March 2021 | Quarterly Report

Introduction

Another strong quarter, with the Fund’s net returns being 12.2% for the EUR class and 7.7% for the USD class¹  . The Australian Fund posted a return of 9.1%. Those returns for the year (which coincides with the Fund’s all time monthly low) were 59.1%, 70.4%, and 36.9% respectively.

It is pleasing to continue our solid recovery since the March 2020 quarter – all the more so because it was generated whilst holding what, with the benefit of hindsight, has so far proven to be a costly insurance product.

We are also reassured by our investee companies showing their strong business resilience during the pandemic, with many of them ready to capitalise on the potential uplift of the economy and its further digitisation.

Snapshot

• The vast majority of our holdings performed well over the quarter – the exceptions being Vestas²   (leader in wind energy, based in Copenhagen), and the three gold producers we own.
• One of the best performers was Western Forest. Its latest results demonstrated the cash flow benefits from higher lumber prices, and we were also pleased to see management’s execution on some sensible strategies.
• Our businesses that benefit from the “discretionary” and “back to nature” themes (Capri, Dick’s Sporting and Thor) all released results that confirmed their business momentum – leading to impressive share price ascents.
• Linamar and Lear (discussed later) have rallied, perhaps reflecting not only high hopes of an upturn in the global automotive industry but also expectations of new levers of growth via their specific innovations.
• Our two long-term underappreciated businesses (Walgreen Boots and H&R Block) continued to play catch up – but there is still a lot of ground to cover for us to consider these “great investments”.
• We initiated a position in the Chinese juggernaut, Alibaba – providing us with the opportunity to participate in its formidable growth opportunities across Jack Ma’s “iron triangle” of e-commerce, logistics and finance.
• A fair portion of the Fund is allocated to the underperforming gold producers, but so far this form of “insurance” has been a significant drag to the Fund’s performance (2.5% for the quarter and 4.5% over the last six months).
• Kirkland Lake, Northern Star and Regis Resources, all provided positive operational updates. But their share prices fell. We bought at these lower prices during the quarter to increase the Fund’s position to 10.8%.
• Vestas also reported a solid operational update and also suffered a declining share price. We remain positive, not only given its fundamental performance, but also the increasing global political commitment and general public demand for renewable energy.
• The Fund’s cash holding is 5.5%. This is by far the lowest level since inception. It reflects our changing view as to the merits of holding it versus other investments, given the continuing changes to the monetary and fiscal environment.
• We continue to see some pockets of the equity markets seemingly priced from widely optimistic assumptions. But then again, this is not the only bubble:

“What kind of a lunatic would loan money to a European government for
a hundred years at less than 1%?”

– Charlie Munger, Caltech Interview, December 2020

Contribution

Figure 1: Top Contributors/Detractors (Quarter)³  

Source: Alluvium, Factset, Private Reporting Pty Ltd.

Figure 2: Top Contributors/Detractors (Since Inception)³  

Source: Alluvium, Factset, Private Reporting Pty Ltd.

Contribution (continued)

Table 1: Contribution Details³  

Source: Alluvium, Factset, Private Reporting Pty Ltd.

Table 2: Quarterly Purchases

Table 3: Quarterly Sales

Performance Review

Most of our positions performed admirably over the quarter – continuing their strong run over the preceding six months or so. More than half of the Fund’s positions posted double digit price gains and less than a handful went backwards.

The most significant news is our initiation of a position in Alibaba. Founded by the charismatic Jack Ma in 1999, Alibaba started life as a pure e-commerce business to business platform but it has since morphed into a sprawling services infrastructure for China, with its current activities also spanning financial services, cloud computing, media and entertainment among other things. We believe Alibaba provides us with a terrific opportunity to participate in the expanding Chinese economy and its growing middle class of consumers via its variety of businesses across emerging industries.

