Let’s not beat around the bush: the returns over the quarter were exceptional and unlikely to be duplicated any time soon. But of course, they only partially reverse the exceptionally poor returns of the prior quarter.
The Fund posted a return of 20.1% for the EUR class and 22.9% for the USD class1 . The 9.2% return for the Australian Fund is explained by the rising AUD – nothing unheard of when markets switch to ‘risk-on’ mode. Given the reverse also holds and our inability to predict imminent changes in risk appetite, our preference has always been not to hedge our foreign currency exposure.
After such a bloodbath during the March quarter, it was no surprise that equity markets would experience some mean reversion. However, we do question how much is justifiable given COVID-19’s unknown longer term effects on consumer behaviour, the associated depth of decline in economic activity, and its likely duration. If equity markets are a reliable signal – we would assume it’s all over. We are far more circumspect.
The stimulus measures are extraordinary. If interest rates are zero forever, what does that make stocks worth? Austria recently issued a 100 year bond at a rate of 0.88%2 . 100 years! How long can this continue? Will long term rates head below zero? What risk premium does one apply? After all, the closer ones discount rate is to zero, the closer the valuation is to infinity…
“The risk reward for equity is maybe as bad as I’ve seen in my career.” – Stanley Druckenmiller, 12 May 2020
- A broad range of positions contributed to the Fund’s strong return.
- Only four of the Fund’s holdings posted a negative return over the quarter, and only two of those were notable (Walgreens3 down 6.3%4 and Southwest down 4.0%).
- Many of the stronger performers were high conviction positions that were heavily sold off in the prior quarter, like Thor Industries (returning 156.2%), Dick’s Sporting (95.6%), LyondellBasell (34.3%) and Lear Corporation (34.2%).
- Our recently introduced holding in the Australian gold producer, Regis Resources (bought in March), performed well and returned 43.4% over the quarter. Perhaps others share our concerns about monetary debasement.
- We introduced one new position during the quarter – Micron Technology, which is a US listed producer of memory and storage solutions for a wide range of devices.
- As we became increasingly concerned with the longer term ramifications of COVID-19, we completely sold our position in what we consider to be the most vulnerable of our four airline holdings – United.
- We have maintained our investments in three other airlines (Delta, and the low cost carriers Ryanair and Southwest).
- Some quite surprising volatility along with fund inflows were the catalysts for some trading activity, such as:
- trimming our holdings in some of the better performers like Thor, F5 Networks and Dick’s Sporting;
- increasing some other existing positions (mainly HCA Healthcare, Samsung and Vestas).
- As a result of fund inflows and this trading, we ended the quarter with 23 positions and 27.6% cash.
Figure 1: Top Contributors/Detractors (Quarter)5
Source: Alluvium, Factset, Private Reporting Pty Ltd.
Figure 2: Top Contributors/Detractors (Year)5
Source: Alluvium, Factset, Private Reporting Pty Ltd.
Table 1: Contribution Details
|June 2020||June 2020 Quarter Summary||June 2020 Last 12 Months Summary|
|End Weight||Beg. Weight||Return||Contribution||Beg. Weight||Return||Contribution|
|Delta Air Lines||1.6%||2.2%||-1.7%||-0.3%||3.1%||-49.9%||-2.3%|
|Cash, Currency & Fees||27.5%||18.6%||-2.0%||19.4%||-0.4%|
Source: Alluvium, Factset, Private Reporting Pty Ltd.
Table 2: Quarterly Purchases
|Kirkland Lake||New Position|
|Northern Star||New Position|
Table 3: Quarterly Sales
|F5 Networks||Complete Sale|
We were more active than usual with our trading during the June quarter. This was simply a function of price volatility. The short summary of our activity is that we generally sold into rebounding markets in April and May, and balanced this selling in June with some buying partly as a result of fund inflow. In hindsight, our performance would have been marginally better (as at quarter’s end) had we not sold. The net effect was an increase in our cash position to 27.5% from 18.6% over the quarter. This is indicative of our cautiousness.
Most of the Fund’s positions produced double digit returns over the quarter; in fact half posted returns of greater than 20%, and a quarter more than 40%. But hang on, do not give us too much credit. Far from it, four holdings posted negative returns from already depressed levels. And, given the starting point and the strength of the broad market rebound, we suggest any return of less than 15% can be appropriately classified a “poor performer”.
