September 2021 | Quarterly Report

Introduction

After a substantial sell off in September, the Fund’s net returns turned negative for the quarter. They were -1.3% for the EUR class and -3.5% for the USD class1  . The Australian Fund posted a return of -4.4%.

Those returns for the last 12 months were 32.2%, 30.7%, and 29.5% respectively.

Snapshot

  • The prize for best performance once again goes to Dick’s Sporting2  . Another outstanding set of results showed continued business momentum. With a total return of 24.9%3   (despite it falling by 11.1% in September), the position contributed 1.3%, a nice addition to the 1.5% it provided during the June quarter.
  • HCA Healthcare, the hospital operator, also performed strongly, with its share price up 17.6%. This business is the topic of our “stock focus” for this report, and is discussed in greater detail in the next section.
  • Robert Half, the recruitment agency and consultancy business rounded out the top three with its 13.2% return.
  • Alphabet’s quarterly update once again verified the mightiness of its business. Its share price was up another 9.5% this quarter, which makes it 82.4% over the last year, and it is now trading around 2.5 times its March 2020 lows.
  • To the contrary, our most recent portfolio addition, Alibaba, faces increased regulatory intervention and market concern of more hurting “common prosperity” measures to come. Its share price fell a whopping 35.4% over the quarter and it now trades at less than half its October 2020 highs.
  • As to whether all the bad news is reflected in the price – we do not know but the odds are increasingly in our favour. We purchased some more at these lower prices, but still the position detracted around 1.8%.
“Sometimes buying early on the way down looks like being wrong, but it isn’t.”- Seth Klarman
  • Our three auto parts suppliers are suffering more than we expected due to low production volumes as a result of the semiconductor shortage. Their returns reflected this, with Linamar down 15.2%, Methode Electronics down 14.3% and Lear down 10.4%. Together, they cost the Fund 1.5%.
  • Talking semiconductors, the shortage is not helping one of the major suppliers of memory chips, Micron Technology, which was down 16.4% over the quarter. Its operations remain strong and we bought more.
  • For the gold miners, it was a mixed but net disappointing performance. The main news was Kirkland Lake’s proposed merger with Agnico Eagle Mines. We are awaiting the formal documents, but at first glance whilst the rationale is sound, we are not enamoured by the proposed relative pricing.
  • Irrespective, Kirkland Lake was up 11.0%. Our other two gold miners, Northern Star and Regis Resources, continued their poor runs of late, down 13.1% and 14.8% respectively and together detracted 1.0% from the Fund’s return.
  • In the case of these latter two, this was exacerbated by the currency impact of a falling AUD. With a reasonably stable gold price (in USD terms), in theory this should have been reflected by corresponding increases to their share prices – but clearly that did not happen.
  • We ended September holding the same 26 investee companies and with 7.2% cash.

Contribution

Figure 1: Top Contributors/Detractors (Quarter)4  

Source: Alluvium, Factset, Private Reporting Pty Ltd.

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

Source: Alluvium, Factset, Private Reporting Pty Ltd.

Contribution (continued)

Table 1: Contribution Details4  

September 2021September 2021 Quarter SummarySeptember 2021 Last 12M Summary
StockEnd WeightBeg. WeightReturnContributionBeg. WeightReturnContribution
Capri Holdings2.3%2.5%-15.5%-0.4%2.5%167.9%4.3%
Dick's Sporting6.0%5.2%23.3%1.3%5.3%115.9%4.1%
HCA Healthcare6.1%5.5%17.6%1.0%4.6%95.3%3.9%
Regis Resources5.4%5.7%-13.1%-0.6%4.1%-56.0%-3.5%
Linamar4.2%4.7%-15.2%-0.7%3.9%67.3%3.2%
Lear Corporation3.9%3.9%-10.4%-0.4%4.6%44.6%2.5%
LyondellBasell5.4%5.2%-7.5%-0.4%5.5%39.2%2.4%
Micron Technology5.3%4.8%-16.2%-0.8%3.7%51.0%2.2%
Methode Electronics2.5%3.1%-14.4%-0.4%3.8%48.8%2.1%
Robert Half2.3%2.1%13.1%0.3%2.0%93.2%2.0%
Samsung Electronics4.7%5.0%-8.2%-0.4%4.7%30.6%1.7%
Ryanair3.5%3.2%2.3%0.1%4.0%43.8%1.7%
Subtotal Equities51.6%50.9%-1.4%48.7%26.6%
Other Equities41.2%40.5%-0.7%33.2%6.6%
Cash, Currency & Fees7.2%8.6%0.8%18.1%-1.0%
Total (EUR)100.0%100.0%-1.3%-1.3%100.0%32.2%32.2%

Source: Alluvium, Factset, Private Reporting Pty Ltd.

