The Fund posted a return of 1.2% for the EUR class1 . The Australian Fund posted a similar return of 1.5%. The USD share class of the Fund returned 5.6% as a result of the marked decline in the USD2 . We reiterate our preference is not to hedge.
Equity markets appear to have stabilised a little during the quarter – albeit at surprisingly high levels. Initially, it seemed any concerns over a COVID-19 second wave (which in our view were always entirely valid) were shrugged off, however toward the end of the quarter the market did become increasingly jittery.
Since the lows of 23 March (to 30 September), we have witnessed some stunning returns, almost universally amongst the “growth” stocks. Due to their prominence in the indices, these have fed into some quite extraordinary so called “market” returns, with the S&P 500 up 50.3% and the Nasdaq Composite up an astonishing 62.8%2 . Conversely, the Russell 3000 Value is “only” up 39.3%2 . Since those lows, the MSCI World Index (in USD) has returned 43.3%, with “growth” up 55.8% and “value” up 30.0% according to the relevant sub-indices3 . The Fund (in USD) has returned 41.6%1 .
The Fund’s performance was generated despite it not holding Apple4 (up 107.4%), Tesla (up 393.9%), Facebook (up 76.8%), NVidia (up 154.7%), and Microsoft (up 55.8%)2 . We estimate that these five companies alone (amongst 1,607 constituents) were accountable for almost one quarter of the MSCI World’s 43.3% return.
When we look through COVID-19 to the performance year to date, the returns are only a little less extraordinary – Apple (up 58.8%), Tesla (up 412.8%), Facebook (up 27.6%), NVidia (up 130.3%), Microsoft (up 34.4%)2 . One wonders what these numbers would have looked like had it not been for the pandemic. We suspect lower (and by some margin).
- After initiating four new positions, all with rock solid balance sheets and sound business models, our cash weight was down to 18.1% (from 27.6% at the end of June).
- We ventured beyond our traditional screening criteria, which enabled the Fund to add two other gold producing companies to its sole existing investment in the sector (Regis Resources).
- Although one of our new entrants is likely to come as a surprise, we have been working behind the scenes on this for some months. It just took us a while to overcome various biases and commit the capital.
- Dick’s Sporting continues to impress – its strategy of enhancing “home brands”, providing a better in-store experience, and the fruits of its prior investment in online platforms and initiatives like curbside pickup are really shining through.
- Despite Vestas reporting that its business is facing some headwinds due to supply chain and logistics issues, the share price posted quite a remarkable performance over the quarter.
- Airlines remain under pressure to constrain cash burn. Their share prices are expected to remain volatile for some time. Although our airline holdings did contribute positively to the Fund’s quarterly performance, we remain wary.
- The poorest performer was long time laggard Walgreens Boots, as it reported dismal results for its first full COVID-19 impacted quarter (ended 31 May). The full brunt of the lockdowns had a marked detrimental effect on its business.
- As an illustration of how the equity “market” is valued, according to MSCI, its growth index exhibits a forward price to earnings ratio of 30.1 and its value index 14.53 .
- There are some indications the tide may be turning from “growth” toward more “value” oriented investments.
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
|September 2020||September 2020 Quarter Summary||September 2020 Last 12M Summary|
|Stock||End Weight||Beg. Weight||Return||Contribution||Beg. Weight||Return||Contribution|
|Delta Air Lines||1.6%||1.6%||9.0%||0.1%||3.2%||-46.4%||-2.3%|
|Cash, Currency & Fees||18.1%||27.5%||-3.7%||18.0%||-6.9%|
Source: Alluvium, Factset, Private Reporting Pty Ltd.
Table 2: Quarterly Purchases
|Thor Industries||Increase Position|
|Dick's Sporting||Increase Position|
Table 3: Quarterly Sales
|Lear Corporation||Decrease Position|
|H&R Block||Decrease Position|
During the quarter we introduced four new companies to the portfolio and completely sold out of one. This leaves us with a record 26 holdings as at quarter’s end.