The most notable activity was our selling of United Airlines. We hinted at this in our last report. Over time, we became more accepting that the post COVID-19 rebound (in business fundamentals – not listed equity prices!) is likely to take longer and be less pronounced in certain industries than we had earlier expected. And we felt it prudent to accept our loss and move forward. Whilst the outlook is also not ideal for our other three airline holdings, we feel the risk to their businesses is lower given the markets they serve and their balance sheet strength. None will be immune to sharp sell-offs and volatile pricing depending on the latest COVID-19 health advice and regulations. However, we are reasonably confident all three will survive and, we hope, ultimately prosper. We do not share the same level of confidence with United Airlines. We are sorry to report to you that the Fund incurred a gut wrenching 61.4% loss on that investment.
We introduced a new position to the Fund – Micron Technology. Micron manufactures memory chips (like DRAM and NAND) and storage (like SSD) for products ranging from computers, phones, and data centres to automobiles and smart watches. The business has little debt, generates attractive returns on capital, and provides a respectable earnings yield at current prices. With the significant tailwind from ongoing demand for big data storage, Internet of Things and 5G devices, even after acknowledging the industry’s cyclical nature, we expect the strong sales growth the business has experienced over recent years will, more likely than not, continue.
Ruth’s Hospitality, which operates more than 150 steakhouses, is a business we have had our eye on for some time. Its share price suffered enormously with the COVID-19 concerns – being down around 80% from its pre COVID-19 levels at one stage. We opportunistically took an initial “stake” with a view to increasing it as our COVID-19 concerns eased. However, rather than our concerns easing, they intensified. And with a price circa 60% higher than our entry level, we no longer felt the risk/reward relationship was favourable so we completely sold our position. More on this later.
In another sign of our cautious stance, we trimmed our positions in two businesses that experienced strongly rebounding share prices. We started to decrease our position in Thor Industries (the maker of recreational vehicles, or RVs) in late April and during May. We simply no longer considered it cheap enough to maintain the entirety of our position. Then, after it reported pleasing third quarter results in early June, with the share price rebound accelerating, we sold a little more.
Despite being somewhat warranted, Thor’s performance over the quarter was, in our view, a little excessive. But having such a view cost us – had we not traded our position the Fund’s performance over the quarter would have been around 0.9% better.
“I think I’m going to buy an RV and travel from now on in an RV with our first lady.” – Donald Trump, 8 June 2020
By quarter’s end, Dick’s Sporting was up 2.5 times from its March 20 low. Although we largely consider this recovery to be justified, the investment had become prominent given our buying in March – so we trimmed it a little (to end the quarter with a 4.0% position). Of course in this case, as with Thor Industries, we acted as typical value investors do, and sold too early…
On three occasions in March, we took advantage of the severely depressed share price of LyondellBasell and increased our weighting by around 1.5%. And then during the June quarter after the quite strong rebound in its price it accounted for more than 7% of the portfolio, so we divested about half of that recently acquired stake to end the quarter with a more appropriate 5.4% position. On this occasion, the immediate impression is that our market timing was a little better.
Applying some of the proceeds from a mid June cash inflow we bought more Samsung, Gilead, HCA Healthcare and Vestas Wind Systems (refer next section). In the cases of Samsung and Gilead – this was merely to maintain prior portfolio weights, but in the cases of HCA Healthcare and Vestas, our buying resulted in notable increases in portfolio exposures.
Aside from those companies mentioned, other investments with strongly increasing share prices included Western Forest (the Canadian timber merchant which returned 47.6%), Capri Holdings (the owner of fashion retailers, which returned 44.9%), Regis Resources (the gold producer, which returned 43.4%), Robert Half International (the recruitment firm that returned 41.0%) and Lear Corporation (the automobile parts producer, which returned 34.2%).
Moving on to the ten poorer performers (which in these exceptional times we choose to define as a return of less than 15% over the quarter). They include the three US airlines (with returns ranging from -4.0% to 9.7%). This is no surprise, as we (and clearly other market participants) began to factor in a longer and more gradual recovery in air travel than originally envisaged. Other poor performers include two health orientated businesses, Gilead (the bio pharmacist which returned 3.9%) and McKesson (the drug distributor which returned 13.7%). These are also not surprising but for an entirely different reason. Both businesses have defensive characteristics which led to their out-performance in the March quarter (when they returned 16.2% and -1.9% respectively). More recently, the laws of mean reversion simply were not working in their favour.
More disappointing for us, in this bucket of poor performers, lie Walgreens Boots (down 6.3% following its 21.7% March quarter decline) and H&R Block (up only 2.9% after falling a whopping 39.0% during the March quarter). Both have so far proven to be poor investments. For both of these businesses we are finding it quite difficult to ascertain the degree to which the COVID-19 impacts are temporary rather than representative of ongoing structural challenges. On this one, we are erring to the optimistic side.
