we sell – which in these instances proved wise as the share prices of these companies fell a further 7.3% and 2.2% respectively to quarter’s end. But let’s not be too happy with that ‘apparently’ correct decision. We chewed up 6.6% of the capital invested in Marvelous over four months and we are less proud of our 6.2% loss in Crawford because we tied up capital for around ten months in doing so.
Also in Japan we completely sold two smaller positions due to declining financial strength. The results: One was a poor investment (we lost 1.6% over four months) and the other only mediocre (5.5% gain over six months). Japanese businesses typically rank quite well on our criteria – we are usually ‘fully occupied’ (when applying our diversification rules). So, these divestments then opened up the possibility for us to increase (or initiate) our weighting in better ranked alternatives: Nichirin (which manufactures hoses mainly for automobiles), Haseko (a construction and engineering business), Odelic (which manufactures lighting equipment) and a small building company.
For the same reason of deteriorating financial strength, our rules required we sell Interdigital (the US technology developer/owner) and this resulted in a distasteful 11.8% loss after almost a year of detention. The proceeds were reinvested in new positions – Lyondellbasell (the US chemical producer) and Franklin (the US financial services provider).
The lessons learned from our investments in retail companies have been expensive, so we are pleased that the story for American Eagle (the US retailer) is much more palatable. Those prior painful experiences were the catalyst for us to revisit some elements of our process and introduce new rules – refer ‘We Don’t Break Rules, We Create New Ones!’. More on rule refinements later. We first bought American Eagle in late March/early April last year, and two months later (looking stupid) we ‘averaged down’ and bought more at a 20% lower price. But from its low in mid-August last year to the end of March, it returned a whopping 84.8% (of course, we were unable to capture all of this return – largely as a result of our rules based process). From our perspective, such a share price increase has two ramifications. Firstly, if not accompanied by improving business fundamentals, it becomes a less attractive investment and may breach our pricing rules. Secondly, it may breach our diversification rules (on a stand-alone basis or at the portfolio level). In this case both were reasons for our progressive selling leading to its complete divestment. We are not boasting though – as its price at quarter’s end was 15.3% higher than our average sell price and our holding period was shorter than ideal. But we prefer to lower our risk profile and leave some money on the table for someone else. We concur with Baron Rothschild’s view “I made my fortune by selling too early”. In fact this is one way to protect ourselves against permanent loss of capital.
Continuing with US retailers, we sold some Williams-Sonoma (which started in December) realising a 9.1% return (mostly dividends) on that portion of the Fund (around 1.4%), which we held just short of one year.
And for some more implications of our sector diversification rules let’s turn to the automobile industry. We repositioned the portfolio’s positions in this sector by selling Magna (we realised a pleasant gain of 13.0% over a holding period of around eight months), increased our position in Lear Corp, and established a position in Tenneco.
Back in Europe, we continued to accumulate shares in JM and we can assure you it felt as uncomfortable as the building of our position in Connect that we mentioned previously. The good news: it was not a detractor to the portfolio’s return this quarter. The bad news: it has a long way to go before it can be considered a successful investment. Patience is of the essence.
And finally, an interesting tale of emotions when it comes to Bpost (the Belgian postal operator). Declining in ranking due to price increases, we trimmed our position from 4.8% to 2.6% (in accordance with our rules) and realised an impressive return of 23.6% over ten months, but our selling was halted due to the imminent release of its results (again in accordance with our rules). Our updated analysis prescribed us to sell, but others had already done so – and massively! The price achieved was 28.6% lower than the former tranche and our overall gain was reduced to 8.7%. The sale of that tranche at a loss is another way we protect ourselves against permanent loss of capital.
Figure 4: Diversification by Sector
Source: Alluvium, Factset
Figure 5: Diversification by Region
Source: Alluvium, Factset
Table 1: Fund Overview
|Top 15 holdings||63.6%|
|Number of holdings||21|
|Weighted Average Market Cap. (USD m)||15,803|
Source: Alluvium, Factset
Table 2: Quality Metrics (weighted average)
|Debt (% of EV)||11.8%|
|Return on Invested Capital (5y average)||26.0%|
|Latest Return on Invested Capital||26.5%|
Source: Alluvium, Factset
Table 3: Pricing Metrics (weighted average)
|Enterprise level yield (EBIT/EV)||13.9%|
|Earnings yield (NPAT/Mkt Cap)||10.4%|
|Free cashflow yield (FCF/Mkt Cap)||10.9%|
Source: Alluvium, Factset
Table 4: Top 15 Holdings
Source: Alluvium, Factset
Moving to operational matters. We believe the best investment processes are evolutionary and so we have always maintained that our rules are subject to constant review. After all, if as Stephen Hawking said “Intelligence is the ability to adapt to change” is true, then not adapting would be a stupid course of action!