We sold our position in F5 Networks (the application services business) which, when viewed predominantly on a quantitative basis (as we did at time of purchase), appears to be of high quality, having generated very attractive returns on its invested capital over a prolonged period. But recently, as we introduce more qualitative assessments to our process, we wish to better understand how the business generates these high returns and how sustainable they are. When it comes to F5 Networks, we failed to develop conviction that these returns are enduring. The investment was not a successful one for the Fund – it provided only a small single digit return over the year or so it was owned.
Moving on to our four new positions. Two are gold miners. Once again, this illustrates our changing to a less strict and more qualitatively inclusive process. These purchases are discussed in the next section. The other two are discussed below.
Roche, the Swiss healthcare giant, provides a diverse range of pharmaceuticals and has leading edge diagnostic capabilities. Its significant ongoing investment in research and development has led to the business generating returns on its assets in the order of 20% to 30% over a sustained period. Acquiring a position in such a high quality company on merely acceptable – rather than compelling – pricing metrics (for example, a circa 5% earnings yield) now makes greater sense given the investment alternatives currently available to us. Subject to pricing, we intend to increase our small position (1.7%) as future company updates validate our views on the quality of the business.
Now to our most exciting and somewhat controversial new entrant – Alphabet. This is significant for a couple of reasons. Firstly, we would like to highlight that we could never justify this on our previous, quantitatively based, valuation grounds. Impressive historic financials provide us with only so much confidence on business quality – and not enough for us to pay what we consider to be dangerously high multiples of past earnings. But our updated framework allows us to credit non-quantifiable measures of business superiority.
But even as we look to these qualities, being the sticklers that we are, we really did want to see more evidence of business resiliency. The pandemic largely provided this. It has accelerated the evolution of the ways we work, shop and communicate. And it has increased our confidence that, to a large extent, these are structural. Hence, it has transformed our view as to the quality of Alphabet’s business. Although we are concerned about the economic outlook and the likely adverse effects on advertising revenue, and possibly a tougher regulatory environment, there are so many other facets to the business, with strong tailwinds, that largely outweigh those concerns.
Secondly, we were faced with admitting our mistake. For although it had passed our screen intermittently for some months, we did not buy it at a more opportune time – most notably during the lows of March. We had to overcome our significant regret. On top of that, we had to overcome the possibility of further regret should the share price revisit those levels.
In the end, we asked ourselves a simple question: Would we prefer to hold cash, or Alphabet? Subject to being disciplined on price, we prefer Alphabet. Having established the price we were prepared to pay, we ended up with a position of 1.7% to date.
Now to the main contributors and detractors to the Fund’s quarterly returns.
Ordinarily, we would not comment, but the obvious detractor to the Fund’s Euro denominated return was the 4.2% decline in the value of the USD versus the EUR. This is plain to see in the 4.4% higher return of the USD share class relative to the EUR share class. We do not hedge currency, we have no plans to hedge currency, and we are perfectly accepting of this outcome. So we suggest we move on to the more interesting and relevant matters to our investment mandate.
Dick’s Sporting returned 41.1% over the quarter. It makes our buying in the depths of March look particularly smart. Unfortunately, it makes our selling later in March look decidedly less smart. Although we sold at a price 45.3% higher than our buy price, we have subsequently foregone a further 68.0% return. And to make matters worse, we sold a few more shares than we had bought. Our reasoning? It had grown to close to 7.0% of the Fund at one stage – and we no longer felt the risk/reward relationship justified such a large holding. But despite our selling, we still held a 4.0% position going into the quarter which led to its meaningful contribution.
Vestas Wind Systems (discussed in greater detail in our June 2020 report) announced its second quarter results which included updated guidance for materially lower than previously forecasted EBIT margins (due to provisions and COVID-19 supply chain and logistics complexities). This is a little concerning and warrants monitoring. It serves to remind us that Vestas is, to a large degree, a construction company subject to the same types of risks and unexpected cost blowouts as many fixed price contractors. But the market seems to have shrugged this off. We sense the “invest in green energy” movement over-rides such concerns, as the shares returned a quite remarkable 52.5% over the quarter.
