September 2019 | Quarterly Report

Introduction

The Fund posted a return of 2.8%¹   for the quarter, and has been pretty flat since its inception in late January 2019²  .

The Australian Fund returned 2.4% over the quarter. The longer term performance of the Australian Fund is provided in past quarterly reports, which are available on our website.

Current news headlines point to considerable uncertainty – with the US President facing possible impeachment, the UK Prime Minister acting illegally, Brexit remaining unresolved, possibility of an imminent UK election, increasingly violent protests in Hong Kong, attacking of Saudi oil facilities and escalating trade wars. Amongst this, the relative calmness of the equity markets over the quarter was a tad worrying. It is only now, as we write this in early October, that we are seeing the markets respond. Should investors brace themselves? We think so.

On a different note, it is pleasing to see some semblance of investor sanity as WeWork’s³   IPO was aborted. WeWork has a risky business model and loses billions of dollars a year – meanwhile management enjoys tequila on the company’s $60m Gulfstream jet. The company is rife with related party transactions. And the IPO proposal included CEO shares with 20 times voting rights and for his wife to appoint his successor. Mind-boggling! All amidst Lyft trading at around half its IPO price of six months ago, and Uber at around two thirds its IPO price struck in May.

“In 54 years, I don’t think Berkshire has ever bought a new issue…The idea of saying the best place in the world I could put my money is something where all the selling incentives are there, commissions are higher, the animal spirits are rising, that that’s going to better than 1,000 other things I could buy where there is no similar enthusiasm… just doesn’t make any sense.” – Warren Buffett (May 2019)

Snapshot

• For the first time we can remember in more than three years, “value stocks” had a great run for a week or so in early September. Many of our positions strongly rebounded. For the patient amongst us, we think there’s more to come.
• Canfor Corporation investors received a “take private” offer from its largest shareholder. We exited our position as the share price moved acceptably close to the offer price (given the uncertainty of completion).

“We know from experience that eventually the market catches up with value. It realizes it in one way or another. – Ben Graham (1955 Congressional Hearing)”

• It was a more subdued quarter on the trading front. We completely sold three positions and bought two new positions.
• We have provided some insights as to the Fund’s largest position, LyondellBasell – our aim being to enable readers to better understand our ways of thinking by example.
• There was some interesting developments in the airline industry. Delta Airlines, one of the Fund’s larger positions, and LATAM Airlines announced a new joint venture and Delta’s 20% equity investment. Not a cheap deal from Delta’s perspective, but the rationale appears to be sound.

Contribution

Figure 1: Top Contributors/Detractors (Quarter)⁴  

Source: Alluvium, Factset, Private Reporting Pty Ltd.

Contribution

Figure 2: Top Contributors/Detractors (Quarter)⁴  

Source: Alluvium, Factset, Private Reporting Pty Ltd.

Contribution (continued)

Table 1: Contribution Details

Source: Alluvium, Factset, Private Reporting Pty Ltd.

Table 2: Quarterly Purchases

Table 3: Quarterly Sales

Performance Review

Although performance benefitted from an unexpected bid for one of our significant holdings, it was also tempered by the poor market reaction to the results announced by a couple of investee companies.

Minority investors in Canfor Corporation, the Canadian lumber yard, received a bid from its major shareholder of CAD16.00 to acquire the 49.1% it doesn’t own. We sold at a slight discount to the bid (CAD15.22). We view this as an opportunistic bid for a cyclical company priced at its rock bottom (it was trading at CAD8.80 at the time of the bid). The deal requires various approvals. For us, the pragmatic decision was to sell on market at a slight discount rather than hold and possibly receive the full bid, or maybe even a higher price, or perhaps see the bid rejected and the share price revert. As the price we achieved was 43.2%5 higher than its overly depressed share price at the start of the quarter, the position contributed 1.3% to the Fund’s quarterly return. This was merely a reversal of prior suffering – our realised gain was nothing to be proud of, at only 4.2%.

We wrote in the last quarterly that Dick’s Sporting share price fell 5.1% and that we were not concerned. This most recent quarter it returned 18.7%, more than reversing the June quarter losses. Dick’s reported strong same store sales growth, and management slightly increased their earnings expectations for the current year. Perhaps that explains it.

LyondellBasell ended up contributing more meaningfully than its 5.4% stock return would suggest, as a result of us increasing our position at attractive prices when the shares were “on sale” in mid August. Having the confidence to increase our already sizable position in the face of contrary market feedback is an important part of our process. We elaborate on some of LyondellBasell’s attributes that provide us with this confidence later in this report.

