June 2021 | Quarterly Report

Introduction

The Fund’s net returns for the quarter were 2.2% for the EUR class and 3.2% for the USD class¹  . The Australian Fund posted a return of 4.6%. Those returns for the year were 35.5%, 43.1%, and 31.1% respectively.

Equity markets continue to be buoyant, with “growth” stocks performing best – according to the relevant components of the MSCI World Index. On that, currently half of our investee companies are represented in the Index. A record! Despite this, our active weight is still pretty high at around 97%²  . Our 3.3% position in Alphabet is what brings it down (we are more than happy for it to be the culprit). In all other respects, the Fund hardly resembles an index product.

In our June report last year, we wrote “if equity markets are a reliable signal – we would assume it’s (being COVID-19) all over.” Well, COVID-19’s not all over, and equity markets are clearly not a reliable signal! We remain concerned with some pockets of market exuberance, and see heightened risks epitomized by the likes of “meme” stocks and cryptocurrencies.

“meme stocks are stocks that see dramatic price increases, mostly fuelled by people on social media… These stocks rarely have company fundamentals that back the rise
in price, and are often highly volatile. – Morningstar, 22 June 2021”

And we mention cryptocurrencies, despite the most popular one, Bitcoin, almost halving in “value” (well, we prefer to use the term “price”) over the quarter. Of course, this is after more than doubling in the prior quarter. Compare this to gold – down 9.5% and up 3.3% respectively³  . Which is the better store of value? After all, whilst certainly not advocating Bitcoin, we remain concerned about the declining value of cash and we are comfortable with our 13.2% positioning in the gold miners.

“Inflation is when you pay fifteen dollars for the ten-dollar haircut you
used to get for five dollars when you had hair. – Sam Ewing”

Snapshot

• Investee companies continue to report encouraging results – all consistent with, or above, expectations.
• The stand out was Dick’s Sporting⁴  . Its results quantified just how strong the operation has become – with management deserving full credit as the business reaps the rewards of past initiatives. With its share price performance of 32.1%⁵  , it alone added 1.5% to the Fund’s June quarter’s return.
• Western Forest’s impressive results reflected the favourable conditions in the lumber market, and management’s successful execution on a variety of fronts. Its shares returned 17.1% over the quarter.
• Alphabet and Roche (both formidable businesses) were strong performers. We would have preferred their share prices not rise so strongly, as we were adding to the Fund’s positions in both of these businesses during the quarter.
• For the gold miners, Kirkland Lake and Northern Star’s operations are strong, and their share prices rose accordingly.
• However, Regis Resources announced a fully priced acquisition and raised equity to fund it. The market expressed its disappointment, its share price was down 18.6% and it cost the Fund 1.1% over the quarter.
• There was some modest trading activity, tweaking some positions, accounting for an inflow, and intentionally raising cash to provide some flexibility – as it had reached a record low level of around 3% in mid May.
• We ended June holding the same 26 investee companies as held in March, and with 8.6% cash.

Contribution

Figure 1: Top Contributors/Detractors (Quarter)⁵  

Source: Alluvium, Factset, Private Reporting Pty Ltd.

Figure 2: Top Contributors/Detractors (Since Inception)⁵  

Source: Alluvium, Factset, Private Reporting Pty Ltd.

Contribution (continued)

Table 1: Contribution Details⁵  

Source: Alluvium, Factset, Private Reporting Pty Ltd.

Table 2: Quarterly Purchases

Table 3: Quarterly Sales

Performance Review

As market conditions normalise, returns are becoming more divergent, which is entirely as expected.

On the positive side of the ledger, Dick’s Sporting released its first quarter results – with sales more than double the pandemic affected first quarter of 2020 (and up 52% on 2019) and strong margins leading to record earnings of $3.41 per share. These blew away analysts (and our) expectations. Full year guidance was raised by around 10%. Management has performed admirably, with their investment in online platforms (over a number of years) paying handsome dividends. We discuss Dick’s more in the next section. For now, let’s note the stock jumped 16.9% on the day of the release, and being up 32.1% over the quarter it contributed 1.5% to returns.

