December 2020 | Quarterly Report

Introduction

A strong quarter to finish an extraordinary year. The Fund’s returns were 16.8% for the EUR class and 21.9% for the USD class1  . The Australian Fund posted a return of 13.2%. Those returns for the year were -1.7%, 7.2% and -2.4% respectively. As most of the Fund’s positions are priced in USD, the declining relative value of the USD hurt the EUR and AUD performance.

We mentioned in our September report that the stunning returns from a few “growth” stocks led to extraordinary so called “market” returns (just ten “growth” stocks amongst the MSCI World Index 1,585 constituents accounted for around 75% of its 2020 return)2,   3  . We also mentioned that the tide seemed to be turning for “value”. As illustrated below this was indeed the case for the most recent quarter. And we are pleased to see that the Fund has more than participated in this bounceback over the last three periods shown. Of course, we can also see that despite “value” catching up, there’s lots more ground to recover.

Table 1: From Panic to Euphoria: Returns over the Pandemic Year4  

PanicReboundConsolidationEuphoriaYear
01-Jan - 23-Mar24-Mar - 30-Jun01-Jul - 30-Sep01-Oct - 31-Dec01-Jan - 31-Dec
MSCI World-31.80%38.20%7.90%14.00%15.90%
MSCI World Growth-26.20%44.30%11.70%12.50%33.80%
MSCI World Value-37.30%31.10%4.00%16.60%-0.30%
Fund (USD class)-37.90%34.10%5.60%21.90%7.20%
Gold2.70%15.20%5.20%0.60%25.10%
Bitcoin-11.20%43.40%17.10%171.40%304.70%
Growth - Value (difference)11.10%13.10%7.70%-4.10%34.10%
Fund - Value (difference)-0.60%3.00%1.60%5.30%7.50%

Source: Factset

The benefits of remaining invested during times of market duress are strikingly evident. Had you sold at the lows of March perhaps you would have been relieved to be “out of the market”. But how would you then feel if you were told a mere nine months later that by selling, you missed those subsequent returns?

Snapshot

  • Some of the Fund’s holdings posted phenomenal returns. For example, the share price of Capri Holdings5  , the retailer of Versace, Jimmy Choo, and Michael Kors, more than doubled over the quarter.
  • Our three gold miners are yet to “pan” out. These companies were the worst performers, being down between 25.3% and 7.0%. They cost the Fund 2.0% in performance during the quarter.
  • With the market’s “risk-on” focus, this is no surprise. What is surprising is how well the gold price held up (although admittedly in USD). Even more surprising – Bitcoin rose 1.7 times to be up more than threefold over the year!
  • We believe that maintaining (and increasing) our investment in these gold miners is prudent. So we took advantage of the low share prices, and we have marginally increased the Fund’s position from 8.1% to 8.5%.
  • We consolidated our airline holdings, by completely selling Delta and trimming Ryanair. We are comfortable in maintaining the Fund’s still sizeable Ryanair holding and quite reasonable position in Southwest.
  • Some investee companies provided positive updates – notably Linamar (the Canadian manufacturer), Micron (the US semiconductor producer), Thor (the recreational vehicle maker) and HCA Healthcare (the hospital owner/operator).
  • Illustrating the benefits of solid balance sheets, we were pleased that two of our holdings (Thor and LyondellBasell) strengthened their business by acquiring complementary assets at favourable prices.

Contribution

Figure 1: Top Contributors/Detractors (Quarter)4  

Source: Alluvium, Factset, Private Reporting Pty Ltd.

Contribution

Figure 2: Top Contributors/Detractors (Since Inception)4  

Source: Alluvium, Factset, Private Reporting Pty Ltd.