H&R Block typically receives more than 75% of its income in its fourth quarter (coinciding with the usual US tax return deadline of mid April). But COVID-19 prompted an extension in the current year’s deadline to 15 July, and so H&R Block’s revenue (for year ended 30 April) was down around 15%. With its operational and financial leverage, it barely managed to scrape a profit. We are expecting most of this revenue is simply delayed and not lost (in-line with management’s comments).
As an essential services provider, Walgreens is required to keep trading. Despite government assistance, in most instances this trading comes at a cost, especially in hard lockdown countries like the UK. Coupled with its leverage associated with lease and financing commitments, there’s no doubt the business is going through tough times. But we believe its capable and suitably incentivised management is implementing strategies to strengthen its business model and enhance the value of its offering. Above all, at its current price and based on our estimate of its maintainable earnings, we consider it reasonable value.
In the absence of further information regarding business developments, we intend to maintain the Fund’s current positions in H&R Block and Walgreens, which represented 2.9% and 2.5% of the Fund (respectively) at quarter’s end.
Why We Own Vestas (and Struggle to Own More)
Based in Denmark, Vestas designs, manufactures, installs and services wind turbines across the globe. In fact, with its 25,000 staff and main production facilities based in China and the US, it has installed 20% of the world’s wind capacity6 . With sales exceeding EUR 12b, along with its global reach, scope and size, Vestas remains today the industry leader (40% market share) versus its main competitors: Siemens Gamesa Renewable Energy (Spain), Goldwind (China), and GE Power (US)7 .
Vestas operates in an industry with interesting “tailwinds”. Energy consumption keeps increasing strongly due to factors such as population growth, increasing standards of living, urbanisation, technology needs and electrification of transport. And, according to the Global Wind Energy Council, wind is expected to keep increasing its share of the energy mix. Starting from a low base (3%) compared to fossil fuels like coal (27%) or natural gas (24%), Bloomberg forecasts that wind and solar will provide 50%8 of the world’s electricity by 2050.
The benefits of wind energy include:
- Low carbon footprint – a single turbine produces 30 to 50 times6 more energy than it uses in its entire lifetime which is line with increasingly strong national commitments to reduce greenhouse gases;
- Low operating costs – wind is an unlimited and free resource;
- Predictable operating costs – wind power is not subject to volatile input prices;
- Low production costs – technology advances over the past decade have led to wind energy production costs falling by 50% and wind generation facilities are now cheaper to build than coal or gas plants across most of the world7 ;
- Fast production time – it is vastly quicker to build new wind capacity compared to new fossil fuel factories; and
- Increased self sufficiency – by reducing countries’ dependence on imported commodities.
Vestas exhibits the types of attributes we seek, like:
- Having a solid capital structure as shown by its low debt (debt / EBITDA averaging 0.5 and not exceeding 1.0 over the past seven years), and substantial fixed charge coverage (ratio averaging around 15 over the past three years);
- Being operationally efficient, with a return on invested capital averaging over 25% over the last five years; and
- Demonstrating prudent capital allocation with excess cash being distributed via dividends and share buybacks.
Like all businesses, there are risks associated with Vestas. For example, the tariff wars and COVID-19 caused supply disruptions and additional costs, which resulted in some recently declining margins. However, from a longer term perspective, we see compelling prospects. The energy industry is transitioning to unsubsidised, and we believe its increasingly competitive nature will likely lead to further consolidation and will benefit the larger and the better capitalised participants. Meanwhile, Vestas is making solid strides in its highly profitable “Service” segment (which provides long term recurring revenue with an average contract of 18 years). This business also caters to non-Vestas wind turbines, and we expect Vestas will benefit further from leveraging this multibrand expertise. And, having increased its data analytics capabilities (through its acquisition of Utopus in 2018), we expect it will further improve the value proposition for its customers. We also expect Vestas will grow its offshore segment (which is represented by its joint venture with Mitsubishi) and its operations in the developing markets like Vietnam, Brazil, South Africa and Thailand.
The sector has had many false starts in the past but increasing public pressure to fight pollution, reduce greenhouse gas emissions and “decarbonise” our energy systems is only accelerating the transition to clean energy.
We initiated our position in January, and then after witnessing further positive business developments during the following months we bought a little more in June. We remain on standby to further increase the Fund’s 2.9% weight should its price retract to a more favourable level.
