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.