Table 2: Quarterly Purchases

AlibabaIncrease Position
Micron TechnologyIncrease Position
LyondellBasellIncrease Position
Regis ResourcesIncrease Position

Table 3: Quarterly Sales

VestasDecrease Position

HCA Healthcare – Pandemic Proof!

Led by Sam Hazem (a 38 year company veteran), HCA Healthcare owns and operates 185 hospitals and approximately 2,000 sites of care, including surgery centers, emergency rooms, urgent care centers and physician clinics across the US and UK. With 50,000 licensed beds and 2 million admissions per year, it accounts for about 6% of US inpatient hospital services. Its collection of high-quality hospitals hosts an extensive breadth of services, and this in turn attracts the talented physicians that can perform the most complex, and hence the most profitable, procedures.

As the market leader in a growing industry, HCA is well positioned to negotiate favourable contracts with its suppliers. And these economies of scale are further enhanced by having concentrated pools of assets in specific regions. Like a shopping centre owner, it wants to dominant certain “catchment areas” – preferably those with attractive demographics that complement its business, by owning the best assets. We suspect HCA’s scale, and its “clustering” of assets, are the main contributors to its higher growth, margins and returns on its capital than its peers in this highly competitive market.

This investment opportunity came to our attention via our usual quantitative screening process. HCA displayed consistent returns on its invested capital (of around 20%), and strong, growing earnings power. And it was cheap. In March last year (when we bought our first tranche), based on our through the cycle estimates, it was trading at less than 10 times earnings, a cash flow yield of 9.2% and an EBIT/EV yield of 11.1% and represented a discount of around 15% to our estimation of value.

We admit we were a little apprehensive – it was an election year and healthcare reform is always front of mind. In hindsight that was inconsequential – little did we know of the magnitude of the upcoming pandemic! One week later the share price had fallen 20%. We continued buying. Another week later the share price fell another 20%. We bought more. And then in mid June 2020, we bought again. But, our view (in fact one of our core tenets) is that this volatility did not make the investment more risky. In the end, we had progressively increased our position as the share price fell and partially recovered, and all this time our estimation of value (which is long term orientated) remained pretty constant. Now the share price is up three times on its March 2020 lows, and around twice our average entry price.

In the midst of the pandemic, with elective surgeries being cancelled or postponed to prioritise beds for an influx of COVID-19 patients, the likely effects to HCA’s revenue and profitability were unknown and the duration of any such effects highly uncertain. This was indeed worrisome. But it also highlighted the importance of HCA’s assets – they were even more in demand. And we were confident that the hit to the revenue line would be short term – after all if the public good was to redirect these assets for that use, it is reasonable to expect that in a democratic society the provider of such facilities would be duly compensated. So whilst we were concerned of imminent earnings impacts, we did feel they would be short term and we were quite confident we would not lose our invested capital.

All signs point toward Mr Hazen and his team handling the operational stresses of the pandemic exceptionally well – changing tack quickly at the onset by immediately delaying expansion projects, suspending its share buyback and dividend (both since reinstated), and agreeing short term salary cuts with staff (rather than furloughs) together with other measures to contain operating costs. At the same time, it rolled out a COVID-19 response model to assist its affiliated physicians to navigate the CARES Act and access its benefits – thereby shoring up its revenue line and strengthening relationships. And although HCA itself benefited from CARES Act funding (to the tune of $6b) this has since been repaid.

An investment in HCA is not without any risk. The industry is very sensitive to government changes, and with a growing deficit, this may well put further pressure on health care programs. Also, increased regulation may result in rising costs. And HCA has higher levels of debt than we generally prefer, however its stable revenues and acceptable cash flow coverage mitigates this concern. But overall, our view is that the impressive operational business metrics we outlined above will continue. So despite the business momentum not keeping pace with the share price momentum, we still see value with it trading at around 15 times expected earnings, and an EBIT/EV yield of 8.3%. It remains one of our top conviction holdings.