Brinker International, the owner of Chili’s restaurants in the US, returned 10.1% during the period we owned it over the quarter. It announced full year earnings and held an investment update in August. The investment initiatives management described make sense, but in our view these are required to simply maintain existing earnings, and are unlikely to materially grow them. Accordingly, our expectations of the free cash flow accruing to the business’s owners over time are reduced – as is our valuation. We realised a small capital gain and some dividends over our holding period.

To the negative side of the ledger. H&R Block, the tax agents, was down 19.4% over the quarter. In late August it announced results consistent with our expectations and provided an outlook consistent with its previous guidance. This incorporates lower margins as it invests in its systems and integrates its acquisition of Wave, the small business accounting software. All as expected, and yet the share price immediately fell 9.3%. We are surprised but not perturbed by the market’s reaction.

On the other hand, we are a little more circumspect when it comes to L Brands, which also announced results and provided an update on its troubled Victoria’s Secret business. Margins and earnings are declining. The share price being down 24.9% appears to encapsulate investor uncertainty regarding its turnaround potential – and rightly so. Unfortunately the troubles at Victoria’s Secret seem to dominate perceptions of L Brands, with far less attention on its strongly growing Bath & Body Works business – which is rapidly approaching half of its revenue.

Lear Corporation continues to struggle. During September, light vehicle production forecasts were revised down substantially, partly a consequence of the United Automobile Workers strike at General Motors. We remain comfortable with our holding, but unfortunately we do not see any short term respite. The share price was down 15.3% over the quarter. And rounding out the poor performers – our Canadian timber company that wasn’t bid for, Western Forest, was down 19.7%. And Franklin, the US Fund Manager, was down 17.0%.

And finally, we note some trading in Japan, where we replaced our position in KDDI Corporation with what we consider to be a better investment in the telecommunications sector, T-Gaia. Whereas KDDI operates a network, T-Gaia is a reseller and distributor. We held KDDI for a few months and realised a 21.7% return.

LyondellBasell: Why We Own It

With annual sales of around $40b, and employing 20,000 staff, LyondellBasell is the world’s third largest chemical manufacturer. But it certainly did not reach this point in a linear growth fashion. Resurrected from bankruptcy in the midst of the Global Financial Crisis (“GFC”) a decade ago, LyondellBasell took advantage of the shale gas boom in the US providing plentiful and cheap supply of its feedstock for producing chemicals and plastics. It closed inefficient plants, slashed more than 5,000 employees, and expanded capacity at its facilities located amongst the shale gas fields. Meanwhile, its main competitors in Europe were expanding their production facilities which would not enjoy the benefits of cheap feedstock.

Let’s look at some of the attributes where the company “ticks our boxes”:

• An understandable business model. Despite LyondellBasell’s technology being highly complex (and extremely interesting when you consider the diversity of daily life end uses), the way it operates its business is quite simple;
• A conservative balance sheet, with debt over the past 5 years of between 1.0 and 1.5 times EBITDA and averaging 33.8% of its assets base. Nothing compared to the debt burden of 2009 which precipitated the company into Chapter 11;
• A record of improving margins (to average 15.6% over the last 3 years) and reasonably consistent operating earnings;
• A satisfactory and stable return on invested capital, averaging 23.5% (on Alluvium’s measure) over the last 8 years;
• A disciplined approach to capital allocation, as demonstrated by:
  • the A.Schulman acquisition in October 2018 ($2.1b) which increased its diversity of products and adds circa $200m EBITDA. There have been no unexpected issues and additional synergies have been identified;
  • the $2.7b investments in Texas plants which are budgeted to add circa $450m EBITDA when they come on line;
  • a conservative approach to expansion capital expenditure over the next few years, stepping down to its lowest level post the GFC to about $1b, or 2.5% of sales; and
  • the active share repurchases at attractive prices which are accretive to EPS, and in our view, to share value too;
• A very strong alignment of interests, and with the insiders buying more shares. The CEO owns $28m worth of stock (he purchased $4m shares in 2019). And insider Len Blavatnik (via the holding Access Industries) has invested an extra $600m at the end of 2018 and another $68m in September this year. Access now holds a 23.1% interest;
• A sensible attitude towards reducing its environmental impact with, among other things, its recent joint venture (“JV”) with Suez on recycled materials and its contribution to the Alliance to End Plastic Waste. This company will never be the darling of environmentalists but its sustainability initiatives translate into a green light on our ESG test;
• Most importantly, at its current share price, it is inexpensive. It trades at a discount to our valuation, and at attractive mid teens earnings and cash flow yields. Meanwhile, its capital intensive assets are hard to replicate, and it enjoys cost of production advantages in a stable industry with a diverse range of applications.