Since the Global Financial Crisis of 2008, we have been led to a sense of complacency about the trajectory of share prices. They do not always go up in a straight line. What we witnessed in the past few months is testament to how bumpy the ride can be, and how humbling is this intellectual endeavour that we refer to as investing.
There are always uncertainties, but given the profound new unknowns we are facing, we expect this rocky ride to continue for quite some time. From an investment perspective, perhaps the most important of the unknowns is the extent and duration of the seemingly limitless monetary support provided by every major government around the world. Technically, yes, the central banks do not have any constraints, but in reality, it is hard to conceive that unworthy enterprises will be supported indefinitely. After all, capitalism, by its definition is the allocation of scarce resources to their most productive use. How long can capitalist societies withstand such negation of this basic principle?
Back to the recent surge in market volatility. We did take some advantage of the opportunities provided. We would have performed better had we deployed more capital and, as previously mentioned, held some positions longer. Indeed, our discipline on price versus value may impede us from investing (or encourage us to divest) in businesses at suboptimal times. But, we aim to be roughly right rather than precisely wrong. And of course, deriving a valuation range is an art not a science – recently made all the more challenging as this pandemic leads to such a wide range of potential outcomes.
Our behaviour with regard to our Ruth’s Hospitality investment illustrates this. Ruth ended up being a very short term holding (about six weeks). This is a rarity for us – our preference is to hold our businesses for the long term. And indeed, that was our intention when we first purchased Ruth’s at the end of March for we had been considering investing in this business for some time. By all accounts it offered reasonable value, for example at the end of February its share price of $19.13 reflected a slight discount to our “pre COVID-19” valuation.
In the depth of the sell-off on 20 March it plummeted to an intra-day low of $2.31. Over the ensuing few days we reworked our valuation (accounting for lockdowns and ramp up times). Although by the time we had completed this work (which was at the end of March) the shares had rallied to above $6, this was still considerably lower than our revised valuation. So we purchased a small position at what we thought to be a large enough discount to account for the uncertainty. Over the course of the next month, as we became increasingly concerned about COVID-19’s ramifications, we spent more time working through scenarios involving longer term lockdowns and more significant debt and equity raisings. Our valuation range became wider, the midpoint became lower (to below $10) and the shares were trading higher. The risk/reward equation had changed – so we sold. Our rapidly changing view and unexpected short holding period of this investment is a reflection of the very strange times in which we live.
And so, on that, we take this opportunity to wish that you and your family stay safe and healthy during this second wave or (unfortunately) more accurately the continuation of the first wave of COVID-19 infections globally.
Thank you for your interest,
21 July 2020
Figure 5: Diversification by Sector
Source: Alluvium, Factset
Figure 6: Diversification by Region
Source: Alluvium, Factset
Table 4: Fund Overview
|Top 15 Holdings||56.5%|
|Number of Holdings||23|
|Weight Average Mkt Cap. (USD m)||35,987|
Source: Alluvium, Factset
Table 5: Quality Metrics (weighted average)
|Fixed Charges Coverage (3y median)||9.0x|
|Sales Growth (3y average)||2.3%|
|Return on Invested Capital (3y average)||24.6%|
|Return on Invested Capital (8y average)||28.6%|
Source: Alluvium, Factset
Table 6: Pricing Metrics (weighted average)
|Enterprise Level Yield (EBIT/EV)||7.8%|
|Earnings Yield (NPAT/Mkt Cap)||7.1%|
|Free Cash Flow Yield (FCF/Mkt Cap)||7.2%|
Source: Alluvium, Factset
Table 7: Top 15 Holdings
Source: Alluvium, Factset
Alluvium: Alluvium Asset Management Pty Ltd, ABN 69 143 914 390, AFSL 476067
Australian Fund: Alluvium Global Fund
Factset: Factset Research Systems, Inc.
Fund: Conventum – Alluvium Global Fund
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
Mkt Cap: Market capitalisation
NPAT: Net profit after tax
Operating Assets: Total assets less total liabilities plus total debt (Alluvium adjusted)
Owner’s Earnings: Operating cash flow, plus cash interest paid less assumed maintenance capital expenditure
Return on Invested Capital: Owner’s Earnings as a percentage of Operating Assets
1 Source: European Fund Administration S.A.
2 Source: Bloomberg L.P. – Bloomberg | Austrian Bond Reference
3 Company names have been abbreviated throughout this document in the interest of readability.
4 Source: Factset
5 Returns are time weighted, include dividends, withholding tax, trading costs and are expressed in local currency.
6 Source: Vestas Annual Report 2019
8 Source: Bloomberg NEF – Clean Energy Report
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.