March 2019 | Quarterly Report

Introduction

The Fund returned 4.2%1   for the quarter. Ordinarily, we would happily sign off straight away for similar returns for the next few decades. But ordinarily, the preceding quarter’s returns would not have been so bad. The reality is that the March quarter’s returns are hardly adequate compensation for the December quarter carnage. And although relative performance does not feature prominently in our mindset, we note the Fund suffered to a similar extent as the market during the December quarter, yet lagged during this subsequent quarter’s rebound.

Snapshot

  • Global equity markets rebounded strongly over the quarter. The MSCI World Index was up 11.4%2  , the S&P 500 was up 13.4%, ASX 200 up 10.9% and most European equity markets were up more than 10.0%.
  • Although our trading activity has settled down a little, we did increase some of our North American positions taking advantage of sell-offs after results updates and broker downgrades.
  • We completely sold two Japanese construction companies (Sumitomo Construction3   and Haseko) based on increasing concerns regarding their financial strength.
  • Two Japanese businesses (JAE and Tosoh) are equally responsible for almost half the quarterly performance.
  • In fact, due to their strongly rebounding share prices, our risk and diversification rules required us to trim these positions
    and take some profits.
  • The Fund’s largest holding, Lear Corporation has rebounded strongly. It is pleasing to see that sticking to one’s convictions (after a 40%4   price fall over the second half of last year) was rewarded.
  • The vast majority of performance detraction was attributable to Canfor Corporation (a business that is hostage to prices achieved for the forest based commodities it produces), and Tenneco (the cyclical motor parts business).
  • We initiated two US positions, United Continental (which added to our airline holdings) and United Therapeutics (a pharmaceutical business).
  • We are still far from being fully invested with a cash position at 18.8%. When markets are buoyant this hurts.
  • The portfolio remains invested consistent with our philosophy and approach – being concentrated (22 positions), reasonably priced (free cash flow yield of 9.2%), conservatively financed (debt/EV of 16.9%) and globally diversified.
  • We are continually refining our process by increasing our focus on business quality and capital allocation, at the expense of “apparent cheapness”.
  • Our European offering officially launched in January, and to optimise operational efficiencies, the Fund will be restructured. Investors will receive a letter accompanying this report that provides details.
  • As performance over recent times has failed to meet our expectations, the earning of the past performance fee (to June 2018) was unwarranted and the Alluvium Global Fund will not pay it.
“Eating home cooking is a cornerstone to our approach. But sometimes, home cooking isn’t prepared in a microwave oven but in a crock pot. It’ll be ready when it’s ready.” – Seth Klarman

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

March 2019 March 2019 Quarter Summary March 2019 Year Summary
Stock End Weight Beg. Weight Return Contrib. Beg. Weight Return Contrib.
Canfor Pulp 0.0% 0.0% - - 4.3% 25.7% 1.8%
JAE 4.5% 2.8% 24.2% 1.0% 0.0% 21.2% 0.9%
Western Forest 0.0% 3.4% -1.0% 0.0% 4.4% 9.6% 0.6%
Lear Corporation 5.3% 4.9% 10.7% 0.7% 4.7% -19.7% -0.6%
Hawaiian Holdings 2.8% 2.9% -0.6% 0.0% 4.7% -26.2% -0.7%
Connect Group 0.0% 0.0% - - 2.3% -46.4% -0.9%
Dawnrays Pharmaceuticals 1.8% 3.8% -0.6% 0.0% 2.0% -20.8% -1.0%
Haseko 0.0% 2.8% 0.9% 0.0% 4.9% -23.8% -1.1%
Transcontinental 0.0% 0.0% - - 5.6% -24.1% -1.2%
Nichirin 3.8% 4.2% -6.3% -0.2% 3.8% -33.2% -1.5%
Canfor Corporation 3.9% 2.7% -16.8% -0.6% 0.0% -51.4% -1.9%
Tenneco 1.8% 2.3% -18.6% -0.4% 3.3% -55.1% -1.9%
Other 57.3% 47.4% 3.3% 38.0% -0.4%
Cash 18.8% 22.6% 0.5% 22.1% 0.1%
Total 100.0% 100.0% 4.2% 4.2% 100.0% -7.7% -7.7%