Performance Review

The lights at Dick’s Sporting turned green in the midst of the pandemic. And they now shine brighter! In our June report we set out what we like about this business and highlighted its omnichannel strategy, expanding footprint, and its points of difference like the “experimental” stores and own brands. Well, in August, Dick’s again reported an outstanding set of results and it returned 24.9% for the quarter. Flush with cash, a special dividend was declared and an increase in the share buyback announced. And with this business momentum fuelling higher than expected sales and margins, management increased its profit guidance by around 13%. Of course, no one knows (including them) if these levels can be maintained. As usual we prefer to take a cautious view. But, even based on our conservative assumptions, we do not view Dick’s shares as expensive – it is trading at less than 10 times management’s guided earnings for this year, and around 15 times our estimate of sustainable earnings. And this is despite the share price almost tripling over the last year! Dick’s remains a large holding for us, representing 5.9% of the Fund.

HCA Healthcare (which is the Fund’s largest position at 6.4% (which we discussed in the last section), also reported another strong set of results and also significantly increased its earnings guidance for this year. Its return of 17.6% over the quarter continues its consistent performance since we introduced it to the Fund in early March last year.

Both Alphabet and Robert Half (the recruitment agency) continued their strong performances from the June quarter – both in terms of their underlying businesses (as demonstrated by their quarterly updates) and their share prices which were up 9.5% and 13.2% respectively. Alphabet’s diverse range of businesses (Google, Youtube, Waze, Nest, Fitbit, DeepMind, Waymo, Android, Verily, etc) on the whole are very strong, and analysts have continued to upgrade their earnings estimates. And Robert Half is continuing to benefit from staff shortages, increased efficiencies, and the trend to hybrid/remote working arrangements which they believe to be structural (and we do too). The environment over the last 18 months or so has been beneficial to this business – more so than we had envisaged when we trimmed our position in May.

To the contrary, our most recent portfolio addition, Alibaba, faces increased regulatory intervention – and it seems the market is (rightly) concerned. This intervention does not come as a surprise to us. In our March 2021 report we specifically noted the regulatory risks associated with our Alibaba investment (as well as many other risks in which we have no way of knowing) and our preparedness to accept them. Well clearly the CCP’s recent actions serve as a stark illustration of these risks. The consequent (and understandable) market reactions overwhelmed the generally positive operating results Alibaba reported in August, and its share price fell 35.4% over the quarter. With a free cash flow yield of 6.5%, a net cash position, and impressive (albeit declining) returns on capital, we judged the risk versus return equation in favour of purchasing some more at these lower prices thereby increasing the Fund’s position to 4.4%. Only time will tell if that was a wise judgement.

The Fund holds three automobile part suppliers, and they all continue to suffer from low vehicle production volumes due to the semiconductor shortage. These are turning out to be worse than we expected (and spoke about in our last report). The IHS Markit announcement of its largest single adjustment to its automobile production forecasts (provided in mid September) illustrates the extent of the problems – 2021 forecast cut by 6.2% (from 80.5m to 75.8m units) and 2022 cut by 9.3% (from 91.1m to 82.6m units)5. It estimates that so far this year, lost production has been 1.4m in the first quarter, 2.6m in the second, and 3.1m in the third quarter (to mid September). The first half shortages were due to the ice storm in Texas and the fire at a Japanese facility. Of more concern, the current shortage stems from rolling lockdowns in Malaysia affecting packaging and testing. Malaysia supplies an estimated 13% of global semiconductors to the automobile industry. It is also a major supplier of semiconductors for wider applications, meaning the automotive sector will be competing for supply as the backlog clears.

The effects have now extended across more platforms (including more which our companies supply), so it is becoming increasingly pronounced for them. During their updates, all warned that plant shutdowns were increasing and most likely to continue. Lear Corporation, for example, highlighted the lack of advance notice of production changes, which is proving to be particularly challenging and leading to declines in their own plant’s efficiencies.

All three management teams have also mentioned that supply chain and logistical challenges have resulted in increased costs. And raw material prices are also rising – in some cases very dramatically. Perhaps the best example: the hot-rolled coil steel price which typically ranges from $300-$800 per tonne, and which prior to this year had never reached $1,000, has now been above $1,000 all year, and at the time of writing was approaching $2,0006. Although these businesses do have some ability to pass these costs through to the automakers, it is limited and there is always a few months delay.