Alibaba’s sheer dominance and market reach provides it with an unparalleled data set from which it has options via artificial intelligence (AI) to further monetise. Its payments platform, Alipay, is the world’s largest with around a billion active users (and accounting for more than half of China’s non-bank electronic payments). Its retail marketplaces (including Taobao, TMall and Juhuasuan) have more than 770 million annual active users. Its cloud business is the largest in China, and it grew revenue by 50% last year. All up, Alibaba has grown its top-line by an incredible 48.4% per year, over the last 8 years! Yes, there are risks – regulatory mainly – of which we are aware. And like all investments, there are many risks in which we have no way of knowing, and we suspect these to be more prevalent with this particular opportunity. But we are prepared to accept these risks as trade-offs for the exciting return prospects.

Many of the Fund’s other investments also have their share of opportunities in the AI / data science sectors – to varying extents and in different ways. For instance, Micron, as we discussed here, and Samsung will both see continual increases in semiconductor demand. Dick’s Sporting is showing its data science work is fuelling sales. Lear benefits from designing products to meet the increased electrical requirements in automobiles. And we expect that Alphabet (the parent company of Google and Youtube), as holders of one of the largest data sets in the western world, has further avenues to capitalise on it. We increased our Alphabet position (from 1.8% to 2.8%) during the quarter. And although we had to pay more than what we paid for our first tranche (in August last year), with further signs as to its business strength we were happy to do so.

Western Forest (up 42.3%⁴  ), the Canadian lumber manufacturer, was one of the Fund’s strongest performers. We maintained our position whilst it suffered over the last couple of years as it battled labour strikes (which forced shutdowns / curtailments of its mills), tariff issues and then COVID-19. But now, its recent results are encouraging, as it took advantage of improved prices with initiatives such as product differentiation and redirection from weaker export markets to the improving North American market (both enabling higher margins). It also sold some non core assets to strengthen its balance sheet. It is not alone in being a beneficiary of rebounding commodity prices. LyondellBasell (up 14.6%), released its results and also provided an update consistent with our expectations that the business is ripe to capitalise on expected rising prices, largely as a result of its developments, acquisitions and joint venture deals over the last three years.

Other strong performers included three companies positioned to benefit from the “discretionary” and “back to nature” spending themes. They all continued their strong post pandemic price performance, with: Thor, the maker of recreational vehicles (up 45.3% in the quarter, to make it 227.9% for the year); Dicks Sporting, the retailer of outdoor equipment (up 36.1% in the quarter, 258.2% for the year); and Capri the luxury goods retailer (up 21.4% in the quarter, 372.7% for the year).

This prompts the question: Are these themes cyclical or structural? We believe the “back to nature” theme, which is directly applicable to Dick’s Sporting and Thor, to be largely structural (although the increased stimulus has likely led to an additional cyclical component). The “discretionary spend” theme, on the other hand, we consider to be more cyclical.

Thor, Dick’s Sporting and Capri all released solid operating results during the quarter – generally above expectations. We particularly note the strength of the Dick’s Sporting franchise. Its earnings per share were 84% higher than last year’s fourth quarter and 66% higher for the full year (and the base periods did not suffer any COVID-19 impact). Its e-commerce sales have doubled over the last year, to now account for one third of its business. It has particular strength in the buy online, pick-up in store / curbside, with its point of difference being its physical presence via 800 odd stores – clearly a valuable asset as it enables same day service. Around 70% of Dick’s online sales either ship directly from store or are in-store or curbside pickups. Dick’s also pointed to two other positives – its own brands were outperforming, and management believes its technology platform is effective in driving increased sales. We sold an immaterial amount (less than 0.2%) of Dick’s just to meet diversification requirements, so it still represented 5.3% of the Fund at quarter’s end.