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

West Fraser Timber New Position
United Therapeutics New Position
JAE Increase Position
Dick's Sporting Increase Position

Table 3: Quarterly Sales

Sumitomo Construction Complete Sale
Western Forest Complete Sale
Haseko Complete Sale
Dawnrays Pharmaceuticals Partial Sale

Performance Review

Two of our Japanese stocks (JAE, the electrical equipment business, and Tosoh, a chemical specialist), posted impressive quarterly returns of 22.3% and 22.1% respectively. These are equally responsible for almost half the quarterly performance. JAE is a new addition for the Fund, and based on our purchasing near recent lows, it does seem on first glance that on this occasion we got the timing about right. Tosoh’s share price, on the other hand, has simply recovered to levels mildly above what we have paid for this business on average for the tranches we have bought since August last year. During the quarter we were active in trading the shares of both of these companies – buying in January and then, due to rebounding share prices (and consequent breaches of our diversification rules), selling in February and March – a nice problem to have!

Still in Japan, we exited our positions in Sumitomo Construction and Haseko, the construction businesses. Both were the result of failing our balance sheet strength and risk of financial distress criteria. In fact, we can expect more trading in Japanese shares, as we look to tighten the criteria by which we assess business quality. As we refine this process, we are tending to find fewer Japanese companies are making the grade.

Lear Corporation (the US supplier of seats and electrical systems to automobile manufacturers) and Dick’s Sporting (the US sporting goods retailer) both contributed meaningfully. With regard to Lear Corporation, to a large degree this reflects a reversal of its prior poor performance. Consistent with our view of this being a high quality business, it is the Fund’s largest holding and one we have held for a long time. The evidence suggests our refusal to succumb to the malaise in December (with its share price down 40% over six months) was vindicated. And we think there is more to come. Conversely, Dick’s Sporting is a recent acquisition. We accumulated most of our position in mid December, whereupon over the next couple of weeks (to the end of the year), it fell 14.2%. After rebounding strongly (around 25%) it released results in March which disappointed Mr Market (but did not phase us). The share price fell 11.0%, which provided the opportunity for us to increase our position. All in all, it ended the quarter up 18.0%.

Other solid contributors included Samsung (the Korean electronic IT manufacturer), Franklin Resources (the US investment manager) and AGL (the Australian energy producer) – all long term holdings. It was also pleasing to see some smaller positions we first bought in December posting solid share price gains.

During the quarter we initiated three North American positions. We added to our existing stock of airplanes (as represented by our investments in Delta Air Lines and Hawaiian Holdings) by establishing a position in United Continental. We also bought United Therapeutics (the US pharmaceutical company that develops and commercializes products for patients with chronic and life-threatening diseases). And in Canada, we bought West Fraser Timber (the integrated wood products supplier) and sold its local counterpart, Western Forest Holdings – based on the former being cheaper.

Sticking with Canadian forests, the worst performer for the Fund over the quarter was Canfor Corporation (the Canadian integrated forest products company), with its share price falling 17.1%. As we discussed in our September report the rationale for our purchase was largely to access its pulp business (Canfor Pulp) in a cheaper way. We are not proud to report that the losses we have experienced to date from Canfor Corporation have more than wiped out the prior gains we had made from Canfor Pulp. We discussed Canfor Corporation and the possible reasons for its apparent “cheapness” in our December report. We have always been cognisant that its earnings are largely dictated by prices of its underlying commodities – but with long term double digit cash flow yields, there is no denying it is cheap. However, our track record with “cheap”, cyclical businesses has not been impressive, so we remain on alert.

Tenneco, the US producer of automotive parts, by falling 18.5% continues to be a drag on Fund returns. It released disappointing results, and upon our updated analysis we understand the market’s reactions. We see merit in the restructuring of this company (which will culminate in a spin-off of its Aftermarket and Ride Performance business), but we are questioning whether the likely longer term upside is worthy of maintaining our position.

Closing Remarks

In our view, the best investors continually learn, and integrate these learnings into their process (whilst keeping consistent with their core values and beliefs). When operating within a complex adaptive system – like the equity markets – we think that being void of such openness is an invitation to self destruction.