In mid June we bought more HCA Healthcare, the owner and operator of hospitals, thereby increasing the Fund’s position to 3.8%. Subsequently, HCA’s second quarter results revealed better than expected revenue, and demonstrated management’s ability to control costs and adapt to the different operating environment. We believe this led to the share price being up 28.5% over the quarter. And as we finalise this report, HCA released another pleasing set of results and confirmed it will return, or repay early, all of its share of Provider Relief Fund distributions of approximately $1.6b and approximately $4.4b in Medicare accelerated payments provided under the Coronavirus Aid, Relief, and Economic Security Act (CARES Act).
Gilead, the biopharmaceutical giant that sells Remdesivir (one of only a few drugs cleared by the US Federal Drug Administration for the treatment of COVID-19), had performed reasonably well throughout the pandemic. However, it was the worst performer for the Fund during the quarter, down 17.0% (when adjusting for a dividend). We don’t know the reason for this poor performance. Perhaps it just held up too well during the pandemic and was due some reversion? Gilead did announce a large acquisition at a worrying large price premium (we are concerned, but awaiting further details before making final judgement), but the majority of the sell-off was before this news. Perhaps it was rumoured? Although we had sold a third of our position in Gilead in March and a little more in June, its relatively strong performance meant we still held a 3.5% position at the start of the quarter, so its poor performance during the quarter hurt.
Walgreens Boots increased its quarterly dividend for the 45th consecutive year – but this was little consolation when the share price was down 15.3%. It announced poor operating results for its third quarter (ended May – so fully incorporating the COVID-19 impacts). Top-line sales were actually okay, being slightly better than the prior year’s comparable quarter. But the lockdowns, particularly in the UK, did have a huge impact in that market on sales and profitability. And margins were impacted more broadly due to changing categories, increased supply chain costs and the costs associated with social distancing and cleaning. Whilst we are far from enamoured with this business, it is currently providing a double digit earnings yield, a decent cash flow yield of around 8.5%, and with no pending liquidity issues, we remain holders.
Thor Industries announced its fourth quarter results. The recreational vehicle market is booming. Order backlogs are at record levels, and so far hindsight suggests COVID-19 was a mere third quarter blip, subsequently followed by a fourth quarter filip as sales exceeded those of a year ago. Despite these impressive results, Thor declined 10.6% during the quarter, suggesting as is often the case, that a good result was “more than priced in”. We had reduced the Fund’s position to 2.4% by the end of the June quarter, so the 10.6% decline in Thor’s price over the quarter, despite being disappointing, did not affect returns too much.
Why Our Growing Interest in Gold Miners?
Gold may well yield nothing… but cash costs something!
Since the Fund’s inception, cash has accounted for around one-fifth of the portfolio. As we have struggled to identify opportunities, we have been hesitant to deploy capital. Historically (prior to the Fund’s inception) holding cash has at least rewarded us by earning some interest. In more recent years this has not been the case. Much of our cash is now costly to hold. So, the traditionally held reluctance to invest in gold (relative to cash) on the basis that it provides no yield no longer has any merit (unless it is extended to also argue that we should now cease to own cash). And, proponents of that argument further contend that as gold does not provide any cash flow, it can’t be valued. But doesn’t that same argument also apply to cash?
Gold has a proven ability to retain relative value, which bodes well for our goal to preserve capital
Evidence suggests that gold has retained its relative value over the long term. As an example, an apparently widely reported statistic is that an ounce of gold bought 350 loaves of bread during the time of King Nebuchadnezzar of Babylon (who reigned during the sixth century BC)6 . Well, nowadays, an ounce of gold would yield you close to 500 loaves.
Conversely, when it comes to cash, we believe the huge fiscal and monetary stimulus measures over recent years, which are only likely to continue, is an effective “debasement” of fiat currencies globally. And so when compared to gold, we have less conviction that cash will maintain its relative value. And although general consensus appears to be that the market is currently pricing low inflation for many years to come, nobody can predict when inflation will reappear. But we know that when it does it is likely to lead to very strong increases in the price of the precious metal.