Kirkland Lake, which was up 13.1%, also reported solid first quarter results – with more gold produced at lower cost than expected, as well as news of promising mine expansion. It is trading at a quite a discount to our valuation, so we took the opportunity to increase the Fund’s position from 3.6% to 4.0% over the quarter.

Robert Half (up 14.5%), is benefiting from the pent-up post COVID-19 employment and consultancy services demand. We like the business, however its strength is progressively being reflected in its strongly performing share price. This has two ramifications: (1) it has grown in prominence in the portfolio; and (2) it is less attractively priced relative to our conservative valuation. Accordingly, we trimmed our position a little during the quarter.

Western Forest’s impressive results reflected not only the strong lumber market, but also management’s ability to capitalise on it by diverting sales toward the most profitable regions. Management appear to have successfully re-established its operations post the strikes of 2019 and early 2020, and now has fully repaid its debt. Its shares continued their strong run from last quarter, with a return of 17.1%.

The core businesses of Alphabet (Search, Network, Youtube, Cloud) continue to thrive. And Roche (the diagnostic and pharmaceutical company) is also performing solidly. These two juggernauts provide products that have become well entrenched amongst their customers – so they enjoy a fair degree of pricing power. Their businesses are incredibly strong, they are growing, and they are spinning off vast amounts of cash – in which their management teams have invested in attractive endeavours. It is little wonder that, as we look to increase our investment in both, others are bidding up for these “compounding machines”. Alphabet was up 18.4% over the quarter, and Roche up 16.3%.

The Fund still holds a reasonable position (totalling 11.7%) in three “Auto Parts Suppliers” – though we use this term with some hesitancy as two (Methode Electronics and Linamar) are increasingly becoming more diverse. As has been well reported, the semiconductor shortage is causing production issues in the automotive industry – and this clearly has ramifications across the whole supply chain. All three reported results that were in-line or slightly better than expectations, and maintained their confident outlooks – although Linamar did note its expectation of softening volumes in the second quarter and beyond. Both Lear and Methode’s management teams noted automakers were diverting their limited supply of semiconductors to their most profitable platforms, ie higher value vehicles. For example, Lear pointed to the Porsche Taycan and Methode to premium Sports Utility Vehicles. Fortuitously, both Lear and Methode’s components are prevalent on these platforms. As Donald Duda, Methode’s CEO stated on its conference call on 24 June, ”Now, do we get a better allocation of chips because of our customers wanting to ship their premium vehicles, trucks and SUVs? Yes, that does help us…” Share performance was mixed, Methode was up 17.5%, Linamar up 5.2% but Lear was down 3.3%.

We first bought Methode in October 2019. It has been a steady performer for the Fund, but having grown to a large position, and trading at quite a premium to our valuation, we trimmed our holding to 3.1%.

McKesson, a significant player in the healthcare supply chain, also reported strong results. McKesson has been instrumental in the pandemic “effort”, having distributed 170m COVID-19 vaccines doses as of mid-June. This activity partly explains the better than expected results and the upgrade in management’s full year guidance. The business generates strong cash flows, which is judicially being applied to new investments and share repurchases. Management recently announced its agreement to sell parts of its European business, and it is exploring “strategic alternatives” for the remainder. This is an example of its commitment to streamline the operations – with an increasing focus in the areas it has deep expertise and sees as being central to long term growth. All the above tick our “capital allocation” box. Its shares were down 1.7% over the quarter, and we increased our position marginally to 4.6%.

Sticking on that theme for a moment, we can report on two other examples of capital allocation by our investee companies this quarter. One good. One, well, not so good in our view.

HCA Healthcare sold four hospitals in Georgia for USD950m (to a local operator), having recognised these facilities as “not able to fully benefit from a broader HCA Healthcare presence in their areas.” HCA thereby freed up cash for investments in core markets where it is better positioned to add value.