Contribution (continued)

Table 2: Contribution Details

December 2020December 2020 Quarter SummaryDecember 2020 Last 12M Summary
StockEnd WeightBeg. WeightReturnContributionBeg. WeightReturnContribution
Vestas4.1%4.3%39.8%1.5%122.7%3.4%
HCA Healthcare5.0%4.6%32.1%1.5%29.9%2.3%
Micron Technology4.9%3.7%60.1%2.1%60.7%2.1%
Linamar5.7%3.9%70.5%2.8%4.2%37.8%2.0%
Samsung Electronics5.8%4.7%39.2%1.8%3.8%47.3%1.9%
Thor Industries1.6%2.0%-1.8%0.0%3.5%28.3%1.5%
McKesson4.5%4.7%17.0%0.9%4.2%26.7%1.3%
Walgreens Boots1.8%2.0%12.0%0.3%3.2%-30.3%-1.5%
H&R Block2.5%3.1%-1.7%0.0%4.4%-29.2%-2.3%
Hawaiian Holdings2.4%-67.4%-2.5%
Delta Air Lines1.6%4.8%0.1%3.0%-45.0%-2.7%
United Airlines1.9%-64.8%-3.7%
Subtotal Equities35.9%34.6%11.0%1.8%
Other Equities50.9%47.3%9.0%4.4%
Cash, Currency & Fees13.2%18.1%-3.2%-7.8%
Total (EUR)100.0%100.0%16.8%16.8%-1.7%-1.7%

Source: Alluvium, Factset, Private Reporting Pty Ltd.

Table 2: Quarterly Purchases

Regis ResourcesIncrease Position
AlibabaIncrease Position
Northern StarIncrease Position
RocheIncrease Position

Table 3: Quarterly Sales

Methode ElectronicsDecrease Position
Robert HalfDecrease Position
Capri HoldingsDecrease Position
LinamarDecrease Position

Performance Review

There were some phenomenal share price increases amongst the Fund’s holdings over the quarter. In fact, of the 26 positions, fifteen were up more than 20%, and six of those more than 40%.

Capri’s price increased from $18.00 to $42.00 (133.3%), which alone accounted for roughly one fifth of the Fund’s return over the quarter. And yet, there was no startling news! Its pleasing results announced in early November were followed by progressive increases in analysts price targets (some substantial), leading to a continual, gradual rise of its share price.

Capri now represents 4.9% of the Fund, more than three times its weight during those dark, scary days of late March. We are pleased we maintained our stance. And, not only that, we demonstrated our faith by buying more and increasing its weight from 1.4% to 2.0% of the Fund. In March, it was priced as if the risk of bankruptcy was high. Clearly the market is not assuming that to be the case anymore. In fact, it seems to better appreciate the turnaround potential for Jimmy Choo, the expansion possibilities of Versace and the cost savings opportunities at Michael Kors. And with the business still only being priced at an 8% earnings yield, it is not out of our “realms of value”, particularly when other luxury houses like Ferragamo, Ralph Lauren, Moncler and Burberry are priced at earnings yields in the region of 2% to 4%. So, we still feel there is a good chance we will see the share price progress even further.

Linamar is a long term high conviction position, and with its share price increasing 70.2% over the quarter, it now competes with LyondellBasell for the Fund’s largest position. We discussed Linamar in detail here. Management provided a positive market update in early October, and followed up by reporting solid results a month later – which brought to light its rebounding sales, highlighted its ample liquidity (after refinancing debt) and demonstrated its impressive cash conversion. Analysts upgrades immediately followed, and the share price response was strong.

Rounding out the top performers, Micron (which we discuss in the next section) was up 60.1%. And Ryanair (discussed later in this section) returned 48.6%. Lear was up 45.8% and Vestas (which we wrote about here) was up 43.2%. Lear and Vestas both announced uneventful third quarter results. Perhaps if anything the operational impacts from COVID-19 are less severe than may have been anticipated. Or, perhaps, in the case of Lear, it was simply a long-awaited “catch-up”? As we had meaningful positions in all four of these companies (totalling 16.5%), those strong returns really propelled the Fund’s result.

Let’s also not ignore the category of “very strong” (but not “phenomenal”) share price increases, for therein lie three of our largest positions. LyondellBasell was up 31.6%, Samsung returned 39.8% and HCA Healthcare posted a 31.4% return. Together, these three positions accounted for 14.8% of the Fund at the start of the quarter, and their total contribution to the Fund’s returns was 5.4%.