Our process has always been to identify quality businesses and buy them when they are priced reasonably. Consistent with our aim of minimising behavioral biases, we objectively assess quality by analysing the returns a business has generated relative to the capital it employed. This continues to be the case. But we have refined the way we measure it. We believe these refinements better encapsulate management’s capital allocation proficiency. When combined with our tightening of the criteria – we are becoming more discerning.

Assuming our ‘quality’ assessment is accurate, and the value metrics are sound, performance is still far from guaranteed. There is no guide as to how long it will take for other market participants to recognise value. In fact, the subtle art of investing is firstly about being convinced now of an asset’s value, and secondly, being sufficiently confident (enough to risk capital) that over time, the broader market will also be convinced of this value. This is often difficult – particularly when faced with conflicting market feedback. In other words, holding decent businesses that are priced reasonably is, we believe, necessary but not sufficient. Patience and emotional temperity are also required because it usually takes some time for value to be appreciated by the broader market.

Which leads us to performance, which, over the last year or so has failed to meet our expectations. We believe this relates to a temporary period when the market is simply not conducive to our investment style. In any event, hindsight tells us that the earning of the past performance fee (for the year ended June 2018) was unwarranted. So, the Fund will not pay that performance fee and the liability has been removed from the Fund’s accounts.

Moving to business matters, it was a milestone quarter for Alluvium. In January we officially launched our second fund – the Luxembourg domiciled “Conventum – Alluvium Global Fund”. It has (only) been 15 months in the making! This is a highly regulated fund with quality service providers and is based in a widely respected asset management jurisdiction.

This can be considered the start of a new chapter for Alluvium. We are in the process of restructuring the Fund to become a feeder into the Conventum – Alluvium Global Fund. This will provide significant operational efficiencies. We expect the process to be finalised by July. More details about the administrative changes are provided in the accompanying investor letter. As always, we are more than happy to answer any questions you may have regarding this upcoming restructure.

Overall, we have now circa $38m under management which provides more scale benefits – that said, ‘keeping the eye on the ball’ remains warranted more than ever actually.

Thank you for your interest,

Stuart Pearce
Principal

12 April 2019

Alexis Delloye
Principal

Profile

Figure 5: Diversification by Sector

Source: Alluvium, Factset

Figure 6: Diversification by Region

Source: Alluvium, Factset

Table 4: Fund Overview

Cash 18.8%
Top 15 holdings 65.0%
Number of Holdings 22
W.Avg Mkt Cap (USDm) 28,177

Source: Alluvium, Factset

Table 5: Quality Metrics (weighted average)

Debt (% of EV) 16.9%
Piotroski Score 6.4
ROIC (5y Avg) 27.8%
ROIC (Latest) 23.7%

Source: Alluvium, Factset

Table 6: Pricing Metrics (weighted average)

Enterprise Level Yield (EBIT/EV) 14.9%
Earnings Yield (NPAT/Mkt Cap) 11.8%
Free Cashflow Yield (FCF/Mkt Cap) 9.2%

Source: Alluvium, Factset

Table 7: Top 15 Holdings

Lear Corporation 5.3%
Dick's Sporting 5.2%
Delta Air Lines 5.0%
H&R Block 4.7%
LyondellBasell 4.6%
Tosoh 4.6%
Gilead 4.6%
JAE 4.5%
Samsung Electronics 4.4%
Canfor Corporation 3.9%
AGL Energy 3.9%
Nichirin 3.8%
Franklin 3.6%
Gap 3.6%
United Therapeutics 3.3%

Source: Alluvium, Factset

Definitions

General

Administrator: Apex and/or Mainstream
Alluvium: Alluvium Asset Management Pty Ltd, ABN 69 143 914 390, AFSL 476067
Apex: Apex Fund Services Limited
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)
Nexia: Nexia Sydney Audit Pty Ltd

Portfolio Metrics

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

Footnotes

1 Source: Administrator

2 Source: Factset

3 Company names have been abbreviated throughout this document in the interest of readability.

4 Returns include dividends and are expressed in local currency. Source: Alluvium, Factset, Interactive Brokers.

5 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.

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.

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