December 2018 | Half Year Report

Introduction

There was no hiding the carnage on global equity markets over the last few months. Despite our high cash levels and our conservatively priced portfolio, the decline of 11.4%¹   was the Fund’s worst quarterly result since inception. Whilst disappointing, this is nevertheless consistent with the range of outcomes achieved historically from global equity markets. Over the 49 years of data availability, the Index has posted quarterly declines of more than 10%²   on 16 occasions. And, sad to say, the poor returns over recent periods are not unique to the global equities asset class – they are just more apparent…

We cannot anticipate what market participants think, or how they feel and behave. All we can do is keep investing in the manner which we believe makes most sense. We will not revisit our investment philosophy – which has proven to be wise over the longer term – simply because recent market conditions have not vindicated it. To do so would heed to what the market thinks and although we acknowledge market efficiency over the longer term, there is plenty of evidence to suggest that this is not the case over shorter time frames. We rather just stick to our quite basic process that analyses business fundamentals, as demonstrated by actual financial results, and invests in those businesses where value (as we see it) appears.

Snapshot

• The sell-off was indiscriminate – no matter if growth or value biased, small or large cap focussed, invested in cyclical or stable businesses – it would have been a miracle for a long only equity fund to have posted a positive return.
• Based on the common indices, US equity markets fell 13.7% and European equities in the range of 10% to 15%²  .
• Asia (ex Japan) was spared the worst with Hong Kong down 4.5% and Singapore only 6.9%. Japanese equities fell 17.2%²  .
• In last quarter’s report we mentioned the uphill battle to post a positive result when three of the largest Fund positions recorded price declines of more than 20%²  . This quarter seven of the Fund’s holdings posted such a decline.
• But unlike last quarter – there were far too few offsetting results. Only one of the Fund’s positions posted an acceptable performance. This was AGL³  , the Australian energy supplier, which returned 5.6%⁴  .
• With the majority of Fund’s assets held in foreign currencies, the AUD decline of around 3%²   against most currencies helped – although there is a little give and take here, with the positive effect being offset by the declining Canadian dollar.
• During the quarter we completely sold the Fund’s holdings in three businesses – Transcontinental, Williams-Sonoma and Canfor Pulp. Although it was pleasing to realise some profits, they would have been far greater had we sold earlier.
• We also initiated positions in four businesses new to the Fund, and repurchased one which the Fund has held in the past.
• Over recent years the market had appeared complacent, but the return to more normal levels of price volatility did result in our trading some of our holdings in order to maintain appropriate portfolio weights.
• The Fund’s cash accounted for 22.6% of assets at quarter’s end.
• Our investing style remains unchanged – favouring near term and more certain cash flows to long term, less certain ones.
• We are cautiously monitoring the sell-off and maintaining up to date analysis so that, to the extent that price declines appear extreme for businesses that suit our investment style, we may deploy our cash.
• Our business plans have progressed with our European offering in the same strategy starting at the end of this month.

No one feels the financial pain of the Fund’s recent bout of poor performance more than us. But this is all about the long term, and pursuing our disciplined investment process is what we think will generate long term outperformance.

“I never buy at the bottom and I always sell too soon.” – Baron Rothschild

Performance

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 performance⁵  .

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.

Contribution

Figure 3: Top Contributors/Detractors (Quarter)

Source: Alluvium, Factset, Private Reporting

Figure 4: Top Contributors/Detractors (Year)

Source: Alluvium, Factset, Private Reporting

Holdings

Table 1: Contribution Details

Source: Alluvium, Factset, Private Reporting. Returns include dividends and are time-weighted in AUD. Returns quoted in commentary sections are in local currencies.

Table 2: Quarterly Purchases

Table 3: Quarterly Sales

Performance Review

Normally our bar chart would contain at least some contributors to the Fund’s performance over the quarter. But we only show the most material in absolute terms – and AGL which returned 5.6% – still failed to make the cut. AGL proved to be resilient even in the face of threats of increased regulation in the Australian energy market (to the extent of forced divestments of electricity generators). We believe its defensive characteristics, and its reasonably cheap price led to its shares being able to withstand that negative sentiment.

The automotive sector remains out of favour. We hold three positions which all appear to have been affected. Over the quarter the US listed Tenneco and Lear Corporation shares fell 35.0% and 15.3% respectively while the shares of the Japanese listed automobile hose manufacturer, Nichirin, plummeted by 25.1%. Collectively, these businesses cost the Fund around 2.6%. Whilst no doubt trade tensions and an expected slowing in general economic activity will have some effects on future cash flows they will generate, the extent that this is being reflected in current share prices feels extreme.

The share price of Transcontinental (the Canadian packaging and media company) continued its decline, despite a small bounce upon release of its full year results. Our updated analysis resulted in this business failing our financial strength criteria – arguably confirming that the poor share price performance of the September quarter was justifiable. We concede our approach is far from perfect. In this instance the numbers validated the market’s concern and waiting for this verification proved costly! We sold our position. It was not a successful investment for the Fund. Although our total return was marginally positive, we held up a lot of the Fund’s capital over a long period of time and we realised a loss on that capital.