Aside from their usual updates the main news was LyondellBasell’s USD2b acquisition of a 50% interest in Sasol’s Louisiana operations. These are newly constructed assets which adjoin LyondellBasell’s existing plant, and they will be operated by LyondellBasell. They are being acquired at a significant discount of around 35% to their estimated replacement cost, and there is potential for LyondellBasell to secure 100% ownership over time. It is a great example of LyondellBasell’s use of its conservative balance sheet and its disciplined capital allocation which we wrote about here. We are inclined to trust management’s assertion that significant synergies and attractive earnings and cash flow accretion can be expected.

Also in the acquiring mood, Thor made what we judge to be a prudent deal. It bought Tiffin Motorhomes, a luxury recreational vehicle manufacturer, a segment where Thor is not prevalent. And with a price of USD300m (which is less than 40% annual sales – compared to Thor trading at over 80% of its sales), combined with Thor’s wherewithal to increase Tiffin’s lower margins, we are inclined to agree with management’s view of the accretive nature of the deal.

In late October, after their prices had rebounded strongly from their March lows, we trimmed our airline holdings. Although we maintain our confidence that these businesses will survive – in fact thrive in the case of the well capitalised budget operators, we felt it prudent to decrease the Fund’s positioning to the sector. We did so by a complete divestment of Delta and by trimming our Ryanair position (by selling a quarter of it, or approximately 1%).

Of course, our timing was not brilliant as little did we know a vaccine announcement was imminent. So both Delta and Ryanair continued to rally after our selling. In fact Ryanair was up 48.6% over the quarter, and with our reduced 3.9% position it still contributed 2.0% to the Fund’s return. Delta was up a more muted 30.6%, but the Fund experienced little of this.

Our reasoning for not selling any of the Fund’s Southwest position, and for only selling a little of Ryanair, is that both are focussed on the leisure market, are extremely well capitalised (and have proven access to capital) and are well positioned to further strengthen their businesses. For example, Ryanair recently announced it had increased its order of Boeing Max aircraft (which is extremely efficient and so facilitates lowest airfares) by 75 to 210 jets. Given the current glut of planes, Boeing’s need for cash, and the financial positions of other carriers, we know which side of the negotiating table we’d like to be sitting.

“I have never in my 30 years in the industry seen such a clean-out… The real
seismic change from Covid will be the growth opportunities across Europe. They are much greater than after the financial crisis or 9/11.” – Michael O’Leary, as quoted in the Financial Times, 27/12/2020

Our gold miners, which we wrote extensively about in our last report were the main poor performers. Regis Resources was the worst, down 25.3%, but Kirkland Lake (down 18.7%) and Northern Star (down 7.0%) also suffered. This is only to be expected in such a “risk-on” environment. Our views have not changed, and we took advantage of these price falls by buying more Kirkland Lake and Northern Star, to slightly increase the Fund’s position in the three gold producers to 8.5%.

Our two pharmaceutical holdings (Gilead and Roche) also performed poorly and were down 8.9% and 2.4% respectively. Gilead made yet another acquisition (USD1.4b), but that pales in comparison to its USD21b Immunomedics deal we referred to in our September report, in which we highlighted our concerns but elected to pass judgement until more details were released. Those details, being the “compelling efficacy” of Trodelvy (Immunomedics’ cancer drug) were released. Although we remain wary, given Gilead’s sales from its current franchise, the potential upside from Trodelvy (and its internal pipeline), and the depressed share price, we believe the risk is to the upside, so we intend to maintain our position. And with regard to Roche, we cannot identify any valid reason for its share price to have fallen, and we continued to build our position.

We also bought a little more Robert Half (the recruiter) after it announced its third quarter results in late October. They were not well received, and with its share price falling 13.3% over the ensuing four days, we increased the Fund’s position marginally to 2.7%. Robert Half was a solid, but not spectacular performer, up 17.6% for the quarter.

Walgreens released full year results in October. With the COVID headwinds continuing (lower footfall due to lockdowns, the poor expectations were (and still are) seemingly priced in. In fact, its share price appears to reflect the double whammy of a low multiple (sub 10 times) being applied to a currently depressed level of earnings. We think that management’s recent initiatives to restore growth are very promising. These include the VillageMD $1b investment to provide an integrated primary care and pharmacy model, and the partnership with Microsoft and Adobe to accelerate the omnichannel sales and digitalisation of their customer experience. And the recent new CEO (poached from Starbucks) does have a track record of successfully implementing strategies such as these. So there is plenty of scope to more than recover its earnings. Accordingly, we intend to maintain our position in this underperforming stock.