Gold producing companies best fit our investment strategy
There are a variety of options for us to access this gold investment theme. For example: we could buy physical gold and store it in a vault; we could invest in a Fund that holds the physical; we could access derivative exposures; we could invest in a Fund that holds shares in gold producers; or we could simply invest in the gold producers ourselves. We chose the latter.
Why? Well there are a few reasons. Firstly, to be frank, owning businesses sits more comfortably with us, as it is most in-line with our mandate. And when it comes to a choice between a Fund that invests in the gold producers (whether it be an index product or a specialist active manager), or investing in the underlying companies directly, we believe we have the skill set to identify the gold miners that best suit the Fund’s investment objectives. So we prefer to invest directly.
Secondly, it is cheaper. When compared to the physical, in a company structure there are no storage costs to pay (the gold is already very well stored – underground!), and reserves are far cheaper (for good reason) than immediately available bullion. When compared to a Fund, there aren’t any third party management fees.
But most importantly, in our view, there is additional upside in holding the gold producers due to: (1) their leverage (both operationally and financially) to the gold price; (2) access to their management’s operational expertise; and (3) access to their management’s capital allocation skills. Additionally, there is a “convenience” benefit, in that as they generate cash, they can be valued by traditional means. And this also enables price metrics to be compared with our existing holdings and investment alternatives.
We acknowledge the potential downsides – for example: exploration failures, sovereign risk, cost blowouts, poor capital allocation, and financing issues. But we believe that by prudent analysis we can mitigate those downside risks, and that after doing so, the potential returns more than compensate for them.
Gold companies: Regis Resources, Northern Star and Kirkland Lake are now held by the Fund
We have owned Regis Resources since mid March (we bought near the trough of the COVID-19 market rout). This met our traditional screening criteria, and although not appearing strikingly cheap at the time, we believed it to be a wise investment for the Fund, as discussed in our March 2020 report.
Having made the decision to invest more in gold miners, and accepting that no companies other than Regis met our investment criteria (and in any case wanting a more diversified exposure), we tweaked the screen to allow other gold producers to meet the criteria (but without sacrificing too many of our ideal attributes). We then narrowed the results to those companies solely focussed on gold (rather than being diversified), and considered those risks we mentioned previously (exploration versus production assets, sovereign risk, perceived management skills, etc). The final list comprised five companies (including Regis). Within this subset, we looked at value by applying two different frameworks: (1) our traditional cash flow based approach; and (2) current reserve value based on different price assumptions, and management guided extraction costs.
As a result, we initiated positions in Northern Star Resources (which operates in Western Australia and Alaska, US) and Kirkland Lake (which operates in Ontario, Canada and Victoria, Australia). Both have reserves which, based on current gold prices, are worth over USD20b. Regis, by comparison, is smaller with reserves worth around USD7b.
By quarter’s end these gold producers accounted for 8.1% of the Fund.
Today, maintaining cash in “investable” currencies comes at a cost. This initially caused us to question the rationale of holding it, which then led us to venture beyond our typical holdings. Although not a conventional investment for us, we were attracted by gold as a highly liquid, quasi currency. Coupled with our increasing lack of confidence in the ability of our cash to maintain its real value, the switch from cash to the precious metal (or its derivatives like gold producers) is appealing to us.
Does this foray to gold mean we have lost confidence in the system? No – but we are getting more worried every day. We recognise the power of central banks. Having injected unprecedented levels of cash in the economy during the Global Financial Crisis a decade ago, they are now setting a new level of “un-precedence”.
We feel these three positions provide some degree of hedge against a collapse of confidence in the overall financial system, the decline of the value of cash and the increased geopolitical risks we are likely to face.
Six months after experiencing the heavy losses of the March quarter, it is an opportune time for retrospection. We preface this by reiterating that we believe the outcome of a decision is not necessary reflective of the wiseness of it – particularly when it comes to investing, and even more so if one applies short term outcomes.