There were two refinements. Firstly, realising we may be missing attractive investment opportunities due to our financial leverage rules we changed their focus from debt relative to assets to debt serviceability. Secondly, being prompted by higher than desired turnover attributable to companies failing our Piotroski score criteria (one of the financial strength rules we employ) we revisited its appropriateness and noted:
- our process already analyses financial strength by the use of measures such as Return on Invested Capital (total capital rather than just equity capital) and Free Cash Flow (rather than merely earnings); and
- the empirical evidence of the Piotroski Score is based on its application to a ‘low price-to-book’ strategy, whereas we assess ‘value’ from an earnings yield perspective (the reasoning being that the value of internally generated intangible assets is far more prevalent in today’s world than in Mr Graham’s time).
In light of the above, we concluded it would be appropriate to loosen (but not eliminate) the strict Piotroski score rules in such a way that discretion is allowed when a company’s financial strength fails the prior rules but is acceptable under the newly more relaxed rules.
Now to some administrative changes. The Fund has until now used Interactive Brokers as prime broker and custodian. As the Fund does not employ derivatives, nor hedge or short stocks, a prime broker is not necessary and not ideal (because it may access the Fund’s holdings for its own ‘book’). Our preference is for the Fund’s assets to be kept in a separate account from its broker and this has necessitated the appointment of a new administrator (Mainstream) by which the Fund has access to a custody facility with JP Morgan. We thank our former administrator (Apex) for their high level of service. Our insistence to fully understand the intricacies of unit price calculations (for there are many when it comes to performance fees, series accounting, etc) so we can independently reconcile each series unit’s NAV calculation, means we have not been the easiest client. It is unfortunate we cannot continue our relationship with Apex but we do look to a fruitful path forward with Mainstream.
We have also introduced some firm wide policies. After battling our bureaucratic processes, our two Directors have finally approved our Proxy Voting Policy and our Environment, Social and Governance (ESG) Policy. We believe ESG should be part of each investment decision – but by their very nature, the issues are subjective. For example, most would probably agree that businesses that manufacture armaments, produce tobacco, or engage in gambling activities are not ‘ESG-friendly’. However, would you say a company that helps spread fake news, uses your information without your consent and invests massively to increasing customers’ addiction is more ethical? The very fact that ‘responsible investing’ has to be dealt on a case by case has rendered the writing of our ESG Policy a rather easy task. In essence, we simply avoid any investment in a company that, in our considered view, results in poor societal outcomes or where we have concerns in relation to its governance.
And finally – our Remuneration Policy is almost complete. This will simply reflect that we are more concerned with generating returns from our investments in Alluvium’s strategy rather than the wealth that may be accumulated via growing Alluvium’s assets under management.
Best as always,
Administrator: Apex and/or Mainstream
Alluvium: Alluvium Asset Management Pty Ltd, ABN 69 143 914 390, AFSL 476067
Apex: Apex Fund Services Limited
AUD: Australian Dollars
Factset: Factset Research Systems, Inc.
Fund: Alluvium Global Fund
GST: Goods and services tax
Interactive Brokers: Interactive Brokers, LLC
JP Morgan: JPMorgan Chase & Co.
Mainstream: Mainstream Fund Services Pty Ltd
MSCI World Index: MSCI World Net Total Return Index (AUD, unhedged)
Enterprise Value (EV): The market value of equity plus the book value of debt
EBIT: Earnings before interest and tax
Earnings Yield: The most conservative result from four different calculations at the equity level
Free Cash Flow (FCF): Cash flow from operations less capital expenditure
Return on Invested Capital: EBIT as a percentage of the average capital invested in the business operations
Piotroski Score: A discrete score (from 0 to 9) to assess the strength of a firm’s financial position
1 Source: Administrator
2 Source: Factset
3 Comprises: (i) 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 (ii) the Fund from 7 June 2016 sourced from the Administrator.
4 Estimated from publicly available data. Source: Blackrock, Inc.
5 Company names have been abbreviated throughout this document in the interest of readability.
6 Returns include dividends and are expressed in local currency. Source: Alluvium, Factset, Interactive Brokers.
Alluvium is the issuer of units in the Fund and is solely responsible for the preparation of this document. The 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 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 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 Fund.