Micron: It’s all about data

We were alerted to Micron as an opportunity through our usual, quantitatively based screening process. Although there are hundreds of semiconductor businesses available to us, very few pass our “cheapness” test. Micron is one of the select few that does – well, at least it did at the time of our purchase.

Micron is a vertically integrated semiconductor business with its vision being to accelerate the transformation of information into intelligence. Employing 40,000 staff in 17 countries, the company designs and manufactures a wide portfolio of memory and storage products (DRAM, NAND and SSDs) which are the very core of many applications including artificial intelligence (AI), 5G, machine learning, internet of things, and autonomous vehicles.

Data is now considered the new business currency. Smarter technology is only possible because we can collect, store and manage data with unprecedented speed and efficiency. As device capabilities increase, more memory and storage is required both for physical devices and in the cloud, thereby creating a virtuous circle. It is a secular trend which has only started. Just as no one could anticipate in the early 2000’s the universal adoption of smart devices, no one can accurately predict the future demand for memory and storage. We can simply agree: it will be extraordinary. However, it won’t be a straight line, this industry remains highly cyclical. Selling prices can experience swings as much as 30% year on year!

With the industry’s exciting tailwinds being obvious, we are very optimistic about its long term prospects. But the landscape is definitely not set in stone. In this growing era of digitalisation and AI, the industry is becoming increasingly important to a nation’s economic competitiveness and national security. This brings to light heightened regulatory risks. It was recently highlighted by the US-China “trade war”, causing significant headwinds to US players (particularly Micron with its top customer being Huawei). These efforts to restrict Chinese access to US technology may be a double edge sword; the result may lead to continued erosion of US technological leadership to the benefit of the South Koreans and Chinese.

And then of course, in this highly competitive industry, successful companies are born from their successful research and development (R&D). And with products constantly subject to competing technologies they risk rapid obsolescence, so the massive investment in R&D needs to continue. Yet production requires significant capital investment (which, to a large extent is unique to the technology). So there’s a delicate balancing act between R&D investment, innovation and capital investment.

At the time of our analysis in June last year, Micron appeared attractively priced, and had exhibited strong returns on invested capital and solid sales growth over a prolonged period. This was enough of a catalyst for us to refine our cash flow assumptions and our valuation. With its share price being at a reasonable discount, we built our position. Since then, the share price has increased. It is not as attractive an investment as it once was, but as the following table shows, amongst a subset of 15 listed semiconductor peers, it more than holds its own:

Table 5: Micron versus Peers

Mkt CapROICROICNPAT
(USD b)(3y avg)(8y avg)Yield
Micron98.927.0%19.1%3.0%
Peer Average99.220.6%15.9%2.1%

Source: Factset

The strong rise in its share price prompts the question: Was the business so under priced at the time of our purchase to suggest that it is only now at fair value? Or is it now overpriced? We bought at a discount of around 10% to our “valuation”, and it now trades at a premium to it. But with valuation being more of an art than a science, and recognising our conservativeness, the industry’s tailwinds and the peer group’s metrics, we err toward the former and intend to remain holders.

Closing Remarks

We believe that managing our assets is about investing in businesses that are mispriced and that we feel comfortable owning. The latter means (amongst other things) that they must have business models which we understand, and they must not undertake or promote activities which, in our view, are detrimental to society. The extraordinary investment returns of many businesses that do not meet our “comfortable” criteria over recent years has made it all the more challenging for us to “beat the market”. We are still not prepared to invest in “uncomfortable” businesses. What we are prepared to do though, is to increase our willingness to pay uncomfortable prices for the quality businesses that we are comfortable owning.

We have experienced an extended period of more than a dozen years (and still counting) of central banks flooding the system with liquidity. This hides a variety of risks; whether it be the perilous businesses with continued access to funding; the hedge fund that posted incredible returns (but trades on high margins); the aggressively leveraged private equity fund (with flamboyant managers that look like rock stars); or the lofty share prices of companies with far distant, assumed to be highly growing, inherently uncertain cash flows. This prompts questions: Is there sufficient awareness of the widening margin of valuation error as the discount rate approaches zero? Is proper account being taken of the possibility that, for those businesses that consume cash, the capital tap which has flowed so freely for the last dozen years, may well be “turned off”?