On the other hand, Regis Resources announced its acquisition of a 30% interest in Tropicana, a significant mine located in the Western Australian gold fields that produces around 400 Koz of gold annually. There is no doubt it paid a full price for the asset – and whilst we can sympathise with management’s reasoning, it does not make for a stellar allocation of the capital it raised at a deeply discounted price. We participated in the raising (well, after all, we were sort of forced to), and as a result the Fund’s holding is higher than ideal. But with the market’s reaction being so extreme (the share price fell around 12% initially and has continued to drift lower), despite our disappointment, we view the company as being too cheap to sell. It ended the quarter down 15.6%.

There were four other poor performers. Thor (the manufacturer of recreational vehicles) reported absolutely fantastic results and record order backlogs. But it seems the market wanted more and its share price was down 16.1%. Southwest Airlines, which one can expect to be quite volatile given current uncertainties, was down 13.1% (after returning 31.0% over the March quarter). Micron (the semiconductor manufacturer) was down 3.7% and Vestas (the wind turbine manufacturer) down 5.4%.

We cannot explain why these share prices fell, but perhaps they were due for some reversion, for the yearly returns to the start of this quarter for Thor, Southwest, Micron and Vestas were 227.9%, 71.5%, 109.7% and 138.8% respectively. We are not concerned with these short term market gyrations. There was no news which would cause us to lower our valuations. In fact, quite the contrary – in the case of Thor and Micron, during the June quarter we re-assessed the long term sustainable earnings of these businesses and this led to material increases to our valuations. For Micron it prompted us to increase our investment.

Our activity increased as a result of fund inflows. The net result was increases to our positions in Micron, Roche, Alibaba and McKesson. We allowed our positions in Dick’s Sporting, Capri, and the three Auto Parts Suppliers to be diluted a little. Additionally, as mentioned above, we bought more of the gold producers – Regis Resources (via participation in the equity raising), Northern Star and Kirkland Lake, and we trimmed our Robert Half position.

An intentional outcome was to increase our cash position, which was 8.6% at the end of the quarter.

Dick’s Sporting – Keeping their Eye on the Ball

Back in 1948, soon after the second world war ended, Dick Stack’s Grandma gave her 18 year-old grandson $300 to open a fishing tackle store in Binghamton, New York. Around 30 years later, the business had doubled (two stores), and Ed Stack joined his father. Then, in 1984 Ed and his siblings bought their Dad’s business, and Ed became Chairman and CEO. Since that time, Ed and his cohort have grown and transformed Dick’s into the nation’s largest sporting goods retailer, with over 850 outlets across 47 states, employing around 50,000 “teammates”, and with annual turnover approaching $10b. In February this year, Lauren Hobart, a member of Dick’s management team for ten years, became the company’s third CEO (over 73 years).

Dick’s offers a full range of sporting products – including national brands (like Adidas and Under Armour), and its own brands exclusive to its stores. Dick’s physical presence provides brands with a vast distribution platform, powerfully showcasing their merchandise by offering a comprehensive shopping experience for the customer (for example, its Golf Galaxy stores). We believe that it is this offering which facilitates a strong relationship with the brands – and this is despite them both competing to some extent for the customer relationship. And this is currently being further enhanced by Dick’s first ever “DICK’S House of Sport”, a new concept store, and the experiential “Soccer Shops”, just announced this April.

We are all aware of the effect online retailers have had on the traditional bricks-and-mortar operators over recent years. After all, they are unburdened by costly leases and outdated, inefficient legacy processes. In the sporting arena alone, in February 2017 MC Sports went bankrupt and all of its 68 stores were closed; in September 2016, Golfsmith, which was the largest golfing retailer in the US with 109 stores, filed for bankruptcy; and in March 2016 Sports Authority, which was a major Dick’s competitor with 464 stores filed for bankruptcy.

But rather than succumb to these burdens, Dick’s has successfully adapted to this new era of retailing, for example: by using its store footprint (and expanding it) as the core of its omni-channel strategy; developing and launching its own brands; adding the more “experiential” elements to its stores; and investing in supply chain management and online capabilities. So, whereas competitors have been falling by the wayside, Dick’s has been prudently and opportunistically expanding. In fact, of those bankruptcies listed above, Dick’s acquired Golfsmith (but only kept 36 of its 109 stores), and it acquired the intellectual property of Sports Authority’s e-commerce website and loyalty program, and took over 31 of its store leases.

