June 2019 | Quarterly Report

Introduction

The Australian Fund posted a modest return of 0.2%¹   for the quarter – masking some wild swings such as the 9.0% decline during May. Although too early to comment with conviction, the strongly rebounding prices of many of the holdings in June provides some degree of confirmation to our thoughts at the time, that, “this too will pass…”.

The Australian Fund’s annual return for the year ended June 2019, at -9.0%, was well below par. Despite widespread acceptance that our “value” investing style has been out of favour, we can’t simply dismiss our poor performance under this guise. Why? Firstly, because irrespective, our returns should not have been so poor. And secondly, it would be incomplete without addressing the question as to whether or not our investing style will ever return to favour. More on this later.

“Many investors have apparently underestimated the importance of reasonable price-earnings relationships” – S.F Nicholson (1960)

With Alluvium now offering two funds (the Australian Fund and the European Fund to which it feeds), going forward it makes most sense to report on the underlying positions of the European Fund and how they have contributed before considering the effects of currency which will give rise to performance differences between the funds. Further, as we report both quarterly and rolling annual data each quarter (where available), from now on we will refer to all reports as “Quarterly Reports”.

Snapshot

• The migration of the Australian Fund to its new “feeder” structure necessitated all positions be realised.
• This served to enforce the commonly confronted question “if I didn’t own it, would I buy it?”
• What an effective way to counteract behavioral biases such as “the endowment effect”, “loss aversion” and “anchoring”!
• When we combine the selling that was prompted by the Australian Fund’s restructure with our progressive investment of the European Fund, it led to a very active quarter.
• Our increasing focus on business quality and capital allocation (rather than merely “apparent cheapness”) resulted in six of the Australian Fund’s prior positions not being purchased in the European Fund.
• In addition, the European Fund invested in a few opportunities which were not held previously by the Australian Fund.
• At the end of the quarter, we held 26 positions with weights of between 1.3% and 5.9%, and a cash weighting of 19.4%²  .
• H&R Block³   continues to perform well, and two of our new positions, KDDI Communications (the Japanese telecommunications provider) and McKesson (the US drug distributor) also contributed meaningfully.
• Two of our retail holdings – Gap and Capri Holdings (which owns the Michael Kors, Jimmy Choo and Versace brands) performed poorly. The share prices of both companies suffered – and together these positions cost 1.6% over the quarter.
• Gap reported results that were unexpectedly disappointing to both us and the broader market. Capri reported results that simply disappointed the market.
• Also, our two Canadian timber yards continue to struggle. These businesses are being hit from both sides, as their input costs rise and timber prices decline.
• Other companies new to the portfolio include two retailers – Walgreens Boots (the drugstore chain) and L Brands (operating the Victoria’s Secret and Bath and Body Works retail businesses). We also bought another airline – taking a position in the European budget carrier, Ryanair.

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 performance⁴  .

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. All data in local currency.

Holdings

Table 1: Contribution Details

Source: Alluvium, Factset, Private Reporting. Data relates to the European Fund. Its inception was 30 January 2019. All data in local currency unless otherwise indicated.

Performance Review

As the Australian Fund’s restructure took course, along with some unusual but necessary trading activity there were some material changes to the underlying investments. Two of the new holdings contributed meaningfully over the very short period we have owned them. The first, McKesson, is a US based drug distributor. Investing in such a business is certainly not without risk. There is immense pressure to reduce health care costs in the US (which may lead to regulatory action) and the opioid epidemic has lead to litigation (some that involve McKesson). But fortuitously a few weeks after our buying, McKesson announced results and guidance which were taken favourably, and its share price at quarter’s end was 13.9%5 greater than our entry level. The second, KDDI Communications which is a Japanese telecommunications business, also announced results in mid May, about a month after we built our position. The share price ended the quarter 14.9% higher than our purchase price

There were two longer term holdings that performed well – H&R Block (23.5% return) and Delta Air Lines (10.5% return). Whilst on airlines, SouthWest Airlines shares have lagged recently, perhaps due to the delays of its 737 Max deliveries. As has Ryanair’s share price, which reflects increased capacity and irrational pricing on its short haul European routes. It too will experience delays in optimising its fleet due to the 737 Max problems. We built a position in both businesses over the quarter.

