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.