The result? Well, the ecommerce channel has grown from just 10% of sales in 2014, to 16% in 2018 and to a whopping (pandemic boosted) 30% in 2020. After adding 8.5 million new “athletes” over the past year, Dick’s now has 20 million active members of its loyalty program, and they account for 70% of total sales. Another initiative – which has not been universally applauded – was Dick’s abandoning the sales of firearms and ammunition in all of its stores (in 2019). However, the result of this has been fruitful, with much of that space being more productively used for marketing “proper” sporting products.

Dick’s is one of the Fund’s initial investments stemming from early 2019 (although we also held it directly in the Australian Fund at that time). It came to our attention in late 2018 by our screening processes – with the business achieving high cash returns on its invested capital, and being available at a reasonable price. The shares were trading at that time around $30 or so, and it provided an EBIT yield of 13.7% and a free cash flow yield of 7.8%. Fast forward a few years to today – and despite its share price hovering around $100, those metrics are little changed (in fact, they are a little more attractive).

The retail industry is tough – and Dick’s will continue to face challenges. So far it has met these challenges head-on, and evolved to become a better business as a result of them. We are well aware that Dick’s ongoing success demands that it remains first and foremost in the minds of “athletes”. This means adapting as required to be sure to remain a shopping destination of their choice, and ensuring its own brands, such as its “athleisure” range maintain their appeal. The possibility that management fails in these endeavours is, in our view, the biggest investment risk. However, management’s execution over recent years has been “right on par”, they seems to have “all bases covered”, and if these recent lifestyle trends continue, they may well put some more “points on the board”.

Closing Remarks

We have repeatedly expressed our concerns of the likely consequences of trillions of dollars being pumped into the global economy since the crisis of 2008: capital is not always directed to its optimal use; many assets become outrageously mispriced; and purchasing power declines. With regard to the latter, according to the “official” figures, inflation has, until very recently, been kept under control and the Japanese deflation nightmare has been avoided.

A low, stable and predictable rise in prices is considered by economists to be the best scenario. It means that, for example, consumers are not enticed to delay (nor to bring forward) their purchases and it instils confidence in the credit markets. But the recent “official” inflation figures coming through are vindicating our concerns of sustainably higher than desired inflation. And the anecdotal evidence is even more compelling – we only need to look at commodity prices, building costs, used car prices, etc. Buffett put it very simply at Berkshire’s AGM in early May, noting that they are “seeing very substantial inflation. We are raising prices. People are raising prices to us and it’s being accepted…Every day costs are going up”.

Traditional finance education leads us to believe that inflation is either “demand-pull” (often linked to excess liquidity in the system, ie loose monetary policy), or “cost-push” (which may be led by supply bottlenecks or rising wage pressures). But inflation may also well be the result of a third, more subjective, less technical cause: self fulfilling expectations of it. We believe that consumers, often without even realising it, adapt their behaviours depending on their expectations of future prices or wage levels. But who influences those expectations? Is it not those policymakers who managed to avoid the economic meltdown in the past 13 years?

“Inflation is one of those behavioral things that, once everybody starts worrying about it, that’s when inflation takes root.” – Julia Coronado, former economist at the Fed

We are surprised that after the biggest-ever expansion of money supply in modern history we have only just recently seen inflation pick up. Does it have something to do with consumers placing blind confidence in central bankers to fix problems as they arise? Financial markets are built on trust and credibility. The Chairman of the US Federal Reserve claimed that these recent higher inflation figures are only “transitory”. But there are certainly many, including famous investors, like Stan Druckenmiller, Paul Tudor-Jones, and Ray Dalio which appear to have a different view to that “transitory” nature. We wonder whether there’s been a little too much faith in “central bank” speak over recent years. What could be the consequences if policymakers are proved wrong and lose credibility? Consumers may well start to lose confidence and review their expectations. That in turn brings the risk of higher than desired inflation.