There’s unfortunately news on the negative side of the ledger. Two of our retailers, which together represented around 7.5% of the Australian Fund at the start of the quarter, cost the portfolio 1.5%. Gap returned a woeful -30.7% and Capri Holdings did not fare much better – down 24.2%. Both reported earnings over the quarter, and Capri Holdings also provided a detailed update. In Gap’s case, merchandising errors led to poor margins across the board – particularly disappointing in the case of “Old Navy” which Gap is currently in the process of spinning off. Capri Holdings (which owns the Michael Kors, Jimmy Choo and Versace brands) reported sound results, but it seemed the revised outlook perturbed investors and caused a sell-off. When we look to the earnings actually achieved, and when we see the CEO and CFO buying more than USD20m worth of shares, then despite management’s poorer outlook we are comfortable with our current position.

Turning to our two Canadian timber yards, Canfor Corporation was down 22.4% over the quarter and Western Forest’s return was -11.8%, together costing the portfolio 1.1%. Rising input prices, lower selling prices, together with ongoing trade and labour issues are weighing on these companies. Both businesses are working through these conditions. Canfor has permanently closed one operation and curtailed production at most of its other sawmills. Western Forest has curtailed production at three sawmills. Competitors have done so too. When we look to recent earnings (which are not at their cyclical peak) the businesses are currently priced extremely cheaply (double digit cash flow and earnings yields). We maintain our positions for the time being.

Dick’s Sporting share price fell 5.1% over the quarter. We have no idea why and are not concerned. On the other hand, AGL, the Australian electricity and gas distributor, announced it had entered exclusive due diligence to acquire Vocus, the telecommunications provider. At a stretch, the rationale may seem plausible, albeit far-fetched. AGL ultimately withdrew its offer, but to us the proposal signalled the lack of organic growth opportunities amid an uncertain regulatory environment. With its current quite low returns on capital, and with the prospect of these returns falling further, it was a borderline sell before this news provided the definitive catalyst.

And in the US we sold United Therapeutics, which ended up being an exercise of short term value destruction. We recognised our purchase was a mistake, acted swiftly, and contained our losses at 14.4%. Had we held to the end of the quarter, the result would have been far worse. Similarly, we sold Tenneco. Biting the bullet here despite our significant investment loss also proved wise with hindsight – as it subsequently fell 57% to the end of the quarter.

Aside from McKesson mentioned above, some new US positions of note include L Brands (the US retailer most known for Victoria’s Secret but also housing the growing Bath and Body Works chain) and Brinker International (running the Chili’s Grill and Bar and Maggiano’s Little Italy restaurant chains).

Moving back to Japan, we no longer hold JAE and Nichirin, realising profits in the former and losses for the latter. Tosoh, the chemical specialist, gave back some of its solid March quarter’s performance and was down 12.0%. This cost the Fund around 0.4%. And in Hong Kong, we sold Dawnrays Pharmaceuticals and bought Shenhua Energy.

The resulting end of quarter portfolio is slightly less concentrated than historically, with 26 holdings, and a lower weighting to small companies – with only one position having a market capitalisation of less than USD1 billion.

Closing Remarks

Managing assets is perplexing. The market is a complex and adaptive system. “Complex” because it is neither fully knowable nor predictable. “Adaptive” because of the inherent feedback loops. Hands up if you ever predicted there could be negative interest rates? And the irony of this is that those who succeed at managing assets have not “cracked” the code but rather stick to their beliefs and stayed rational along their investment journey. As Warren Buffett put it: “You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ.” Rationality is essential. Taking this onboard, rather than expend effort on what we consider to be the futile task of trying to understand the market and make predictions, we feel we are better off continuing sifting through our universe of companies to find understandable and reasonably stable businesses which are attractively priced.

At an overall portfolio level, on average our holdings are priced around 10 times their most recent annual earnings. Over the last year they have distributed over 7% of their current market value back to their shareholders (by way of dividends and buybacks). But they are not void of growth. On average their sales have grown 6% per year and their cashflows have more than doubled over the last eight years.