We believe this company is well placed in this indispensable $4 trillion industry and will provide its shareholders attractive returns over the long run.

The Airline Industry

We have maintained the Fund’s solid positioning in the airlines, so it is worthy to note the consolidation theme playing out. Delta Air Lines (a 3.2% position) announced a new JV with LATAM Airlines. As part of the JV, Delta will acquire a 20% interest in LATAM for $1.9b (at a 30% premium to LATAM’s prevailing share price) as well as invest a further $350m into the JV, and take on 14 of LATAM’s existing and committed A350 aircraft – the rationale being that Delta’s current fleet of fifteen A350’s is subscale. This is a major deal both for Delta and LATAM.

On initial impressions, from a short term financial perspective, this does not seem a great deal for Delta. But on a longer term and strategic level, it may well be a game changer. The ramifications are quite pronounced. LATAM will now end its partnership with American Airlines and leave the Oneworld Alliance. Delta will end its arrangements with GOL (the Brazilian low cost carrier), but it gains far greater access, growth and connectivity for long haul South American routes. The JV is illustrative of the changing nature and consolidation in the airline industry. It also highlights Delta’s model of investing substantially in partial ownership stakes of other airlines (Delta also owns 49% of Virgin Atlantic and Aeromexico, 9.2% of Korean Air and 3.6% of China Eastern). Delta also has JV’s with Virgin Australia, WestJet in Canada and Air France – KLM.

Closing Remarks

As we wrote in the introduction, the complacency of the equity markets over recent times seems eerie. This is likely the result of the US Fed’s counteracting forces. On the one hand, the trade war escalations are feeding through the system. As businesses become increasingly hesitant to invest, and consumers reluctant to spend, economic activity declines. On the other hand, the US Fed responds by decreasing its target cash rate.

There is no doubt the declining economic activity is reducing the near term cash flows of solid and profitable businesses. The market’s response appears to be to mark down the share prices of these businesses (which are generally viewed as “value” stocks). The lower target cash rate has fed through to lower long term rates. Hence, future earnings are now assumed to be worth more in today’s dollars than previously. So the market’s response is to boost the prices of the shares in those business where the “value” lies in more distant expected cash flows (ie, “growth” stocks). Net-net, value continues to underperform.

Meanwhile, fund flows from active to passive management continue. We recognise the benefits of index investing, and have no real problem with it. But the fact is that it is a momentum strategy – for many dollars invested in an index stem from the sale of a non-index stock, whereby a robot then indiscriminately buys the shares of those companies fortunate to be of a size sufficient to meet index inclusion and irrespective of investment merit. It all works well whilst the funds are flowing…

“This is very much like the bubble in synthetic asset-backed CDOs before the Great Financial Crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows based on Nobel-approved models of risk that proved to be untrue.” – Michael Burry (September 2019)

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 solely responsible for the preparation of this document.

The Fund is a sub fund of Conventum. Conventum is an open-ended investment company (société d’investissement à capital variable, “SICAV”) with multiple sub-funds incorporated under Luxembourg law, subject to Part 1 of the Luxembourg Law of 17 December 2010 on undertakings for collective investment, as amended. The SICAV has appointed Conventum Asset Management S.A. as the Management Company in charge of the portfolio management, the central administration and the distribution of the SICAV. Conventum Asset Management S.A. has appointed Alluvium as the Asset Manager of the Fund. Relevant documents for the Fund are available via the following links: Prospectus (FR/EN), Key Investor Information Document (“KIID”), (FR/EN).

Alluvium is the issuer of units in the Australian Fund, which is an unregistered managed investment trust available to Wholesale Clients as defined under Section 761G of the Corporations Act 2001 (Cth). The Australian Fund feeds into the Fund. An Information Memorandum (“IM”) is available here.

A person should obtain a copy of the Prospectus, the KIID, and/or the IM and should consider the documents carefully before deciding whether to acquire, or to continue to hold, or in making any other decision in respect of shares in the Fund or units in the Australian 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 nor the Australian Fund.