Even though inflation is not haunting our investment methodology, it would be remiss of us not to pay attention to it. Our overarching objective remains to preserve the capital that we have been mandated to diligently manage – and we believe that thinking about inflation is a wise additional overlay to our process.

So how vulnerable is our portfolio? Well, to start with our 8.6% cash is now costly to hold and it is losing purchasing power by the minute. So why hold it? We are reluctantly prepared to pay this price for the optionality it provides.

Our 13.2% position in gold miners is not as clear cut as may appear on the surface. Whilst on the one hand, they provide leveraged exposure to what we consider to be the ultimate long term store of value. But we are also cognisant that, on the other hand, rising oil prices and increased wages pressures, result in fast rising extraction costs. Net-net – we have a positive long term view. We also hold two other commodity linked companies – Lyondellbasell and Western Forest (together 7.3%), and we also believe both are likely to be net beneficiaries of higher prices. So, together that makes around a quarter of the Fund where we feel mildly positive.

A fair chunk of the Fund (18.0%) is dedicated to “health” stocks. Whether it be providing life altering products (Gilead and Roche), or providing facilities for medical procedures (HCA Healthcare), or distributing products at lowest cost (McKesson), we are of the view that the underlying businesses can well withstand inflationary pressures. Likewise, we expect that the “platform” businesses we hold (Alphabet and Alibaba – totalling 6.6% of the Fund) are resilient due to the nature of their products. For example, Google recently upped the fee it charges Alluvium by over 10% – and we didn’t even bat an eyelid! So, all up there’s a quarter of the Fund that we feel is pretty resilient.

The semiconductor companies – Micron and Samsung Electronics – account for 9.8% of the Fund. We can envisage that rising raw material costs may dampen their short term earnings. But, given the critical nature of their products, and our sense that the current high demand is enduring, we do expect that over the longer term, increased costs will effectively feed through the system such that they are ultimately borne by the end consumer. So, we reckon these are also pretty resilient.

Ryanair and Southwest (together 5.0% of the Fund) have earnings which are very sensitive to their fuel costs. However, both have substantial hedges. Ryanair is approximately 50% hedged over the next year at around $54/barrel and Southwest similarly hedged but for a longer time period at about $65/barrel. These contracts go a long way toward mitigating cost increases. Additionally, given what we foresee as significant pent-up demand, we do have some confidence that these airlines will be able to pass on at least a portion of their increased costs through higher fares. And, as the lowest cost operators in their respective regions, we expect both of them to thrive over the longer term (and a little inflation in the interim may well help them on their way). So, we classify these as “mildly vulnerable”.

Conversely, there are pockets of the portfolio (totalling about a quarter) where we do have some concerns – and which we classify as “vulnerable”. For example, the three Auto Parts Suppliers (11.7% of the Fund) are likely to face additional challenges due to rising costs. Although they maintain sound long term relationships with their customers, and their product positioning is strong, they will not be immune to inflationary pressures. Linamar, in relation to the industrial and agricultural markets it serves, recently warned that “supply chain disruptions including shipping container shortages and higher commodity prices are negatively impacting production, shipments and costs in 2021”. And for the consumer sector (Thor, Capri and Dick’s, together 9.9% of Fund), their ability to pass on higher costs is questionable, and in any case likely to be lagging. And as far as the construction business of Vestas (3.1%) is concerned, if the recent experiences of last year are any reliable guide (where margins were significantly impacted by supply chain disruption and consequent higher costs), it does not bode well.

Overall, we have some measures of protection – but they’re not perfect. We derive most comfort from knowing that our investee companies are not trading at super excessive prices, have low levels of financial leverage such that interest rate hikes will have little earnings impact, and they share one or both of the following important attributes: (1) desirable products which offer value at a reasonable price; (2) lowest cost operators in their industry.

To conclude, after being the envy of the world when major cities were fighting the pandemic, Sydney is now in “lockdown”. The limits on our freedom are annoying – but they do not impact our work – which is not disrupted easily! Rest assured – we remain with all hands on deck.

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.