It is plainly apparent that our lack of holding the large tech, high growth stocks has resulted in the Fund’s performance not being as strong as the performance of some of its peers – performance that we suspect has been largely the result of a dangerous momentum play. We are not going to get sidetracked nor be seduced by the siren’s call.
Not surprisingly, our position in the airlines going into the COVID-19 pandemic cost us dearly. But what about our subsequent actions? During March our analysis suggested Hawaiian was in a particularly precarious position (this was pre CARES Act relief), and we adopted the most prudent approach in order to preserve capital – we sold it. This was at a price that in hindsight was near the lows. It has subsequently risen 32.3% to the end of September. Similarly, shortly after the April announcement of the CARES Act funding, we completely sold United, again to reduce risk. United’s share price had climbed 44.5% in that intervening period. So, although we have subsequently foregone a further 12.5% share price rise to the end of the quarter, given the risk relieved, we are quite pleased with this outcome.
Selling these two airlines has cost the Fund an estimated 0.8% in foregone subsequent returns (to the end of September). But how did the airlines we chose to hold fare (pardon the pun)? Since we sold Hawaiian, both Ryanair and Delta have rebounded similarly (over 30%), but Southwest, with the strongest balance sheet amongst the US carriers, is up only 6.7% (but from a not as depressed base). Retaining these four airlines since the mid March lows has added 2.4% to the Fund’s return. Put another way, we achieved 75% of the potential benefit (had we not sold at all) with around 70% of the capital at risk, and with a refined exposure to the less risky, better capitalised entities. None of our airline positions have accessed further government funding; rather all separately raised debt during the recent quarter, and Ryanair also placed equity in a well received offering.
“I think it’s pretty telling that the strongest balance sheets going into this crisis are going to be the two that didn’t take the government loan – Paul Jacobson, Delta CFO, 17/9/2020”
With widely fluctuating share prices depending on the latest news on vaccines, government support, travel restrictions, etc, we could have played the trading game (a game of luck, not skill). But we chose rather to adopt an easier and more conservative long term investment approach. In a similar vein, our selling in May of the Fund’s small position in Ruth’s Hospitality also cost a little in foregone performance, but we feel it was the correct decision.
Whilst it is very early days, the share prices of many of the Fund’s holdings more recently appear to better reflect company fundamentals – at least as we see it. The Fund’s performance during September and October to date has been better (certainly in a relative sense) than it has been for some time. Many of our investee companies are starting to report more positive news, like Linamar (refer our December 2019 report) which last week highlighted increased market forecasts for global motor vehicle sales and production and more positive momentum for its Access and Agricultural markets. As this permeates through the investment markets, perhaps it could well mark the start of a long awaited rotation toward more value style investing.
We are grateful for managing your capital and thank you for your support. Please keep safe and healthy.
12 October 2020
Figure 5: Diversification by Sector
Source: Alluvium, Factset
Figure 6: Diversification by Region
Source: Alluvium, Factset
Table 4: Fund Overview
|Top 15 Holdings||61.8%|
|Number of Holdings||26|
|Weight Average Mkt Cap. (USD m)||64,910|
Source: Alluvium, Factset
Table 5: Quality Metrics (weighted average)
|Fixed Charges Coverage (3y median)||11.5x|
|Sales Growth (3y average)||7.5%|
|Return on Invested Capital (3y average)||24.8%|
|Return on Invested Capital (8y average)||25.2%|
Source: Alluvium, Factset
Table 6: Pricing Metrics (weighted average)
|Enterprise Level Yield (EBIT/EV)||6.2%|
|Earnings Yield (NPAT/Mkt Cap)||3.8%|
|Free Cash Flow Yield (FCF/Mkt Cap)||8.0%|
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: Factset
3 Source: https://www.msci.com/
4 Company names have been abbreviated throughout this document in the interest of readability.
5 Returns are time weighted, include dividends, withholding tax, trading costs and are expressed in local currency.
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.