Last quarter we wrote about the positive contributions from our airline holdings, which represent around 8% of the Fund’s assets, This quarter they failed to perform, with Delta Air Lines share price falling 13.7%, and Hawaiian Holdings share price tumbling 34.1%. Both still have those double digit earnings yields (now even higher), and just because Hawaiian Holdings downgraded its fourth quarter revenue guidance (and Delta Air Lines did the same in January) it does not mean their long term business fundamentals are affected. We remain comfortable with these positions.

Canfor Corporation announced three noteworthy items over the quarter – and one assumes by the market’s reaction that none were taken too positively. The first two were acquisitions, one small US based operation for USD110m and the other a 70% interest in a larger Swedish private saw milling operation, Vida, for CAD580m. The third announcement was that it decided to curtail its British Columbia sawmill operations over the fourth quarter (later extended to the first quarter of 2019) due to uncompetitive log costs and reduced lumber prices. We are not too perturbed by the sawmill curtailment, as this is part of the normal vicissitudes of the business. But we are always wary of acquisitions, despite rationales always making sense. However, we view the business as being priced very cheaply, and based on that assessment we maintain our position.

We cannot really point to any business developments that warrant the poorly performing share prices of the remaining Fund holdings. We just put it down to general market malaise. In fact, if we were to perform an attribution analysis (where stock performance is compared to Index performance) it is likely none of those would feature prominently. We do not perform attribution analysis because it is not the way we think.

Moving on to Portfolio Activity – we continued our selling of Williams-Sonoma and Canfor Pulp to the point of completely exiting these two positions. Both were solid performers to the Fund’s returns over their holding periods. Of course, had our trading prowess been greater, those returns could have been all the more higher…

With some newly freed up capacity to acquire US retailers (courtesy of our Williams-Sonoma sale) we initiated positions in Michael Kors (since renamed Capri Holdings) and Dick’s Sporting. And increased volatility afforded us an opportunity to acquire Thor Industries, a US listed manufacturer of recreational vehicles, at an attractive entry price.

We also bought JAE (Japan Aviation Electronics), a business that manufactures and sells connectors, switches and interface equipment. Despite its name, its products are overwhelmingly used in mobile devices and automobiles (the aerospace industry accounts for only around 5% of its revenue).

And finally on the acquisition side, we re-established a position in Western Forest, one of the Fund’s former holdings. We bought back into this business at a similar price to that which we paid in January 2017.

Trading is not our passion, but with wildly fluctuating shares prices and new opportunities surfacing, our disciplined process does require us to be active in trimming and topping up some positions. Most notable was our selling of Gap down to 3.6% to facilitate further buying of Capri and Dick’s Sporting, our trimming of Franklin Resources and H&R Block and our increases to our Hawaiian Holdings, Lear Corporation, LyondellBasell and Samsung positions.

Closing Remarks

We are not happy with the performance this year. We knew from the outset that our approach would not deliver positive returns year in, year out. However, we are particularly disappointed with those “learning opportunities” (witnessed during the first nine months of the year).

Our evaluation of our performance is less harsh when it comes to the Fund’s returns over the final quarter. Our conservative approach was simply not validated. Despite our large cash position and our portfolio of businesses trading at double digit cash flow yields, our Fund suffered terribly.

This does not cause us to question the validity of our investing rationale. Although our process has naturally evolved, our core value investing philosophy, which we still regard to be conservative, has not and will not change. In investing, short term outcomes are influenced predominantly by luck. Refer to: https://alluvium-am.com/2017/01/10/musings-with-mates/, as well as the excellent work of Michael Mauboussin.

We would also like to place the Fund’s return in perspective. For example, an investment in Australian housing at the start of the quarter that was financed at the typical level (80% debt) and realised at the end of the quarter, would, based on CoreLogic’s house price data⁸   (aggregate five capital cities), have suffered a whopping decline of 47.4%. Just because you don’t see it does not mean it is not real!

Property is generally seen to be a long term investment. But why not apply the same principle to your equity investments? Counterintuitively, equity mispricing occurs partly as a result of the benefits it offers. With ample liquidity and extremely low transaction costs an investment portfolio containing listed equity afford investors the opportunity to avoid the higher transaction costs (brokerage, stamp duty, liquidy) prevalent in other forms of investment – for example, residential property.

Profile

Figure 5: Diversification by Sector

Source: Alluvium, Factset

Figure 6: Diversification by Region

Source: Alluvium, Factset

Table 4: Fund Overview

Source: Alluvium, Factset

Table 5: Quality Metrics (weighted average)

Source: Alluvium, Factset

Table 6: Pricing Metrics (weighted average)

Source: Alluvium, Factset

Table 7: Top 15 Holdings

Source: Alluvium, Factset

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.