Despite all this, the quarterly updates from these companies did not contain entirely bad news. Linamar still guides to strong growth this year and next (albeit noting that it is quite uncertain) and Methode Electronics has maintained its earnings guidance (but also noting increased uncertainty). Lear however lowered its revenue outlook by around 3% (as a result of known lost sales since its May guidance) and due to those rising costs we mentioned (and delays in passing them through) its bottom line earnings have been revised down by 17.1%.

All indications are that the pent-up consumer demand for new cars is very strong, and that these sales are not “lost” but merely “deferred” (until the semiconductors become available), and so they will add to future year’s sales . But the share price declines of these companies is arguably reflecting these business disruptions to be of a more permanent nature. Over the quarter, Lear returned -10.4%, Linamar -15.2% and Methode -14.3%. At the end of September, these three investments, after costing the Fund 1.5% in return, represented 10.6% of the Fund.

Whilst talking semiconductors, one of the major suppliers of memory chips (Micron), which represents 5.3% of the Fund, saw its share price continue its downward trajectory from its April peaks (down 16.4% over the quarter). This makes little sense to us, as its July reports confirmed the strength of the business, and the updated capital allocation plan announced in August (which included the initiation of a dividend and a more opportunistic approach to share buybacks) as well as its September update, vindicated this. Perhaps it is a reaction to concerns over the near term over DRAM pricing. Regardless, we viewed this sell-off as an excellent opportunity to increase our position. After all, as we see it, the long-term case of extraordinary growth in memory demand (stemming from artificial intelligence, internet of things, 5G) remains absolutely unchanged.

We view our investment in the gold miners (to date) to be an insurance policy which is unfortunately becoming all the more expensive. With Regis Resources being down 13.6% and Northern Star down 12.3% – only Kirkland Lake provided a little respite (being up 11.0%). The most noteworthy news across these holdings was the announced agreed merger of Kirkland Lake and Agnico Eagle Mines, a Canadian listed primarily gold miner with mostly Canadian assets. Their asset bases and the consequent scale of the enterprise, certainly auger well for synergies – but we harbour some initial reservations on the relative pricing. We will wait to review the further more detailed documentation before passing any more comment.

We have mentioned in previous reports that we endeavour to continually refine our process. This includes taking a longer term view of our investments – which therefore entails longer holding periods and by extension, lower turnover levels. This has indeed been the case. The only trading of any note during the quarter was our purchasing of Alibaba to increase its position from 3.3% to 4.4%. In fact this is the only new position over the last year. We also have only completely sold out of one business (Delta Airlines) over the last year. So we ended the quarter with the same 26 holdings as we started, and 7.2% cash.

We hope that you are physically and mentally fit and well during these trying times, and as always we appreciate your interest.

Stuart Pearce
Principal

22 October 2021

Alexis Delloye
Principal

Profile

Figure 3: Diversification by Sector

Source: Alluvium, Factset

Figure 4: Diversification by Region

Source: Alluvium, Factset

Table 4: Fund Overview

Cash7.2%
Top 15 Holdings67.9%
Number of Holdings26
Weight Average Mkt Cap. (USD m)144,131

Source: Alluvium, Factset

Table 5: Quality Metrics (weighted average)

Fixed Charges Coverage (3y median)8.5x
Sales Growth (3y average)5.9%
Return on Invested Capital (3y average)25.6%
Return on Invested Capital (8y average)26.0%

Source: Alluvium, Factset

Table 6: Pricing Metrics (weighted average)

Enterprise Level Yield (EBIT/EV)8.5%
Earnings Yield (NPAT/Mkt Cap)6.2%
Free Cash Flow Yield (FCF/Mkt Cap)6.2%

Source: Alluvium, Factset

Table 7: Top 15 Holdings

HCA Healthcare6.1%
Dick's Sporting6.0%
LyondellBasell5.4%
Regis Resources5.4%
Micron Technology5.3%
McKesson5.0%
Samsung Electronics4.7%
Kirkland Lake4.5%
Alibaba4.4%
Linamar4.2%
Lear Corporation3.9%
Roche3.5%
Ryanair3.5%
Alphabet3.4%
H&R Block2.9%

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

3 Source: Factset

4 Returns are time weighted, include dividends, withholding tax, trading costs and are expressed in local currency.

5 https://ihsmarkit.com

6 Source: Factset – U.S. Midwest Domestic Hot-Rolled Coil Steel (CRU) Index

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.

By | 2021-10-29T08:50:59+11:00 October 2021|Reports|0 Comments

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