These businesses include the likes of Lear Corporation (which at 5.9% of the Fund is our largest position). Lear Corporation supplies seats and electrical systems to automobile manufacturers. It has demonstrated its ability to earn high rates of return on existing capital, deploy around half its free cash flow to projects that deliver similar high rates of return, and return its excess cash flow to shareholders primarily through buying back its shares. Its earnings per share last year was $18.27 and it has averaged $16.40 over the last three years. Lear Corporation’s share price was $139.27 at the end of the quarter. The resulting price earnings ratios (of 7.6 and 8.5 times respectively) for such a high quality business are compelling.

Airlines account for 12.7% of the Fund. As a group, our airline holdings have generated on average cash returns of 18% on their invested operating assets over the last eight years. As a sign of the changing industry landscape – rather than solely invest their earnings in new capacity only to then engage in price wars – they are spending their excess cash on reducing share count (on average by around 20% over the eight year time frame). The market currently prices these businesses, on average, at less than 10 times their earnings. Operating in a growing industry thanks to demographic and lifestyle tailwinds, we feel these investments provide reasonable quality long dated cash flow streams available to us today at attractive prices.

We have two chemical producers in the portfolio. Both are priced at double digit earnings and free cash flow yields. One of them, LyondellBasell (at 5.2% of the Fund), has generated an average return north of 20% on its operating assets over eight years. During July, having earlier announced it had terminated discussions to acquire Braskem, the large Brazilian chemical business, it bought back 10% of its shares – adding to the 35% it has bought over the five years prior.

The businesses we own are not particularly sexy (with the possible exception of L Brand’s Victoria’s Secret line). And like all businesses there are risks. Will we see the return of irrational capacity in the skies? How will US health care reform pan out? Will the expansion of Capri’s Versace brand be successful?

But then we look at the risks other companies face – risks that our businesses are not exposed to. For example, the risks the platform companies face from international tax crackdowns or forced break-ups, or the risks financial disrupters face by strong incumbents broadening their businesses.

Assessing investment risks involves weighing up the probabilities and earnings ramifications of the business risks against the prices being paid for the business. The goal being adequate compensation by way of future returns for the investment risks being assumed.

In our view, that equation stacks up well for our holdings, but not so favourably across the broader market. And this means that if we continue to lag the broader market returns – we will at least do so being able to sleep comfortably at night with the confidence that our returns were generated with less risk (according to our perception of risk).

Recently, with more frequency than we would like, we have come across a quandary. Many of the businesses we hold have become cheaper since our purchases. If our assessment of value was correct, even with hindsight, it is premature at this point to call these investments “mistakes”. The time to make that call is either when selling, or in our preferred case where we continue to hold the investment – at least a few years post purchase. And, if in the interim our assessment of value is unchanged or increases, and if there are no better opportunities, and if it makes sense from a portfolio construction perspective, the mistake would be not to buy more.

By undertaking our analysis, and acting sensibly and in accordance with our process, we are unfortunately only halfway towards reaching satisfactory performance results. There is a massive force known as the market, which will painfully dwarf our efforts (to buy economically and fundamentally sound businesses) and with such an impact that can easily result in the bottom line being below average. In other words, buying quality businesses at reasonable prices is, we believe, necessary but not sufficient. Having the will and patience to withstand short term price fluctuations is also a prerequisite.

“Even the intelligent investor is likely to need considerable willpower to keep from following the crowd” – Benjamin Graham

Now returning to the question – is our investment style permanently out of favour? Let’s first define our style. We like to think of it as buying interests in underlying businesses for prices less than what these businesses are worth. We don’t think this concept will ever go out of favour. We think the more important question is whether the reliance of traditional metrics (such as past earnings and cash flows) in calculating business value is as valid today as it has been in the past. On this, we are considerably more circumspect – so much so that our process of assessing business value has and will continue to evolve.

Irrespective, given our broad universe, the opportunities we find most compelling are unlikely to be meaningfully represented in broad market indices, and we do tend to avoid the “darlings” and the fads. This is not being contrarian simply for the sake of being contrarian. Rather, it is the result of our process that requires that business quality and price – as assessed on objective data – compare favourably to the rest of the peloton. Now, we are waiting for the broader market to join us in recognising the intrinsic value of these companies.

Thank you for your interest.

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.