We are a little more cautious on Capri which released its quarterly results in early February. All three fashion houses (Versace, Jimmy Choo and Michael Kors) showed tangible signs of positive momentum, such as an acceleration of e-commerce sales, improving gross margins and higher ticket prices. This is despite around 50% of its Europe, Middle East and Africa (EMEA) stores being closed – so the performance in the US and Asia was particularly strong. However, despite these positive signs, management does have concerns, citing “lack of visibility surrounding the progression of the pandemic, macro fundamentals and tourism flows”. We indeed share management’s concerns. As the discount to our valuation is nowhere near as compelling as it was a few months ago, we felt it prudent to trim our position, from 4.7% at the start of the quarter to 3.3% at the end.

We were pleased that two longer term laggards, Walgreens Boots and H&R Block, performed well (with their share prices up 37.7% and 37.5% respectively). Maintaining our conviction since their lows (as we discussed in our June 2020 report) has added meaningfully to the Fund’s performance since that time, most notably during the recent quarter. Both released pretty pleasing results, and Walgreens also announced the $6.5b sale of its interest in Alliance Healthcare, the pharmaceutical wholesaler, to fuel further investment in its core retail pharmacy and healthcare businesses.

Once again, the main detractors to performance over the quarter rests almost exclusively with the gold producers. These three companies together cost the Fund 2.5%. Despite reporting good results, the share prices suffered (Kirkland Lake -19.3%, Regis Resources -22.5%, Northern Star -25.3%). We hear there has been a wave of outflows from sector specific funds. Any such selling pressure would provide one possible explanation as to why these shares appear to be trading so out of line with their fundamentals. For on our numbers, employing conservative gold price and extraction cost assumptions, all three are well priced based on their identified reserves, and Regis and Kirkland Lake also look compelling value based on their expected cash flows over the next year or two alone. We topped up our positions in all three over the quarter.

The only other detractor was Vestas. Its full year results reported in early February revealed an increasing order backlog, a strongly growing services business (at impressive margins and across multiple brands), and a clear and succinct rationale behind its recent MHI joint venture deal with Mitsubishi.

“if you try to run a company as a mid-sized in a business…global requirements… you will have a margin dilution…That was also one of the strategic reasons why we did what we did.”

– Henrik Andersen, CEO, 10 February 2021 investor call

Nevertheless, the Vesta share price declined 9.6%. We like the industry. Installed wind capacity has increased over the last twenty years from 12 GW to over 700 GW, while its costs have decreased by 63% over the last ten. And there’s no letting up, a new era of growth is supported by massive political commitment. With Vestas being one of the only few dominant players with 40% market share (and the one solely focused on wind generation), we are comfortable with our current 3.3% position.

Lear – A comfortable (and more connected) investment

Lear is a highly reputed supplier of seats and electronic systems to most global auto manufacturers. Its top customers include General Motors, Ford and Stellantis (the merger of Peugeot and Fiat Chrysler) which, in 2020, accounted for 19%, 13% and 11% respectively of its $20b sales. Headquartered in Michigan, it has 175,000 employees located globally.

Lear is a market leader in precision engineered seat mechanisms, which account for three quarters of its sales. It is one of the two major players in this market. In 2019, its seating systems were fitted to around 20m of the 87m vehicles produced across 400 different nameplates. And Lear’s fast growing E-systems business, which accounts for the remaining 25% of sales, is a leader in integrated electrical and electronic systems. It is well positioned to capitalise on growing electric vehicle sales.

Lear has represented a large part of the Fund since its inception. The key reasons we like it are:

• it is well positioned to take advantage of the key secular industry trends, namely the growing electrification, connectivity and autonomy of vehicles;
• it is well represented in the growing segment of luxury and performance cars, with 52% of its sales directed to crossover/sport utility vehicles (with Lear’s content being around $1,000 compared to $700 for passenger cars);
• its E-Systems business is the fastest growing and most profitable segment. It comprises: Electrical Distribution (wire harnesses, terminals and connectors), Electronic Systems (for example on board battery chargers, management systems, high voltage power distribution systems) and Software and Connected Services. In 2010, E-Systems had 5 customers across 9 models. Fast forward to 2020, it now has 7 customers across more than 90 models;
• the expertise it has developed in its E-systems business provides its Seating business with competitive advantages;
• its management has demonstrated prudent capital allocation. Lear has been judiciously repurchasing its shares for the last ten years, thereby reducing its share count by 43%. It has consistently paid a dividend all while reinvesting in the business as opportunities arose;
• its capital expenditure over the past 12 years has been predominantly directed toward the fast growing E-systems segment. The most recent example of note is its acquisition of Xevo (which provides a smart in-vehicle entertainment and commerce platform to both merchant and auto manufacturers) in 2019 for $300m;
• its manufacturing footprint in low cost countries, where 86% of its employees are based, not only facilitates higher operating margins but also allows it to serve customers better by being physically close to them;
• it is well equipped to reap the long-term growth opportunities in China as demand for luxury and performance features increase strongly in this region;
• it is conservatively financed, with fixed charge cover averaging 7.9 times over the last eight years. So, despite it falling to 4.9 times during the recent COVID-19 impacted year, it still has more than adequate capacity to finance further growth opportunities; and
• its highly automated supply chain enables just-in-time assembly and delivery of products and allows scaling up or down depending on the demand conditions. This resonates well with the cyclical nature of the automotive industry.

We are confident Lear will achieve continual earnings growth via market share gains. And should the automotive industry experience a strong post COVID-19 recovery – which it is expected to do so – then Lear is perfectly poised to reap further benefits. Despite its share price having more than doubled over the last year, we do not see it as being overly expensive, and we are comfortable maintaining our 5.3% position.

Closing Remarks

We think it may be useful to explain some changes to the Fund’s composition over the last year or so.

The Fund’s cash holding since inception has averaged around 20%. This is due to us struggling to find compelling investment opportunities (given our prudent mindset and our valuation framework) and appreciating the optionality provided by holding ample cash to deploy capital freely should such opportunities arise. But over the last six months our cash level has progressively decreased, and it is now 5.5%. Our reasoning is twofold – the first is our reassessment of risks. Despite having in the past frequently cautioned readers on the high prices of many “growth” stocks (we have not changed our view – we still consider most to be grossly overpriced), we have now witnessed the resilience of some businesses throughout the pandemic. As a result we now consider some to be of a higher quality and to have a lower risk profile than we did previously – thereby attributing them a higher valuation. When combined, in some instances, with a relative pullback in prices, we have become more inclined to take positions (or increase them) in certain businesses, notably Alibaba and Alphabet. The second explanation for the decline in cash level merely reflects our ongoing concerns about the “pump priming” of all major economies by way of completely unprecedented levels of fiscal and monetary stimulus. Across all major currencies cash now has holding costs. Meanwhile, we harbor grave concerns that its future purchasing power will continue to erode. So, in short, we would now rather forego the optionality that a large cash buffer provides, and be invested in businesses – particularly those that may benefit from inflation, and those that provide the Fund with some resilience to it.

As mentioned, most “growth” stocks appear grossly overpriced. But there are plenty more examples of exuberance out there. We are amazed at some of the IPOs, SPACs, and consequent SPAC deals. Then there is the “Gamestop Phenomenon”. And prices of “fintech” businesses seem to imply every player will succeed – which is unlikely in our capitalist society. In many respects, such exuberance brings with it memories of past times, eloquently expressed with this famous quote:

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100%
of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal.
And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”

– Scott McNealy, then Chairman and CEO, Sun Microsystems (courtesy Business Week, 2002)

We think there could be a few “what were you thinking?” examples to play out over the coming years.

We hope that our readers are in good spirits during these bizarre times. From our mostly unhindered life in Sydney, we feel for others in the worse stricken regions. We wish you the best and thank you for your interest.

Profile

Figure 3: Diversification by Sector

Source: Alluvium, Factset

Figure 4: 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.