“But as with frogs in water that is slowly being heated to a boil, investors are being conditioned not to recognise the danger.” – Seth Klarman, quoted in Financial Times, 16 January, 2021

Will a new Biden administration (void of the Trump pressures) facilitate a change in direction for the US Central Bank – ie a move away from the “Powell put”? After all, as Seth Klarman further notes, it is dangerous to assume that deficits don’t matter, and that no matter how much debt is outstanding, we can always pile on more.

Although the current share prices of some of the Fund’s holdings appear to factor in pretty strong assumptions, they are still within our “bounds of reasonableness”. Conversely, consider Tesla. We appreciate the technology, acknowledge the growth potential, and even quite admire Elon Musk. But it doesn’t take a rocket scientist (which Elon Musk may well be) to conclude that its share price (at over 1,500 times earnings and USD1.5m per car sold) incorporates some wildly optimistic assumptions. Let’s play with some. Imagine in ten years time Tesla sells 20 million cars per year (it currently sells half a million) at an average price of USD55,000 (in-line with recent prices) at a net margin of 4% (they’re currently sub 2%). With the resultant profitability of USD44.0b, that would place it on a P/E ratio of around 19 times, and implied value of USD41,750 per car sold. But you have to wait ten years and not earn any return before you get there! Alternatively, you could buy BMW at just shy of 9.3 times current (not hypothetical 2031) earnings and a little less than USD22,500 per current car sold (not hypothetical 2031 sales).

We reflect on how quickly things change. In January we were blissfully unaware of the imminent pandemic, and basking in the glory of health and freedom. And for the equities market, in mid March as the S&P 500 fell another 12% overnight (adding to its 20% decline month to date), it felt like capitulation. Contrast these with today. We are witnessing full emergency wards, lockdowns, and harsh travel restrictions. But for the equities market, we are just seeing complacency, in fact, exuberance…

We appreciate our good fortune of living in Sydney where we continue to enjoy life and work, for the most part, as if the current pandemic was a far distant concern. We feel for others in the worse stricken regions. We wish you the best for 2021 and hope you and your families are healthy and in good spirits. Thank you for your interest.

Stuart Pearce
Principal

29 January 2021

Alexis Delloye
Principal

Profile

Figure 5: Diversification by Sector

Source: Alluvium, Factset

Figure 6: Diversification by Region

Source: Alluvium, Factset

Table 6: Fund Overview

Cash13.2%
Top 15 Holdings67.0%
Number of Holdings25
Weight Average Mkt Cap. (USD m)88,209

Source: Alluvium, Factset

Table 7: Quality Metrics (weighted average)

Fixed Charges Coverage (3y median)12.7x
Sales Growth (3y average)7.4%
Return on Invested Capital (3y average)25.8%
Return on Invested Capital (8y average)26.9%

Source: Alluvium, Factset

Table 8: Pricing Metrics (weighted average)

Enterprise Level Yield (EBIT/EV)6.0%
Earnings Yield (NPAT/Mkt Cap)3.4%
Free Cash Flow Yield (FCF/Mkt Cap)7.4%

Source: Alluvium, Factset

Table 9: Top 15 Holdings

LyondellBasell5.9%
Samsung Electronics5.8%
Linamar5.7%
Lear Corporation5.0%
HCA Healthcare5.0%
Micron Technology4.9%
Capri Holdings4.7%
McKesson4.5%
Dick's Sporting4.2%
Methode Electronics4.2%
Vestas4.1%
Kirkland Lake3.8%
Ryanair3.7%
Regis Resources2.7%
Roche2.7%

Source: Alluvium, Factset

Definitions

General

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

Portfolio Metrics

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

Footnotes

1 Source: European Fund Administration S.A.

2 Source: Factset

3 Source: https://www.msci.com

4 Returns are time weighted, include dividends, and are expressed in local currency.

5 Company names have been abbreviated throughout this document in the interest of readability.

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.

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